Can Bitcoin be a productive asset?

Authors: Pascal Hügli, Brick Towers

Compiled by Luccy, BlockBeats

Editor's note:

With the maturation of the Bitcoin market and the emergence of various income products, people are starting to think about how to promote its financial process while maintaining the local characteristics of Bitcoin. This article discusses different categories of Bitcoin income products, from local consensus and assets to income, and emphasizes the importance of local design in reducing trust dependence and counterparty risk.

In analyzing existing solutions, taking the Brick Towers project as an example, Pascal Hügli demonstrated how to achieve close to perfect Bitcoin fit by combining local Bitcoin consensus, assets, and income. This article emphasizes the importance of balancing innovation and risk management in the financialization process of digital currency. Despite many challenges and unknown factors, Bitcoin, as an open and decentralized protocol, its localization design and basic characteristics will continue to lead the development direction of financial technology.

Bitcoin is undergoing a remarkable evolution, and there are multiple perspectives on its essential nature. Some see it as a currency for everyday transactions, while others view it as a modern-day gold for storing value. Still, others see it as a decentralized global platform for safeguarding and verifying off-chain transactions. While these perspectives all have their merits, Bitcoin is increasingly being seen as a form of digital foundational currency.

The function of Bitcoin is similar to physical gold, serving as a holding asset, hedging tool against inflation, and providing currency denomination similar to the US dollar. Bitcoin is reshaping the concept of currency as a fundamental asset. Its transparent algorithm and fixed supply of 21 million units ensure a non-discretionary monetary policy. In contrast, traditional fiat currencies like the US dollar rely on central authorities to manage their supply, which raises questions about their predictability and effectiveness in volatile, uncertain, complex, and ambiguous (VUCA) times.

This contrast is particularly prominent in Nobel laureate Friedrich August von Hayek's criticism of centralized monetary decision-making in his work 'The Pretense of Knowledge'. The transparent and predictable monetary policy of Bitcoin contrasts sharply with the opaque and potentially unpredictable nature of traditional fiat currency management.

Whether to use BTC

For staunch Bitcoin supporters, the 21 million supply cap is sacrosanct. Altering this cap would fundamentally change the nature of Bitcoin, making it entirely different. Therefore, the Bitcoin community generally views leveraged Bitcoin with suspicion. Many believe that any form of leverage is akin to the practices of fiat currency, undermining the core principles of Bitcoin.

The suspicion of leveraged Bitcoin is rooted in the difference between commodity credit and circulation credit outlined by Ludwig von Mises. Commodity credit is based on real savings, while circulation credit is not supported in this way, similar to unsecured promissory notes. Bitcoin supporters believe that leveraged trading creates 'paper bitcoins' that are economically risky and unstable.

Even some more detailed views within the community maintain a cautious attitude towards leveraged Bitcoin, consistent with the position of Caitlin Long and others. Caitlin Long has been warning of the dangers of leveraged Bitcoin. In 2022, the collapse of some leveraged Bitcoin lending companies such as Celsius and BlockFi further reinforced Long's and others' concerns about the risks of leveraged Bitcoin.

Celsius and other companies have proven this point

The encrypted market experienced a major turmoil in 2022 similar to the collapse of Lehman Brothers, triggering widespread credit tightening and affecting multiple participants in the encryption lending field. Contrary to assumptions, most encrypted lending activities are not peer-to-peer and involve significant counterparty risk, as customers directly lend funds to platforms, which then invest these funds in speculative strategies without adequate risk management.

During the DeFi summer of 2020, the rise of major DeFi protocols provided promising avenues for yield generation. However, many of these protocols lack sustainable business models and tokenomics. They heavily rely on inflation of protocol tokens to sustain attractive yields, resulting in an unsustainable ecosystem that deviates from fundamental economic principles.

The crypto credit tightening in 2022 has exposed various issues with centralized income tools, highlighting concerns about transparency, trust, liquidity, market and counterparty risks. In addition, it also highlights the flaws in centralized and off-chain risk management processes, which mimic the flaws of traditional banks when applied to blockchain-based "banking services".

