Understanding Bitcoin as a productive asset: Part 2
In the first part of this two-part blog post, we introduced Bitcoin as a new type of monetary asset and discussed the need for productive yield generation. Only then, we believe, can Bitcoin take the next step in its evolutionary phase.
In the second part, we now look at three perspectives on Bitcoin yield products in terms of their trust minimization, and assess the risks and trade-offs involved. Based on the findings, we define what we consider to be the gold standard of a Bitcoin yield product and explain the implications for banks and their clients.
It’s All a Trust Spectrum, Anon
Bitcoin-powered finance will necessarily be built in layers. From a system’s point of view, this isn’t much different from today’s financial system, where there is an inherent hierarchy in money-like assets. To properly understand the inevitable trade-offs that come with this, it is important to have a high-level framework to distinguish the different implementations of Bitcoin residing on different layers.
When it comes to offering yield on Bitcoin, it is essential to understand that options can be built along a three-folded trust spectrum. The primary aspects to look at are:
- Consensus
- Asset
- Yield
Assessing Bitcoin-like assets and Bitcoin yield products based on their degree of Bitcoin nativeness provides a valuable framework for evaluating their alignment with Bitcoin’s ethos. Assets and products scoring higher on this spectrum are typically more trust-minimized, reducing reliance on intermediaries in favor of transparent and resilient code.
This shift mitigates counterparty risks, as reliance transitions from off-chain intermediaries to code. Unlike intermediaries that require trust, the code’s transparency allows it to be publicly reviewed and understood, enhancing its resilience. We consider this approach more transparent and resilient because the wider community can quickly detect and address security vulnerabilities.
This is a progression worth exploring, and creating options for a native yield on Bitcoin should be the gold standard and the ultimate goal of the Bitcoin community.
Consensus Angle
This assessment categorizes Bitcoin yield products based on their alignment with the Bitcoin blockchain’s consensus, distinguishing between four categories.
- No Consensus: This category represents centralized platforms where the base infrastructure remains off-chain. Examples include centralized platforms like Celsius or BlockFi, which hold full custody over users’ assets, exposing them to counterparty risks and dependency on intermediaries. While these platforms utilize Bitcoin, their yield strategies are primarily executed off-chain through traditional finance mechanisms. Despite being a step towards Bitcoin adoption, these platforms remain highly centralized, resembling traditional financial institutions, yet often unregulated in contrast.
- Standalone Consensus: In this category, the base 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’s and are not explicitly tied to Bitcoin’s consensus.
- Inherited Consensus: Here, the base infrastructure is decentralized, represented by Bitcoin sidechains or Layer-2 solutions with distributed consensus. While these sidechains have their own consensus mechanisms, they aim to align more closely with Bitcoin’s blockchain. Examples include federated sidechains like Rootstock, Liquid Network or Stacks.
- Native Consensus: This category relies on Bitcoin’s native consensus mechanism as the underlying security model. Instead of a separate blockchain or sidechain, it utilizes off-chain state channels cryptographically linked to the Bitcoin blockchain. The Lightning Network is a prime example of this approach, offering a high level of trust-minimization by fully relying on Bitcoin’s consensus.
The closer a Bitcoin yield product is to Bitcoin’s native consensus, the more aligned it is with Bitcoin and generally the more trust-minimized it is perceived to be. However, nuances exist within the standalone and inherited consensus categories, where the level of decentralization and security of the underlying infrastructure varies.
Overall, while no consensus yields the lowest level of decentralization and trust-minimization, native consensus is believed to offer the highest level of trust-minimization, although considerations of consensus security and decentralization require further analysis.
Asset Angle
When considering the asset used by Bitcoin yield products, alignment with Bitcoin (BTC) can be categorized into three main groups.
- Non-BTC: This category includes solutions that use assets other than BTC, which results in a low level of alignment with Bitcoin. The stacking option of Stacks can be put into this category. In stacking, the native Stacks coin (STX) is locked up for a specific period to contribute to the security and operation of the Stacks network. In return, the “stacker” is rewarded with a native Bitcoin yield in BTC. It is important to mention that Stacks offers another yield generation option, which will be discussed further below.
- Tokenized BTC: Here, the asset used is a tokenized version of BTC, increasing 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), and others. Additionally, tokenized BTC is hosted on Bitcoin sidechains with inherited consensus mechanisms, such as sBTC(soon on Stacks), XBTC, aBTC, L-BTC, and RBTC.
- Native BTC: This category features assets that are “on-chain” (on the blockchain) Bitcoin (BTC) without any tokenized versions involved, offering the highest level of alignment with Bitcoin. Various solutions from centralized crypto exchanges (CEX) use BTC directly as an asset, for example in the form of a savings solution, where the BTC locked for a period of time generates a return. There are also new “on-chain” developments (on the blockchain) such as the Bitcoin staking protocol from Babylon and the Liquid Staking protocol from Stroom. Babylon aims to scale the security of Bitcoin by adapting proof-of-stake mechanisms for Bitcoin staking. Stroom uses the Lightning Network as mentioned above to enable Liquid Staking. The BTC transferred into the Lightning Network by Stroom are used to efficiently facilitate payments between peers and to earn fees. These earnings are then distributed to users as tokenized Bitcoin versions like stBTC and bstBTC on other blockchains such as Ethereum. These tokenized versions can be used in the existing decentralized finance (DeFi) ecosystem of Ethereum, for example, for lending and borrowing.
