What is Bitcoin’s next evolutionary step after the introduction of the Bitcoin ETF – and what do banks need to bear in mind?
First Part: How to properly understand Bitcoin as a productive asset
The following blog post reflects the authors’ insights and opinions regarding the development of Bitcoin as a productive asset and discusses possible strategies for action in relation to the trust assumptions for banks.
Since the launch of Bitcoin spot ETFs in the US in January 2024, Bitcoin has become accessible as an asset to a broad institutional investor base. This marked a significant milestone on its journey as a monetary asset.
Quelle: https://www.news.bitcoin.com
The next major step in the development of Bitcoin as an investable asset is the development of yield generation opportunities (similar to dividends on stocks or coupons on bonds). In the first part of this two-part blog post, we introduce Bitcoin as a new type of monetary asset, discuss the need to use Bitcoin productively and analyse how initial approaches in this area led to the 2022 crypto credit crisis.
In the second part, we propose three perspectives on Bitcoin yield products in terms of trustworthiness. Through this introduction of the consensus, asset and yield perspectives, we consider and evaluate the risks and trade-offs of different yield products. Based on the findings, we define what we consider to be the gold standard of a Bitcoin yield product and point to initial implementations that are starting to establish themselves in the market.
Bitcoin, an unprecedented monetary asset
What is Bitcoin? This question still seems to be up for debate. Some hope it to be a medium of exchange for everyday use. Others consider bitcoin as digital gold that will serve as the 21st century’s prime store of value. Yet others see Bitcoin as a globally distributed storage layer, which trustlessly anchors and verifies off-chain computation of any kind.
All these viewpoints are somewhat true (and will become “truer” as time goes on). As of today, Bitcoin has morphed into a digital base money first and foremost. As a bearer asset like gold, a risk-free asset like Treasuries, and a currency denomination like the dollar[1], Bitcoin is becoming the new base money for the digital economy. Existing on top, there will be a multi-layered system of finance, supporting a new Bitcoin-based economy.
Bitcoin (BTC) is redefining the very concept of a monetary base asset. Guided by a transparent algorithm, the cryptocurrency operates under a non-discretionary monetary policy. Not only is there a supply limit (hard cap) of 21 million, but thanks to Bitcoin’s transparent supply schedule, we know exactly how many digital base money units there are at any given time. Bitcoin’s monetary policy is virtually unchangeable, while also being provably scarce.
Contrast this to today’s base money, the US dollar. Undoubtedly, USD is the world’s prime fiat currency and thus of great relevance. Nonetheless, the world has come to accept that the US dollar’s decision-making power over its supply lies in the hands of a small group of unelected technocrats. And it is this group that is tasked with constantly adjusting the US dollar’s base money supply to the vicissitudes of an ever-changing economy.
While this is considered a feature by many experts, it is also a fact that the US dollar’s future supply schedule cannot be known, as its rate of change might be erratic, and its supply cap is hypothetically unlimited. The central bank’s ability to anticipate the incredibly complex interactions of human action in assessing the “right” amount of base money was severely questioned by Nobel laureate Friedrich August von Hayek in his prize lecture “The Pretense of Knowledge” [2].
To leverage, or not to leverage Bitcoin
For most Bitcoin proponents, the 21 million hard cap of Bitcoin is non-negotiable. As prominent Bitcoin writer Nic Carter summarized: “Bitcoin’s supply schedule cannot change, because Bitcoin IS the supply schedule” [3]. As he and many believe, any alteration would produce something that is distinctly non-Bitcoin. Consequently, in the new world of Bitcoin, where an unchangeable monetary policy reigns supreme, the concept of credit and leverage is met with scepticism. Any type of leverage that creates more claims to Bitcoin is seen as a deviation from Bitcoin’s sacrosanct monetary supply limit.
Leveraging Bitcoin through financial means is considered outright monetary expansion by some Bitcoiners, which they believe is a very “fiat thing” to do. They reject any kind of credit or leverage whatsoever. More nuanced Bitcoiners don’t entirely disapprove of leverage, but still remain sceptical of most of it. They follow the great monetary economist Ludwig von Mises, a prominent figure of the Austrian School of Economics, who delineated two fundamental types of credit in his book “The Theory of Money and Credit” [4]: Commodity credit and circulation credit.
According to von Mises, commodity credit is credit extended based on the tangible presence of real savings. Circulation credit, on the other hand, is credit that is not backed by any underlying real savings. In more technical terms, such credit claims are referred to as unbacked IOUs (from “I owe you”). It is these “paper Bitcoins” created through leverage that Bitcoiners consider economically unstable and thus problematic.
This sentiment echoes throughout the community, with figures prominent like Caitlin Long, former Wall Street veteran turned CEO of Custodia Bank, cautioning against the perils of leveraging Bitcoin. As she aptly puts it, “A fool and his leveraged Bitcoin are soon parted.” [5] Her stance appears compelling, and for good reason. The events of 2022, marked by the downfall of leveraged-based Bitcoin lending companies like Celsius and BlockFi, underscored the validity of Long’s position and that of her peers.
In a scenario reminiscent of the Lehman Brothers collapse, the wider crypto market spiralled into a credit crunch in 2022, impacting numerous players within the crypto lending sector. From crypto lenders and brokers to hedge funds and exchanges, a multitude of market participants either suspended operations or filed for bankruptcy altogether.
