Author: Pascal Hügli, Brick Towers, Translator: Luccy, BlockBeats
Editor’s Note:
As the Bitcoin market matures and various income products emerge, people are starting to think about how to promote the financialization process of Bitcoin while maintaining its native characteristics. This article discusses different categories of Bitcoin income products, emphasizing the importance of localized design in reducing trust dependencies and counterparty risks.
By analyzing existing solutions and using the Brick Towers project as an example, Pascal Hügli demonstrates how combining native Bitcoin consensus, assets, and income can achieve a close fit with Bitcoin’s core principles. The article highlights the importance of balancing innovation and risk management in the process of digitizing currencies. Despite numerous challenges and unknown factors, Bitcoin, as an open and decentralized protocol, will continue to lead the direction of financial technology development with its localized design and fundamental characteristics.
Bitcoin is undergoing a remarkable evolution, with multiple perspectives on its nature. Some view it as a currency for daily transactions, others as a modern gold for storing value, and some as a decentralized global platform for protecting and verifying off-chain transactions. While these views have their merits, Bitcoin is increasingly being seen as a digital foundational currency.
Similar to physical gold, Bitcoin functions as a holding asset, an inflation hedge tool, and provides a currency face value similar to the US dollar, reshaping the concept of currency base assets. 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, raising questions about their predictability and effectiveness in the volatile, uncertain, complex, and ambiguous (VUCA) era.
This contrast is especially pronounced in Nobel laureate Friedrich August von Hayek’s criticism of centralized monetary decision-making in his work “The Pretense of Knowledge”. Bitcoin’s transparent and predictable monetary policy contrasts sharply with the opaque and potentially unpredictable nature of traditional fiat currency management.
To leverage Bitcoin or not?
For staunch Bitcoin supporters, the 21 million supply limit is sacrosanct and inviolable. Changing this limit would fundamentally alter the nature of Bitcoin, making it entirely different. Therefore, the Bitcoin community generally views leveraged Bitcoin with skepticism. Many believe that any form of leverage is akin to fiat currency practices and undermines Bitcoin’s core principles.
This skepticism towards leveraged Bitcoin is rooted in the distinction between commodity credit and circulation credit outlined by Ludwig von Mises. Commodity credit is based on real savings, while circulation credit lacks such support, resembling unsecured notes. Bitcoin supporters argue that leveraging creates “paper Bitcoins,” which are economically risky and unstable.
Even within the community, some more nuanced viewpoints maintain caution towards leveraged Bitcoin, aligning with positions held by Caitlin Long and others. Caitlin Long has long been warning about the dangers of leveraged Bitcoin. In 2022, the collapse of some leverage-based Bitcoin lending companies like Celsius and BlockFi further reinforces Long’s and others’ concerns about the risks of leveraged Bitcoin.
Celsius and other companies demonstrate this
In 2022, the crypto market experienced significant turmoil similar to the collapse of Lehman Brothers, triggering widespread credit tightening and affecting multiple participants in the crypto lending space. Contrary to assumptions, most crypto lending activities are not peer-to-peer and carry significant counterparty risks since customers lend funds directly 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 income generation pathways. However, many of these protocols lacked sustainable business models and token economics. They heavily relied on the inflation of protocol tokens to sustain attractive returns, leading to an unsustainable ecosystem detached from basic economic principles.
The crypto credit crunch of 2022 exposed various issues with centralized income tools, highlighting concerns about transparency, trust, liquidity, market, and counterparty risks. Additionally, it underscored the flaws of centralized and off-chain risk management processes when applied to blockchain-based “banking services,” mirroring the shortcomings of traditional banking.
Despite the optimism brought by the bull markets of 2020 and 2021, the lack of these necessary processes led to the collapse of many institutions like Voyager, Three Arrows Capital, Celsius, BlockFi, and FTX. The inability to transparently and independently implement necessary checks and balances often results in overregulation and recurrent failures and fraud, reflecting historical challenges of the traditional banking system. However, a lack of regulation is not the solution either.
