2023-4-6 15:00 |
Over-collateralized, bitcoin-backed stablecoins are going to be an integral part of hyperbitcoinization.
This is an opinion editorial by David Seroy, founder and president of Old North Capital Fund and a contributor to the Sovryn protocol.
It is this author's opinion that over-collateralized, bitcoin-backed stablecoins issued on “DeFi” rails will become a highly-demanded and integral part of the Bitcoin economy in both developed and developing countries.
Bitcoin, Deficits And TaxationBitcoin as a hedge against monetary debasement is only half the battle. As sovereign debt goes parabolic, rate hikes become unviable without breaking the economy. Instead, it seems probable that governments will use taxation to quell inflation and reduce deficits. When governments collect taxes, they remove money from the economy and reduce the purchasing power of individuals and businesses. This reduces demand for goods and services, which in turn helps to control inflation and deficits without the economic blunt-force trauma of rate hikes during a debt crisis.
To hedge against these risks, Bitcoin must not only protect against the hidden tax of monetary debasement but also against literal tax. The problem is that the world is not yet ready for a pure bitcoin standard without dollars. Dollars still provide a service, even for the most ardent Bitcoiner. Dollars are the most widely-accepted and most stable (despite inflation risk) currency unit. As such, governments could use the existing demand for dollar access as chokepoints for taxation or even bail-ins. As an example, we could see higher capital gains taxes levied on bitcoin sales, a sales tax on any bitcoin spent in the “real economy” or a bail-in where dollars held in bank accounts receive a haircut to socialize debt burdens.
The solution is to create a way for Bitcoiners to access dollars without spending their bitcoin — in a parallel system which minimizes tax exposure, counterparty risk and dependency on legacy fiat rails. As an added benefit, this system should drive savings into bitcoin as opposed to competing for savings as stablecoins backed by U.S. treasuries do. Over-collateralized, bitcoin-backed stablecoins on “Bitcoin DeFi” rails provide the most viable path toward these goals.
Existing ProtocolsThe advent of projects like Sovryn Dollar using Zero protocol and Fuji Money on Bitcoin sidechains (Rootstock and Liquid, respectively) allow users to borrow dollar stablecoins against their bitcoin in a quasi-decentralized way. Each implementation uses different mechanisms to maintain the peg. However, the core premise is that bitcoin collateral is locked into a smart contract and a new stablecoin is minted into existence as a dollar-denominated loan against the collateral. The stablecoin(s) can be redeemed for $1 of bitcoin at any time, thus maintaining the stablecoin peg and justifying the moniker of “bitcoin-backed stablecoins.”
It's important to note these are over-collateralized stablecoin models, which are fundamentally different from algorithmic stablecoin models such as Terra Luna, as well as fiat-backed stablecoins such as USD Coin (USDC) and Tether (USDT). Over-collateralized stablecoins are generally considered the most credible way to create censorship-resistant stablecoins and, in this author’s opinion, is the model most similar to Austrian economist Ludwig von Mises’ description of commodity credit.
Over-collateralized stablecoins are predicated on always ensuring there is more value in bitcoin collateral than there are outstanding stablecoin claims. This is the stablecoin equivalent of full-reserve banking backed by bitcoin. You can read the specifics of how each protocol maintains its peg during times of extreme volatility via the previously provided links.
Further, each protocol offers two distinct but related products:
Bitcoin-backed borrowing: The ability for users to borrow stablecoins as a loan against their bitcoin collateral (often at 0% interest rate and a small origination fee).Bitcoin-backed stablecoins: As a byproduct of borrowing against bitcoin (as described in point one above), stablecoins are minted into existence. However, anyone can access and use these bitcoin-backed stablecoins regardless of whether they themselves took out the loan to issue the stablecoins.Each product appeals to both the Bitcoin Maximalist and the Dollar Maximalist, since the stablecoins can be held as a liability (stablecoins which are owed, see point one above) or an asset (stablecoins which are owned, see point two above).
For Bitcoin Maximalists, dollars can be accessed without selling bitcoin, at a 0% interest rate, with no set loan term. For Dollar Maximalists, the primary benefit is holding a stable unit of account. For both parties, the benefits include no KYC, permissionless-ness, cryptographic proof of reserves and censorship resistance.
To recap, bitcoin-backed borrowing allows bitcoin holders to access value without selling and potentially incurring taxable events (subject to local laws). As a byproduct of the borrowing, bitcoin-backed stablecoins are minted into existence as a stable unit of account that can be spent or held with the added benefit of censorship resistance and without reliance on the fiat banking system.
