Can Bitcoin become a productive asset?

Authors: Pascal Hügli, Brick Towers

Compiled by: Luccy, BlockBeats

Editor's Note: As the Bitcoin market matures and various yield products emerge, people are beginning to think about how to promote its financialization while maintaining Bitcoin's native characteristics. This article discusses different categories of Bitcoin yield products, from Bitcoin's native consensus and assets to yields, and emphasizes the importance of localized design in reducing trust dependency and counterparty risk.

While analyzing existing solutions, Pascal Hügli uses the Brick Towers project as an example to demonstrate how to achieve near-perfect Bitcoin fit by combining native Bitcoin consensus, assets, and yields. The article highlights the importance of balancing innovation and risk management in the financialization process of digital currencies. Despite facing numerous challenges and unknowns, Bitcoin, as an open and decentralized protocol, will continue to lead the direction of financial technology development with its localized design and foundational characteristics.

Bitcoin is undergoing a remarkable evolution, and there are various opinions about its essence. Some view it as a currency for everyday transactions, others see it as modern gold for storing value, while some consider it a decentralized global platform for protecting and verifying off-chain transactions. While all these views have their merits, Bitcoin is increasingly seen as a digital base currency.

Bitcoin functions similarly to physical gold, serving as a holding asset, an inflation hedge, and providing a currency denomination akin to the US dollar. Bitcoin is reshaping the concept of monetary 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 a volatile, uncertain, complex, and ambiguous (VUCA) era.

This contrast is particularly pronounced in the criticism of centralized monetary decision-making by Nobel laureate Friedrich August von Hayek in his work "The Prepense of Knowledge." Bitcoin's transparent and predictable monetary policy stands in stark contrast to the opacity and potential unpredictability of traditional fiat currency management.

Should We Leverage Bitcoin?

For staunch Bitcoin supporters, the 21 million supply cap is sacred and inviolable. Changing this cap would fundamentally alter the essence of Bitcoin, making it entirely different. Therefore, the Bitcoin community is generally skeptical about leveraging Bitcoin. Many believe that any form of leverage resembles the practices of fiat currency, undermining Bitcoin's core principles.

This skepticism towards leveraged Bitcoin is rooted in the distinction outlined by Ludwig von Mises between commodity credit and circulating credit. Commodity credit is based on real savings, while circulating credit lacks such backing, akin to unsecured promissory notes. Bitcoin supporters argue that leveraging creates "paper Bitcoin," which is economically risky and unstable.

Even some more nuanced views within the community maintain a cautious stance on leveraged Bitcoin, aligning with the position of figures like Caitlin Long. Caitlin Long has been warning about the dangers of leveraged Bitcoin. In 2022, the collapse of several leveraged Bitcoin lending companies such as Celsius and BlockFi further reinforced Long and others' concerns about the risks of leveraged Bitcoin.

Celsius and Other Companies Proved This

The crypto market experienced a significant upheaval in 2022, akin to the collapse of Lehman Brothers, triggering widespread credit tightening that affected multiple participants in the crypto lending space. Contrary to assumptions, most crypto lending activities are not peer-to-peer and involve considerable counterparty risk, as customers directly lend funds to platforms, which then invest those 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 lacked sustainable business models and token economics. They heavily relied on the inflation of protocol tokens to maintain attractive yields, leading to an unsustainable ecosystem detached from fundamental economic principles.

The crypto credit tightening of 2022 exposed various issues with centralized yield tools, highlighting concerns about transparency, trust, and liquidity, market, and counterparty risks. Additionally, it underscored the flaws in centralized and off-chain risk management processes, which, when applied to blockchain-based "banking services," mimicked the shortcomings of traditional banks.

Despite the optimism brought by the bull markets of 2020 and 2021, many institutions such as Voyager, Three Arrows Capital, Celsius, BlockFi, and FTX collapsed due to the lack of these necessary processes. The inability to transparently and independently implement 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 Yields Are Not Optional

So how should we respond? In light of the events of 2022, an increasing number of Bitcoin supporters are questioning whether we should embrace Bitcoin yield products or if they pose too great a risk, similar to fiat currency systems. While these concerns are valid, it is unrealistic to expect Bitcoin yield products to disappear entirely.

As the emerging Bitcoin ecosystem develops, this question becomes increasingly prominent. More and more projects are being established or claim to be developing financial infrastructure and applications directly on Bitcoin. Will this trigger the same issues we have already seen in the broader crypto space?

It is likely. Because that is the nature of the game. Since 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.

It is a historical fact that in any prosperous society, the demand for credit and yields naturally arises, serving as a catalyst for economic growth. Without credit, underdeveloped economies struggle to escape survival mode. Only through obtaining 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 yield mechanisms on top of the Bitcoin protocol. While Bitcoin's role as a currency is often praised, the reality is that to operate effectively as a currency, it requires a local economy to support it.

This underscores the importance of Bitcoin-based yield products in promoting Bitcoin-centric economic growth. Such an ecosystem would utilize Bitcoin as its digital base currency while leveraging yield products to drive its adoption and usage.

It's All About a Trust Spectrum, Anonymously

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, where there are inherent hierarchies among currency-like assets. To properly understand these inevitable trade-offs, we need a high-level framework to distinguish Bitcoin implementations at different levels.