Buoyed by the resurgence of the bull market of 2020/21, institutions such as Voyager, Three Arrows Capital, Celsius, BlockFi, and FTX experienced substantial growth. Contrary to prevailing beliefs, most crypto lending activities were not peer-to-peer and came with significant counterparty risks. It was customers lending directly to the platform. The platforms then went on to deploy these funds into speculative strategies, aiming to generate superior yields without using an adequate level of risk management.
The DeFi summer of 2020 marked a surge in crypto activities. The rise of major DeFi protocols, including decentralized exchanges (DEXs) like UniSwap, and overcollateralized non-custodial lending and borrowing platforms like Aave, have facilitated economically viable and sustainable yield generation methods for liquidity providers and lenders in the on-chain markets.
Numerous large crypto players then capitalized on different versions of these emerging and highly innovative DeFi protocols to provide exceptionally competitive yields.
These yields were primarily fueled[6] by protocol token inflation, artificially facilitating such attractive but unsustainable payouts.
However, because of a lack of a robust business model or properly designed tokenomics, there was no sustainable yield generated. Back then, these DeFi protocols remained disconnected from the traditional economy. This was exactly where a sustainable source of yield through real economic flow would have to come from. Yield is the generated flow above maintenance costs or depreciation of the carrying capacity of some stock of an economically productive asset[7]. DeFi was lacking this, making the entire undertaking unsustainable. It was only later when protocols like Maker or Aave interacted more closely with businesses from the real world that this started to change.
At its core, the main issues of the 2022 crypto credit crunch were:
- Unsound portfolio decisions (Terra-Luna or stETH/ETH trade)
- Excessive leverage taking (3AC super-cycle bet)
- Hunting for unsustainable yields (Artificial yields)
- Unprofessional risk management (Celsius’s collateral investing, Voyager’s highly concentrated uncollateralized lending)
- Unsecured lending to non-rated/unhealthy counterparties
- Misuse of customer funds (FTX, Alameda Research)
- Non-segregated collateral (Voyager, Celsius, Hodlnaut etc.)
What the crypto credit crunch of 2022 brought to light was a myriad of issues surrounding centralized yield instruments. Ever since, concerns regarding transparency and trust have taken centre stage, accompanied by a host of risks including liquidity, market, and counterparty risks.
At the same time, we learned that when new blockchain-based “banking services” are centralized and heavily rely on off-chain risk management processes, they do not really differentiate from traditional banking. And this is a problem. After all, the history of our traditional banking system is proof that an off-chain system without adequate risk management is riddled with continuous failures and fraud. This is mainly because necessary checks and balances cannot technically be implemented in a transparent and independently auditable manner, which tends to create the need to over-regulate.
Bitcoin-based yield is not optional
With all the bad memories from 2022, the inevitable question still stuck in many people’s heads is: Should the ecosystem embrace Bitcoin yield products, or do they pose too great risk, resembling characteristics of the fiat system? While the reservations are indeed justified and the question seems reasonable, it is also naive to believe that bitcoin-based yield products will cease to exist[8].
In any well-functioning society, the need for credit and thus yield naturally arises. As a matter of fact, credit is a prerequisite for a wealthy society. It is in underdeveloped economies, where a web of credit facilities is lacking and the viability of long-term lending is severely constrained, that people are stuck in the clutches of a subsistence economy, mainly revolving around agriculture and direct consumption. It is only when credit is possible that a more roundabout, productive capital structure can emerge[9].
To build the Bitcoin-based economy many Bitcoiners are dreaming of the Bitcoin protocol with the need of a system of credit and yield to emerge on top of it. While proponents may extol Bitcoin’s virtues as a new form of money ad infinitum, the reality remains: money requires a native economy, which turns it into a currency that people can actually use. This underscores the imperative for Bitcoin-based yield mechanisms to foster the development of a robust Bitcoin-centric economy. Such an ecosystem would pivot on Bitcoin as digital base money yet leverage Bitcoin-based yield products to facilitate widespread adoption and utilization.
In the second part of this blog post, we will present our proposed perspectives on consensus, asset and yield. We will also systematically analyse and classify the implementation approaches that can be observed on the market according to these criteria.
Sources:
Brick Towers. (2024). Abgerufen am 1. Mai 2024, von https://bricktowers.io/bitcoin-yield/
Wikipedia. IOU. Abgerufen am 1. Mai 2024, von https://en.wikipedia.org/wiki/IOU
Farrington, A., Larson, A. (2021). Only the Strong Survive. Abgerufen am 1. Mai 2024, von https://www.uncerto.com/only-the-strong-survive
[1] Tantra Labs. (2024). https://medium.com/tantra-labs/the-triumvirate-of-liquidity-4fe4ab48d120
[2] Hayek, F. A. (1974). https://www.nobelprize.org/prizes/economic-sciences/1974/hayek/lecture/
[3] Carter, N. (2020). https://medium.com/@nic__carter/dont-fear-the-reaper-8bbb42358efb
[4] Mises, L. v. (1912). https://mises.org/library/theory-money-and-credit
[5] Long, C. (2021). https://www.youtube.com/watch?v=wTYJgorKWtQ
[6] Farrington, A., Larson, A. (2021). https://www.uncerto.com/only-the-strong-survive
[7] Ross, S., Carter,N., Farrington, A. (2022). https://assets.website-files.com/614e11526f6630959fc98679/629a961965b5a15419d5c72b_On%20Impossible%20Things%20Before%20Breakfast.pdf
[8] CoinDesk. (2020). https://www.coindesk.com/business/2020/11/10/the-case-for-bitcoin-banking-despite-creds-bankruptcy/
[9] Banerjee, A. V., & Duflo, E. (2011). Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty. New York: PublicAffairs.