Despite the optimism brought by the bull markets in 2020 and 2021, the lack of these necessary processes has led to the collapse of many institutions such as Voyager, Three Arrows Capital, Celsius, BlockFi, and FTX. The inability to implement necessary checks and balances transparently and independently often leads to over-regulation and recurring failures and fraud, reflecting the historical challenges of the traditional banking system. However, the lack of regulation is not the solution either.

Bitcoin Profit Is Not Optional

So, how should we respond? In light of this event in 2022, more and more Bitcoin supporters are raising the question: should we accept Bitcoin income products, or do they pose too much risk, similar to the fiat currency system? While these concerns are valid, it is unrealistic to expect Bitcoin income products to disappear completely.

With the development of the emerging Bitcoin ecosystem, this issue is becoming more and more prominent. More and more projects are building or claiming to develop financial infrastructure and applications directly on Bitcoin. Will this once again bring up the issues we have seen in the wider encryption field?

It is very likely. Because that's the nature of the game. Since Bitcoin is a permissionless protocol, anyone can build on top of it, including those who want to create a Bitcoin-driven financial system. And the financial system inevitably needs credit and leverage.

This is a historical fact: in any prosperous society, the demand for credit and returns will naturally arise, becoming a catalyst for economic growth. Without credit, underdeveloped economies will find it difficult to escape the state of subsistence. Only by obtaining credit can a more complex and efficient economic structure be formed.

To achieve the Bitcoin-based economic vision, supporters recognize the need to develop credit and yield mechanisms on top of the Bitcoin protocol. Although Bitcoin is often praised for its role as a currency, the reality is that to operate as a currency effectively, it needs a local economy to support it.

This highlights the importance of Bitcoin-based yield products in promoting Bitcoin-centric economic growth. Such an ecosystem will leverage Bitcoin as its digital base currency, while using yield products to promote its adoption and use.

This is a trust range, anonymous

A Bitcoin-driven financial system will inevitably be built in layers. From a systemic perspective, this is not much different from the current financial system, which also has inherent levels in similar currency assets. To understand these necessary trade-offs correctly, we need a high-level framework to differentiate Bitcoin implementations at different levels.

When providing BTC returns, it is necessary to understand that these options can be built along a triple trust range. The main focus should be on:

· Consensus

· Assets

· Income

Evaluating Bitcoin-native assets and Bitcoin yield products based on the degree of Bitcoin nativeness provides a valuable framework for assessing their consistency with the Bitcoin ethos. Assets and products that score higher on this spectrum typically prioritize trust minimization, reduce reliance on intermediaries, and instead rely on transparent and resilient code.

This transformation reduces the risk of the other party because the reliance on intermediaries outside the chain is transferred to the code. The transparency of the code enhances flexibility compared to the need for trusted intermediaries.

This is a direction worth exploring, creating local revenue options for Bitcoin should be the gold standard and ultimate goal of the Bitcoin community.

Consensus Perspective

According to the consensus of the Bitcoin blockchain, Bitcoin revenue products can be divided into four categories.

No Consensus: This category refers to the infrastructure still being off-chain centralised platforms. For example, Celsius or BlockFi, these centralised platforms completely control user assets, exposing users to counterparty risks and reliance on intermediaries. Although these platforms use Bitcoin, their profit strategies are mainly executed off-chain through traditional financial mechanisms. While these platforms are a step towards Bitcoin adoption, they are still highly centralised, similar to traditional financial institutions, but often lack regulation.

Independent Consensus: In this category, the infrastructure is decentralized, represented by public blockchains such as Ethereum, BNB Chain, Solana, and other blockchains. These blockchains have their own consensus mechanisms independent of Bitcoin, and are not explicitly tied to the consensus of Bitcoin.

Inherited Consensus: In this category, the infrastructure is decentralized, represented by the distributed consensus of Bitcoin sidechains or Layer-2 solutions. Although these sidechains have their own consensus mechanism, they are designed to align more closely with the Bitcoin blockchain. Examples include federated sidechains such as Rootstock, Liquid Network, or Stacks.

Local consensus: This category relies on the security model based on the consensus mechanism of Bitcoin itself. It does not use independent blockchains or sidechains, but uses encrypted off-chain state channels linked to the Bitcoin blockchain. The Lightning Network is an important example of this approach, which provides a high degree of trust minimization by relying entirely on Bitcoin's consensus.