Bitcoin income is not optional
So how do we proceed? Given the events of 2022, more and more Bitcoin supporters are asking the question: should we accept Bitcoin income products, or do they pose too much risk similar to fiat currency systems? While these concerns are valid, expecting Bitcoin income products to disappear entirely is unrealistic.
With the development of the emerging Bitcoin ecosystem, this question becomes increasingly pressing. More and more projects are establishing or claiming to directly develop financial infrastructure and applications on top of Bitcoin. Could this lead us to encounter the same problems we have already seen in the broader crypto space?
It is highly likely. Because that’s the nature of the game. As Bitcoin is a permissionless protocol, anyone can build on it, including those who wish to establish a Bitcoin-driven financial system. And financial systems inevitably require credit and leverage.
This is a historical fact: in any prosperous society, the demand for credit and income naturally arises, becoming a catalyst for economic growth. Undeveloped economies struggle to escape survival without credit. Only through access to credit can more complex and efficient economic structures be formed.
To realize a Bitcoin-based economic vision, supporters recognize the need to develop credit and income mechanisms on top of the Bitcoin protocol. While Bitcoin is often praised as a currency, the reality is that to operate effectively as a currency, it needs a local economy to support it.
This highlights the importance of Bitcoin-based income products in promoting Bitcoin-centric economic growth. Such an ecosystem will leverage Bitcoin as its digital foundational currency while utilizing income products to drive its adoption and use.
It’s all a matter of trust, anonymity. 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 layers within assets similar to currency. To properly understand these necessary trade-offs, we must…A sophisticated framework is needed to differentiate Bitcoin implementations at different levels.
When considering Bitcoin returns, it is essential to understand that these options can be built along a triple trust spectrum. The key areas of focus are:
– Consensus
– Assets
– Returns
Evaluating Bitcoin-like assets and Bitcoin yield products based on the degree of Bitcoin nativeness provides a valuable framework to assess their consistency with the spirit of Bitcoin. Assets and products that score higher on this spectrum generally minimize trust, reducing reliance on intermediaries and instead relying on transparent and flexible code.
This shift reduces counterparty risk, as dependence shifts from off-chain intermediaries to code. The transparency of the code enhances flexibility compared to the need to trust intermediaries.
This is a direction worth exploring, creating native yield options for Bitcoin should be the gold standard and ultimate goal for the Bitcoin community.
Consensus Perspective:
Based on the consensus consistency of the Bitcoin blockchain, Bitcoin yield products can be divided into four categories:
1. No Consensus: This category refers to infrastructure that is still centralized off-chain platforms. Examples include centralized platforms like Celsius or BlockFi, which have full control over user assets, exposing users to counterparty risks and dependence on intermediaries. While these platforms use Bitcoin, their yield strategies are primarily executed off-chain through traditional financial mechanisms. Although these platforms are a step towards Bitcoin adoption, they are still highly centralized, similar to traditional financial institutions but often lacking regulation.
2. Independent Consensus: In this category, the infrastructure is decentralized, represented by public blockchains such as Ethereum, BNB Chain, Solana, and others. These blockchains have their own independent consensus mechanisms, not directly linked to Bitcoin’s consensus.
3. Inherited Consensus: In this category, the infrastructure is decentralized, represented by distributed consensus representatives of Bitcoin sidechains or Layer-2 solutions. While these sidechains have their own consensus mechanisms, they are designed to align more closely with the Bitcoin blockchain. Examples include federated sidechains like Rootstock, Liquid Network, or Stacks.
4. Native Consensus: This category relies on Bitcoin’s own consensus mechanism as the basis for a security model. It does not use independent blockchains or sidechains but leverages off-chain state channels linked to the Bitcoin blockchain through cryptographic means. The Lightning Network is a significant example of this approach, providing high trust minimization by fully relying on Bitcoin’s consensus.
