Author: Pascal Hügli, Brick Towers, Translation: Luccy, BlockBeats
Editor’s Note:
As the Bitcoin market matures and various profit products emerge, people are beginning to consider how to promote the financialization process of Bitcoin while maintaining its local characteristics. From local consensus, assets to income of Bitcoin, this article discusses different categories of Bitcoin profit products and emphasizes the importance of localized design in reducing trust dependency and counterparty risk.
While analyzing existing solutions, using the Brick Towers project as an example, Pascal Hügli demonstrates how to achieve a near-perfect fit for Bitcoin by combining local Bitcoin consensus, assets, and income. The article emphasizes the importance of balancing innovation and risk management in the process of digital currency financialization. Despite facing many challenges and unknown factors, Bitcoin, as an open and decentralized protocol, its localized design and fundamental characteristics will continue to lead the development direction of financial technology.
Bitcoin is undergoing a remarkable evolution, with multiple perspectives on its essence. Some see it as a currency for daily transactions, others as modern gold for storing value, and some view it 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 base currency.
Bitcoin’s functions are similar to physical gold, serving as a holding asset, inflation hedge tool, and providing currency denominations similar to the 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 dollar rely on central authorities to manage their supply, raising questions about predictability and effectiveness in the volatile, uncertain, complex, and ambiguous (VUCA) era.
This contrast is particularly highlighted 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.
Whether to leverage Bitcoin
For staunch Bitcoin supporters, the 21 million supply limit is considered sacred 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 the practices of fiat currency, undermining the core principles of Bitcoin.
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, similar to unsecured promissory notes. Bitcoin supporters believe that leveraged operations create “paper Bitcoins” which are economically risky and unstable.
Even within the community, more nuanced views on leveraged Bitcoin are cautious, consistent with the stance of Caitlin Long et al. Caitlin Long has been warning about the dangers of leveraged Bitcoin. In 2022, the collapse of some leverage-based Bitcoin lending companies like Celsius and BlockFi further reinforced Long’s and others’ concerns about the risks of leveraged Bitcoin.
Celsius and other companies proved this point
The crypto market experienced significant turmoil in 2022, similar to the collapse of Lehman Brothers, triggering widespread credit tightening and impacting multiple participants in the crypto lending space. Contrary to assumptions, most crypto lending activities are not peer-to-peer and carry considerable counterparty risk, as customers lend funds directly to platforms, which then invest these funds in speculative strategies without sufficient risk management.
During the DeFi summer of 2020, the rise of major DeFi protocols provided promising avenues for generating income. However, many of these protocols lacked sustainable business models and token economics. They heavily relied on protocol token inflation to sustain attractive returns, resulting in an unsustainable ecosystem detached from basic economic principles.
The crypto credit tightening in 2022 exposed various issues with centralized income tools, highlighting concerns about transparency, trust, and liquidity, as well as market and counterparty risks. It also underscored the flaws in centralized and off-chain risk management processes, which, when applied to blockchain-based “banking services,” mirrored the shortcomings of traditional banking.
Despite the optimism brought by the bull market 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. Inability to transparently and independently implement the necessary checks and balances often led to overregulation and recurring 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 should we respond? Given the events of 2022, more and more Bitcoin supporters are asking: should we accept Bitcoin income products, or do they pose too much risk, similar to the fiat currency system? While these concerns are valid, hoping for Bitcoin income products to completely disappear is unrealistic.
With the development of the emerging Bitcoin ecosystem, this issue becomes increasingly prominent. More projects are building or claiming to directly develop financial infrastructure and applications on Bitcoin. Will this lead to the same problems we have seen in the broader crypto space again?
It is likely. Because that’s the nature of the game. Since Bitcoin is a permissionless protocol, anyone can build on it, including those who want 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. Underdeveloped economies struggle to move beyond survival without credit. It is only through access to credit that more complex and efficient economic structures can be formed.
To realize the economic vision based on Bitcoin, supporters recognize the need to develop credit and income mechanisms on top of the Bitcoin protocol. While Bitcoin is often praised for its role as a currency, the reality is that for it to function 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 base currency while using 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 in assets similar to currency. To properly understand these necessary trade-offs, weA high-level framework is needed to differentiate Bitcoin implementations on different levels.