The closer the Bitcoin income product is to the local consensus of Bitcoin, the higher the degree of fit with Bitcoin, and it is generally considered that the degree of trust minimization is also higher. However, in the two categories of independent consensus and inherited consensus, there are subtle differences in the degree of decentralization and security of the infrastructure.

Overall, decentralized without consensus and minimal trust have the lowest level, while local consensus is considered to provide the highest level of minimal trust, although consensus security and decentralization considerations still need further analysis.

Source: Brick Towers

Asset Perspective

When considering the assets used in Bitcoin yield products, they can be divided into three categories based on their fit with Bitcoin.

Non-BTC: This category includes solutions that use assets other than BTC, resulting in lower alignment with Bitcoin. An example is the stacking option of Stack, in which the native token STX of Stack is used to generate BTC returns.

Tokenized BTC: Here, the asset used is a tokenized version of BTC, which increases compatibility with Bitcoin compared to non-BTC assets. Tokenized BTC can be found on public blockchains such as Ethereum (WBTC, renBTC, tBTC), BNB Chain (wBTC), Solana (tBTC), etc. In addition, tokenized BTC is held on Bitcoin sidechains with inherited consensus mechanisms, such as sBTC, XBTC, aBTC, L-BTC, and RBTC.

Native BTC: This category of assets is on-chain Bitcoin (BTC), without involving any tokenized versions, providing the highest level of Bitcoin compatibility. Various CEX solutions and Babylon's Bitcoin staking protocol directly utilize BTC. Babylon aims to enhance the security of Bitcoin by adapting the Proof of Stake mechanism for Bitcoin staking. In addition, projects like Stroom Network utilize the Lightning Network to achieve liquid staking, allowing users to earn Lightning Network income by depositing BTC and minting wrapped tokens such as stBTC and bstBTC on EVM-based blockchains for a broader DeFi ecosystem.

Source: Brick Towers

Perspective of Profits

When examining the yield of Bitcoin income products, it involves the issue of conformity with Bitcoin, leading to similar classifications as with assets: non-BTC, tokenized BTC, and native BTC.

Non-BTC income: Babylon provides income through its Proof of Stake (PoS) blockchain's native assets, and enhances the security of the blockchain through Babylon's staking mechanism.

Tokenization of BTC yields: Stroom Network provides lnBTC in token form. Sovryn, running on Rootstock, promotes Bitcoin lending business by using tokenized BTC (RBTC) as yields. On Liquid Network, Blockstream Mining Note (BMN) provides BTC or L-BTC yields at maturity, offering accredited investors a path to obtain Bitcoin computing power through USDT security tokens that comply with EU standards.

Local BTC earnings: Stacks offers various options, including earning through tokenization of BTC in certain income applications, using sBTC. However, for stacking options on Stacks, earnings accumulate in local BTC. Similarly, some centralized income products provided by CEX distribute local BTC as earnings to users.

Source: Brick Towers

The Gold Standard of Bitcoin: Fully Localized

Given the ideal Bitcoin-based income products, the gold standard product will combine the following three features: local Bitcoin consensus, local Bitcoin assets, and local Bitcoin income. Such a product will mimic the perfect Bitcoin fit.

Currently, such solutions are just beginning to be built. One actively developing project is Brick Towers. Their vision for an ideal Bitcoin-based yield product covers achieving a close fit to Bitcoin by incorporating local Bitcoin consensus, assets, and yield. Brick Towers focuses on using Bitcoin as a long-term savings solution, aiming to provide customers with minimal trust reliance and localized approaches to utilizing Bitcoin.

Their planned solution revolves around generating local income in Bitcoin, using Brick Towers' automated service for other nodes in the Lightning Network. By optimizing algorithms to address economic benefits, capital is strategically allocated to meet the liquidity needs of other network participants, thus minimizing counterparty risk while optimizing capital efficiency.

This method not only promotes the growth of the Lighting Network, but also enhances the practicality of Bitcoin as an asset, while providing customers with a seamless and secure way to earn Bitcoin holding income. It is important to note that Brick Towers' solution avoids the use of wrapped coins, further reducing counterparty risks and strengthening their commitment to the Bitcoin local ecosystem.