When providing Bitcoin yields, it is essential to understand that these options can be constructed along a triple trust spectrum. The main focus should be on:

• Consensus
• Assets
• Yields

Evaluating Bitcoin-like assets and Bitcoin yield products based on their degree of Bitcoin nativeness provides a valuable framework for assessing their consistency with the spirit of Bitcoin. Assets and products that score higher on this spectrum are typically trust-minimized, reducing reliance on intermediaries and instead relying on transparent and resilient code.

This shift reduces counterparty risk, as reliance moves from off-chain intermediaries to code. The transparency of code enhances resilience compared to intermediaries that require trust.

This is a promising direction to explore, and 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 categorized into four types.

No Consensus: This category refers to infrastructure that remains centralized off-chain platforms. For example, centralized platforms like Celsius or BlockFi, which have complete control over users' assets, exposing users to counterparty risk and dependence on intermediaries. Although these platforms use Bitcoin, their yield strategies are primarily executed off-chain through traditional financial mechanisms. While these platforms represent a step toward Bitcoin adoption, they remain highly centralized, 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 others. These blockchains have their own consensus mechanisms independent of Bitcoin and are not explicitly tied to Bitcoin's consensus.

Inherited Consensus: In this category, the infrastructure is decentralized, represented by distributed consensus of Bitcoin sidechains or Layer-2 solutions. While these sidechains have their own consensus mechanisms, they aim 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 foundational security model. It does not use independent blockchains or sidechains but instead utilizes cryptographic methods to link to off-chain state channels of the Bitcoin blockchain. The Lightning Network is a significant example of this approach, providing a high level of trust minimization by fully relying on Bitcoin's consensus.

The closer Bitcoin yield products are to Bitcoin's native consensus, the higher their fit with Bitcoin is typically considered, and they are generally regarded as having a higher degree of trust minimization. However, there are subtle differences in the degree of decentralization and security of the infrastructure between independent consensus and inherited consensus.

Overall, no consensus has the lowest level of decentralization and trust minimization, while native consensus is considered to provide the highest level of trust minimization, although considerations of consensus security and decentralization still require further analysis.

Source: Brick Towers

Asset Perspective

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

Non-BTC: This category includes solutions that use assets other than BTC, resulting in a lower fit with Bitcoin. An example is Stacks' stacking option, where Stacks' native token STX is used to generate yields in BTC.

Tokenized BTC: Here, the assets used are tokenized versions of BTC, which improve the fit 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. Additionally, tokenized BTC is held on Bitcoin sidechains with inherited consensus mechanisms, such as sBTC, XBTC, aBTC, L-BTC, and RBTC.

Native BTC: This category consists of on-chain Bitcoin (BTC) without involving any tokenized versions, providing the highest level of fit with Bitcoin. Various CEX solutions and Babylon's Bitcoin staking protocol directly utilize BTC. Babylon aims to extend Bitcoin's security by adapting proof-of-stake mechanisms for Bitcoin staking. Furthermore, projects like Stroom Network leverage the Lightning Network to achieve liquid staking, allowing users to earn Lightning Network income by depositing BTC and minting wrapped tokens like stBTC and bstBTC on EVM-based blockchains for broader DeFi ecosystems.

Source: Brick Towers

Yield Perspective

When examining the yields of Bitcoin yield products, the issue of fit with Bitcoin leads to a classification similar to that of assets: Non-BTC, Tokenized BTC, and Native BTC.

Non-BTC Yields: Babylon provides yields through its native assets on its proof-of-stake (PoS) blockchain, enhancing the security of the blockchain through Babylon's staking mechanism.

Tokenized BTC Yields: Stroom Network offers yields in the form of lnBTC tokens. Sovryn, running on Rootstock, promotes Bitcoin lending by using tokenized BTC (RBTC) as yields. On the Liquid Network, Blockstream Mining Note (BMN) provides yields in BTC or L-BTC at maturity, offering qualified investors a way to acquire Bitcoin hash power through EU-compliant USDT security tokens.

Native BTC Yields: Stacks offers various options, including yields paid in tokenized BTC in certain yield applications, utilizing sBTC. However, for Stacks' stacking options, yields accumulate in native BTC. Similarly, some centralized yield products offered by CEXs distribute native BTC as yields to users.

Source: Brick Towers

The Gold Standard for Bitcoin: Fully Native

Considering the ideal Bitcoin-based yield products, gold standard products would combine the following three characteristics: native Bitcoin consensus, native Bitcoin assets, and native Bitcoin yields. Such products would mimic a near-perfect fit with Bitcoin.

Currently, such solutions are just beginning to be built. One actively developing project is Brick Towers. Their vision for the ideal Bitcoin-based yield product encompasses achieving near-perfect Bitcoin fit by integrating native Bitcoin consensus, assets, and yields. Brick Towers focuses on utilizing Bitcoin as a long-term savings solution, aiming to provide customers with minimized trust dependency and a localized approach to leverage Bitcoin.

Their planned solution revolves around generating native yields in Bitcoin, utilizing Brick Towers' automated services for other nodes in the Lightning Network. By optimizing algorithms for economic efficiency, capital is strategically allocated to meet the liquidity needs of other network participants, thereby 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 yields on their Bitcoin holdings. Importantly, Brick Towers' solution avoids the use of wrapped coins, further reducing counterparty risk and reinforcing their commitment to the native Bitcoin ecosystem.