Incentive AlignmentBitcoin-backed borrowing and bitcoin-backed stablecoins align the incentives of disparate parties with Bitcoin as the Schelling point. Consider the following examples of such parties:
The bitcoin HODLer: An individual who holds mostly bitcoin but still requires dollars to pay expenses. Long term, they don’t want to sell bitcoin and incur a taxable event nor risk losing the potential upside on price appreciation.The dollar HODLer: An individual who needs dollars but has limited access to dollar banking (in the developing world) or has concerns with recent bank failures (in the developed world). Therefore, they need a credible way to hold dollars outside of traditional fiat rails.The maximalist HODLer: An individual who lives off bitcoin and does not need dollars but acknowledges some material amount of the world will use dollars. Therefore, they prefer dollars used by others to be backed by bitcoin because it indirectly supports “number go up” by re-allocating savings into bitcoin as collateral.Each of these disparate and self-interested individuals have a shared cooperation around Bitcoin. For example, the demand for bitcoin-backed borrowing by the bitcoin HODLer pushes bitcoin as pristine collateral into smart contracts, which are in turn used to mint credibly censorship-resistant stablecoins for the dollar HODLer. Correspondingly, the demand for credibly censorship-resistant stablecoins is what drives demand for collateral, which pushes up the price and adoption of bitcoin for the maximalist HODLer. A beautiful incentive alignment and virtuous cycle leads to a fly-wheel effect where all parties perpetuate the goals of the other.
We can see how similar monetary flywheel dynamics played out both historically and in the present day in the Eurodollar system. Eurodollars were born out of the world’s insatiable desire for dollars. To meet the demand, offshore banks loaned dollar-denominated liabilities (aka “Eurodollars”) into existence against the risk-free collateral, U.S. treasuries. Unfortunately, the insatiable demand for dollars (which manifested itself as parabolic growth of Eurodollars) led to: one, mass U.S. sovereign debt issuance; two, mass collateral re-use (aka “rehypothecation”); and three, widespread opaque monetary practices. Put another way, in order to issue vast amounts of dollars globally, the Eurodollar system borrowed gargantuan debts from future generations, while taking on devastating levels of leverage, all while being hidden under a veil of shadows.
Compare this to bitcoin-backed stablecoins. The system collateral is built on savings (bitcoin) instead of debt, can be programmatically restricted from collateral re-use and fractional reserve and is built on-chain so that it has cryptographic auditability.
With bitcoin-backed stablecoins, the same insatiable desire for dollars that has existed for decades and has pushed debt to historical highs will instead be channeled into non-rehypothecated bitcoin collateral underpinning the broader dollar monetary system. For context, the Eurodollar system was recently estimated to be $57 trillion.
Dissecting The LandscapeThere are other solutions for bitcoin-backed borrowing as well as stablecoins. However, these solutions may be inferior to the over-collateralized model described above.
Bitcoin-backed borrowing: For bitcoin-backed borrowing, popular solutions include those offered by Unchained Capital and Ledn. These appear to be very reliable products that have generally served the community well. However, they require KYC-compliant personal data submissions, are limited to fixed loan terms (often 12 months, with no guarantee of refinance), 10%-plus interest rates, 1.5%-to-2%-plus origination/administrative fees, very low loan-to-value ratios and liquidation thresholds (of less than 50%), and perhaps, most critically, have a reliance on the fiat banking system.Specifically, every dollar loaned by Unchained, Ledn or similar companies is the downstream product of savings, which implicitly perpetuates the lifespan of the fiat machine. Any dollars in the fiat system are backed by “the full faith and credit of the U.S. government.” In other words, the redeemability of a single fiat dollar stems from governments’ ability to have indebted themselves by issuing treasuries and subsequently taxing the future productivity of their citizens to pay those debts. On the other hand, the existence of any single bitcoin-backed stablecoin represents at least $1 of savings that has been re-allocated from supplying the fiat system and instead into bitcoin as savings.
Other stablecoins: Other stablecoin solutions often discussed in the Bitcoin community include stablecoins on Taro and RGB, and synthetic USD using inverse perpetual swaps, such as those enabled by Stablesats. These solutions should be welcomed and explored, but they do have limitations. For example, Taro has limited scripting capability. Therefore, it can only have trusted party asset issuance. Additionally, the Lightning Network lacks a global state, making it difficult to build for multiparty applications where many users are coming and going at different times. Ultimately, it is this author’s understanding that, because of these limitations, building native, bitcoin-backed borrowing and bitcoin-backed stablecoins on Taro or the Lightning Network is not possible (or comes with notable limitations). However, minting over-collateralized, bitcoin-backed dollars on sidechains as described above (and possibly one day on Bitcoin Validity Rollups), then issuing them on Taro or RGB in a centralized manner to benefit from the speed and cost of the Lightning Network may still be a viable use case.