When providing Bitcoin returns, it is crucial to understand that these options can be built along a triple trust spectrum. The key areas of focus include:
Consensus
Assets
Returns
Assessing Bitcoin-like assets and Bitcoin yield products based on the degree of Bitcoin nativeness provides a valuable framework for evaluating their consistency with the spirit of Bitcoin. Assets and products that score higher on this spectrum typically minimize trust, reducing reliance on intermediaries and instead relying on transparent and flexible code.
This shift reduces counterparty risk as reliance shifts from off-chain intermediaries to code. The transparency of code enhances flexibility compared to the need for trust in intermediaries.
This is a direction worth exploring, and creating native yield options for Bitcoin should be the gold standard and ultimate goal of the Bitcoin community.
Consensus Perspective
Based on the consensus consistency of the Bitcoin blockchain, Bitcoin yield products can be classified into four categories.
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 users’ assets, exposing users to counterparty risk and reliance 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 lack regulation.
Independent Consensus: In this category, the infrastructure is decentralized, represented by public blockchains like Ethereum, BNB Chain, Solana, and other blockchain representatives. These blockchains have their independent consensus mechanisms that are not directly linked to Bitcoin’s consensus.
Inherited Consensus: In this category, the infrastructure is decentralized, represented by distributed consensus solutions 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.
Native Consensus: This category relies on Bitcoin’s own consensus mechanism as the foundation of its security model. It does not use independent blockchains or sidechains but utilizes 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 level of alignment with Bitcoin and are generally thought 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, the level of decentralization and trust minimization is lowest in the no-consensus category, and 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 classified into three categories.
Non-BTC: This category includes solutions that use assets other than BTC, resulting in lower alignment with Bitcoin. An example is Stack’s stacking option, where Stack’s native token STX is used to generate BTC yield.
Tokenized BTC: Here, the assets used are tokenized versions of BTC, which increase alignment with Bitcoin compared to non-BTC assets. Tokenized BTC can be found on public blockchains like Ethereum (WBTC, renBTC, tBTC), BNB Chain (wBTC), Solana (tBTC), etc. Additionally, tokenized BTC is held on Bitcoin sidechains with inherited consensus mechanisms, such as sBTC, XBTC, aBTC, L-BTC, and RBTC.
Native BTC: The assets in this category are on-chain Bitcoins (BTC) without 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’s security by adapting a Proof of Stake mechanism for Bitcoin staking. Additionally, projects like Stroom Network utilize the Lightning Network to enable liquid staking, where users can earn Lightning Network income by depositing BTC and minting wrapped tokens like stBTC and bstBTC on EVM-based blockchains for a broader DeFi ecosystem.
Earnings Perspective
When examining the returns of Bitcoin yield products, issues of alignment with Bitcoin come into play, resulting in similar classifications as in the asset aspect: non-BTC, tokenized BTC, and native BTC.
Non-BTC Returns: Babylon provides returns through its native assets on a Proof of Stake (PoS) blockchain, enhancing the security of the blockchain through Babylon’s staking mechanism.
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 Liquid Network, Blockstream Mining Note (BMN) provides returns in BTC or L-BTC upon maturity, providing a pathway for eligible investors to gain Bitcoin hash power through USDT security tokens that comply with EU standards.
Native BTC Returns: Stacks offers various options, including returns paid in tokenized BTC in certain yield applications, utilizing sBTC. However, for Stacks’ stacking option, returns are accrued in native BTC. Similarly, some CEX-provided centralized yield products distribute native BTC as returns to users.
Bitcoin’s Gold Standard: Fully Native
When considering ideal Bitcoin-based yield products, the gold standard product will combine the following three features: native Bitcoin consensus, native Bitcoin assets, and native Bitcoin returns. Such a product would mimic a near-perfect alignment with Bitcoin.
Currently, such solutions are just beginning to be developed. One actively developing 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 leveraging Bitcoin.
Their proposed solution revolves around generating native returns in Bitcoin, utilizing Brick Towers’ automated services for other nodes in the Lightning Network. By optimizing algorithms to address economic efficiencies, capital is strategically allocated to meet the liquidity needs of other network participants, optimizing capital efficiency while minimizing counterparty risk.
This approach not only promotes the growth of the Lightning Network but also enhances the utility of Bitcoin as an asset, while 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 risk and strengthening their commitment to the native Bitcoin ecosystem.