Yield Angle
When examining the yield side of Bitcoin yield products, the question of Bitcoin alignment also arises, leading to similar categorizations as with the asset side: non-BTC, tokenized BTC, and native BTC.
- Non-BTC Yield: Babylon offers yields in the native asset of the Proof-of-Stake (PoS) blockchain, enhancing the blockchain’s security through Babylon’s staking mechanism.
- Tokenized BTC Yield: Stroom Network provides yields in the form of lnBTC tokens. Sovryn, operating on Rootstock, facilitates lending and borrowing on Bitcoin using tokenized BTC (RBTC) as yield. On the Liquid Network, the Blockstream Mining Note (BMN) offers yields in BTC or L-BTC at maturity, providing qualified investors access to Bitcoin hashrate through an EU-compliant security token in USDT.
- Native BTC Yield: Stacks offers various options, including yields paid out in tokenized BTC for some yield applications utilizing sBTC. However, for Stacks’ stacking option, yields accrue in native BTC. Similarly, centralized yield products provided by certain CEXs deliver native BTC as yield to users. Similarly, in the realm of solutions close to the Bitcoin blockchain, there are ongoing developments among others by Brick Towers to generate BTC as a native yield within the Lightning Network based on payment flows and the fees generated from them.
Conclusion
Bitcoin-based yield products already exist today in a wide variety of types, forms, and gradations. The complexity is enormous, as these yield solutions extend along a trust spectrum that consists of various components.
For marketing reasons, the individual solutions often position themselves as if the yield solution were based directly and solely on Bitcoin. But the devil is in the detail. On the one hand, there is the question of what base infrastructure the yield solution is based on and to what extent this infrastructure is aligned with the Bitcoin blockchain itself.
There is also the question whether Bitcoin (BTC) is used as an asset or whether “only” a tokenized version of Bitcoin or even a completely different crypto asset is involved. The same question also concerns the yield and what asset it is paid out in.
Overall, the rising popularity of Bitcoin and its increasing use as an investment vehicle are raising the expectations of future bank clients. This makes it necessary for banks to offer access to such yield products not only in securitized form, e.g. as a Bitcoin ETF with a yield component, but also in a native cryptographic form based on solid infrastructure. It therefore makes sense for banks not only to take on the role of observers (see the blog article from Dominik Jocham on the opportunities for banks to position themselves in the context of digital assets) but also to act as explorers or even discoverers on the digital assets market. This enables them to actively drive forward the development of innovative products, position themselves as an attractive employer for talented specialists, and establish the Swiss financial center as an international innovation leader.
To this end, the technical structure and the linking of the assets and return mechanisms used must be analyzed in detail in order to correctly assess the potential trust and risks involved with Bitcoin yield products. This requires a similar level of risk management as for traditional financial products.
To minimize these risks, banks should preferably choose products that have a high degree of decentralization, trust minimization and a close link to the native Bitcoin blockchain.
Sources:
Rootstock. (2024). Retrieved May 17, 2024, from https://rootstock.io/
Liquid Network. (2024). Retrieved May 17, 2024, from https://liquid.net/
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XLink. (2024). Optimizing User Onboarding with aBTC and XLink. Retrieved May 17, 2024, from https://www.xlink.network/blogs/optimizing-user-onboarding-with-abtc-and-xlink
sBTC.Tech (2024). Retrieved May 17, 2024, from https://sbtc.tech/
X. (2024). Retrieved May 17, 2024, from https://x.com/Coin98Analytics/status/1773186167669768537
Babylon. (2024). Retrieved May 17, 2024, from https://babylonchain.io/
Babylon. (2024). Bitcoin Staking: Unlocking 21M Bitcoins to Secure the Proof-of-Stake Economy. Retrieved May 17, 2024, from https://docs.babylonchain.io/papers/btc_staking_litepaper.pdf
Stroom Network. (2024). Retrieved May 17, 2024, from https://stroom.network/
Stroom Network. (2024). Stroom: Liquid Staking Derivative Protocol For Bitcoin Lightning Network Summary. Retrieved May 17, 2024, from https://stroom.network/Primer.pdf
Sovryn. (2024). Retrieved May 17, 2024, from https://sovryn.com/
Blockstream. (2024). Blockstream Mining Note. Retrieved May 17, 2024, from https://blockstream.com/finance/bmn/
The Block. (2024). Retrieved 11.06.2024, from https://www.theblock.co/data/on-chain-metrics/bitcoin/bitcoin-addresses-with-balance-over-x