Stablesats is another way to create a synthetic dollar while holding bitcoin. This is done by using a derivatives market, specifically an instrument called “perpetual inverse swap.” It works by taking a portion of a user’s bitcoin and placing it onto a centralized exchange and taking a “short” position. If the bitcoin price increases, it’s offset by losses from the incorrect short bet. If the bitcoin price decreases, it’s offset by gains on the correct short bet. Effectively, the short position maintains the value in dollars, regardless of fluctuations in the bitcoin price. One issue with this model is that the trade is made on a centralized exchange and thus the bitcoin must be held custodially. Additionally, every synthetic stable that exists represents a perpetual bet against bitcoin. If this market ever grew to substantial size, it not only becomes a centralized custody honeypot but a consistent source of sell pressure against bitcoin.
Bitcoin-backed lending and bitcoin-backed stablecoins appear to function better when they are two sides of the same coin, as opposed to disparate products. Trying to create independent products for stablecoins and bitcoin-backed lending has so far led to tradeoffs of centralization, inferior products or implicit support of the fiat system.
Future Developments And RisksBitcoin-backed stablecoins and bitcoin-backed borrowing on DeFi does not come without risks. These products are still in their infancy. While they are in production and have been battle tested, they still have yet to gain significant Lindy. For example, see Lyn Alden’s commentary regarding bitcoin-backed stablecoins in her article “The Problems With DeFi & Crypto”:
“1) Users would have to trust the underlying smart contracts won’t be exploited for the foreseeable future, 2) that the incentive mechanisms will continue to work for the foreseeable future to properly maintain over-collateralization through all market conditions, 3) that the price oracles won’t be gamed in any destabilizing way, and 4) that the governance of the smart contract won’t become misaligned with users or otherwise captured (referring either to the specific contract governance or the underlying computational layer governance).”
While these concerns are valid, it is this author's belief that many of these limitations can be minimized and further refined with time. For example, should the Bitcoin community see fit, a soft fork such as OP_STARK_VERIFY could be added to enable a trustless cryptographic two-way peg (2WP). In simplest terms, this would enable a validity rollup, which is a sidechain-like construction without the trust of a federation. In the interim (or if a trustless 2WP is never merged with the Bitcoin codebase), the smart contracts and oracles associated with bitcoin-backed borrowing and bitcoin-backed stablecoins are already being battle tested on trusted federations using real funds. The trust assumptions of a federation are not ideal but may be a limitation that the broader Bitcoin community is willing to take on in lieu of making any further changes to Bitcoin code or of leaving the stablecoin space to centralized entities.
However, should the community be open to trustless options, a seemingly-idyllic solution could include a trustless bridge to a validity rollup which hosts a bitcoin-backed stablecoin protocol (as described above), with the upgradability of the protocol burned, and the rollup having a built-in, natively-decentralized BTCUSD oracle price feed. As an added bonus, the peer-to-peer off ramps to traditional fiat while the bitcoin-backed stablecoins bootstraps a circular economy. A path to truly decentralized, bitcoin-backed stablecoins are obtainable and no longer fantastical dreams.
Aside from the core functionality of bitcoin-backed borrowing and bitcoin-backed stablecoins described above, additional programmability can be built into these products, whether on a validity rollup or a federation. For example, fully encrypted, end-to-end private transactions. It’s reasonable to imagine a not-so-distant world in which we have fully-encrypted, private stablecoin transactions, which are provably over-collateralized by bitcoin and issued on a cryptographically-trustless Layer 2 protocol which inherits the security and double spend protection of Bitcoin. That is a noble goal worth pursuing.
The Long And Treacherous RealityIt’s easy to get lost waxing poetically about a bright orange, bitcoin-only future. It’s the end-game vision many of us have often romanticized. But the reality is that getting there is still a long and potentially-treacherous journey ahead — a journey which, by any conceivable stretch of imagination, requires a notable transition period of continued global dollar usage. While Bitcoin itself is inevitable, the speed at which adoption happens is not. Completely ignoring the existing reality of dollars may only push that inevitability further out.
Instead, we can create better dollars, which are backed by bitcoin. Dollars which can be accessed by individuals without implicitly supporting fiat regimes and condemning future generations to unimaginable debt and tax burdens. Dollars which can be provably backed by the most pristine collateral the world has ever known. Dollars which can inherit the permissionless-ness and censorship resistance of Bitcoin. And dollars which don’t rely on trusted human counterparties.
Bitcoin-backed dollars have an opportunity to be the single greatest Trojan horse we have to reduce reliance on the fiat system. They are not some DeFi tool trying to gain affinity from Bitcoin but instead tools which extend the ethos of Bitcoin.
To the nonbelievers: Change my mind. Why shouldn’t Bitcoin have bitcoin-backed stablecoins?
This is a guest post by David Seroy. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.
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