Bitcoin yield products that are closer to Bitcoin’s native consensus are considered to have a higher alignment with Bitcoin and are generally seen to have a higher level of trust minimization. However, in the independent consensus and inherited consensus categories, there are subtle differences in the decentralization level and security of the infrastructure.
Overall, decentralized and trust-minimized levels are lowest in no consensus, whereas native consensus is considered to provide the highest level of trust minimization, although considerations for consensus security and decentralization still require further analysis.
Asset Perspective:
When considering the assets used in Bitcoin yield products, their alignment with Bitcoin can be divided into three categories:
1. Non-BTC: This category includes solutions that use assets other than BTC, resulting in lower alignment with Bitcoin. An example is stacking options in which the native token STX is used to generate BTC yield.
2. Tokenized BTC: In this category, the assets used are tokenized versions of BTC, increasing alignment 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), among others. Additionally, tokenized BTC is hosted on Bitcoin sidechains with inherited consensus mechanisms, such as sBTC, XBTC, aBTC, L-BTC, and RBTC.
3. Native BTC: The assets in this category are on-chain Bitcoin (BTC), without involving any tokenized versions, providing the highest level of Bitcoin alignment. Various CEX solutions and Babylon’s Bitcoin staking protocol directly utilize BTC. Babylon aims to enhance Bitcoin security by adapting a proof-of-stake mechanism through Bitcoin staking. Additionally, projects like Stroom Network utilize the Lightning Network for streaming staking, where users can earn Lightning Network income by depositing BTC and minting wrapped tokens like stBTC and bstBTC on EVM-based blockchains for the broader DeFi ecosystem.
Return Perspective:
When examining the returns of Bitcoin yield products, the issue of alignment with Bitcoin arises, leading to similar classifications as with assets: non-BTC, tokenized BTC, and native BTC.
1. Non-BTC Returns: Babylon provides returns through its proof-of-stake (PoS) blockchain’s native assets, enhancing blockchain security through Babylon’s staking mechanism.
2. Tokenized BTC Returns: Stroom Network offers returns in the form of lnBTC tokens. Sovryn, running on Rootstock, promotes Bitcoin lending by using tokenized BTC (RBTC) as returns. On the Liquid Network, Blockstream Mining Note (BMN) provides BTC or L-BTC returns upon maturity, offering qualified investors a way to obtain Bitcoin hash power through compliant USDT security tokens.
3. Native BTC Returns: Stacks offers various options, including returns paid in tokenized BTC in some yield applications using sBTC. However, for stacking options in Stacks, returns accumulate in native BTC. Similarly, some centralized yield products offered by CEXs distribute native BTC as returns to users.
The Gold Standard for Bitcoin: Complete Nativeness
When considering ideal Bitcoin-based yield products, the gold standard product would combine the following three characteristics: native Bitcoin consensus, native Bitcoin assets, and native Bitcoin returns. Such products would mimic near-perfect alignment with Bitcoin.
Currently, such solutions are just beginning to be constructed. One actively developed project is Brick Towers. Their vision for an ideal Bitcoin-based yield product encompasses achieving near-perfect Bitcoin alignment by incorporating native Bitcoin consensus, assets, and returns. Brick Towers focuses on Bitcoin as a long-term savings solution, aiming to provide customers with a trust-minimized and native approach to leverage Bitcoin.
Their planned solution revolves around generating native yield in Bitcoin, utilizing Brick Towers’ automated services for other nodes in the Lightning Network. By optimizing algorithms for economic benefits, capital is strategically allocated to meet the liquidity needs of other network participants, optimizing capital efficiency while minimizing counterparty risks.
This approach not only promotes the growth of the Lightning Network but also enhances the utility of Bitcoin as an asset, providing customers with a seamless and secure way to earn income from holding Bitcoin. Importantly, Brick Towers’ solution avoids the use of wrapped coins, further reducing counterparty risks and reinforcing their commitment to the native Bitcoin ecosystem.
