Can Bitcoin Become a Yielding Asset?

Written by Pascal Hügli; Translated by Chris, Techub News

Bitcoin is going through a big change, and people have different views on its nature. Some see it as a currency for daily transactions, others as a modern equivalent of gold as a store of value, and still others see it as a decentralized global platform for securing and verifying transactions that occur outside the blockchain. While these views all reflect the characteristics of Bitcoin to a certain extent, Bitcoin is increasingly establishing itself as a digital base currency.

Bitcoin operates similarly to holding physical gold, acts as an inflation hedge, and provides a currency unit similar to the US dollar. Bitcoin is redefining the concept of a monetary base asset. Its transparent algorithm and fixed supply of 21 million coins ensure that it is not a monetary policy that can be changed at will. In contrast, traditional fiat currencies such as the US dollar rely on centralized authorities to manage their supply, which raises questions about their predictability and effectiveness in an era full of volatility, uncertainty, complexity and ambiguity.

This contrast is particularly noteworthy because Nobel laureate Friedrich August von Hayek criticized centralized monetary decision-making in his work The Pretense of Knowledge. Bitcoin's transparent and predictable monetary policy stands in stark contrast to the ambiguity and potential unpredictability of traditional fiat currency management.

Should Bitcoin be Leveraged

For staunch Bitcoin supporters, the unchangeable supply of 21 million coins is "sacred." Changing this would fundamentally change Bitcoin to something completely different. As a result, skepticism about leveraging Bitcoin is widespread within the Bitcoin community. Many believe that any form of leverage is similar to the practices of fiat currencies and undermines the core principles of Bitcoin.

This skepticism about leveraging Bitcoin is rooted in the distinction between commodity credit and circulation credit described by Ludwig von Mises. Commodity credit is based on real savings, while circulation credit lacks such backing and is similar to an unsecured IOU. Bitcoin supporters believe that leverage creates "paper Bitcoins," which are economically risky and unstable.

Even nuanced views within the community are wary of leverage, agreeing with figures such as Caitlin Long, who has been warning about the dangers of leveraged Bitcoin. The collapse of leveraged Bitcoin lending companies such as Celsius and BlockFi in 2022 further reinforced the concerns of Caitlin Long and others about the risks of leveraged Bitcoin.

The collapse of Celsius and others proves this

The crypto market experienced a major turmoil in 2022 similar to the collapse of Lehman Brothers, triggering a widespread credit crunch that affected various players in the crypto lending space. Contrary to expectations, most crypto lending activities are not peer-to-peer and there is considerable counterparty risk, as customers lend funds directly to platforms, which use the funds for speculative strategies without adequate risk management.

As can be seen from these events, leveraged Bitcoin not only poses significant economic risks, but also poses a threat to the stability of the entire cryptocurrency ecosystem.

The Rise and Risks of DeFi Protocols

In the summer of 2020, many DeFi protocols emerged, offering promising avenues for yield generation. However, many of these protocols lacked sustainable business models and token economics. They relied heavily on the inflation of protocol tokens to maintain attractive yields, resulting in an unsustainable ecosystem that was disconnected from fundamental economic principles.

The 2022 crypto credit crunch highlighted various issues with centralized yield instruments, highlighting risks such as transparency, trust, and liquidity, market, and counterparty risk. In addition, it highlighted the pitfalls of centralized and off-chain risk management processes, which, when applied to blockchain-based "banking services," bring the same flaws as traditional banks.

As a result, despite the optimism during the 2020/21 bull run, many institutions, including Voyager, Three Arrows Capital, Celsius, BlockFi, and FTX, collapsed due to the lack of these processes. The inability to transparently and independently implement the necessary checks and balances often leads to overregulation and repeated failures and fraud, reflecting the historic challenges of the traditional banking system.

The Importance of Bitcoin Yield Products

How should we respond to this situation? In light of this event in 2022, a growing number of Bitcoin supporters are asking the question: should we accept Bitcoin yield products, the risks they carry are too great. While there are legitimate concerns, it is unrealistic to expect Bitcoin yield products to disappear entirely.

As the Bitcoin ecosystem develops, questions about Bitcoin yield products are becoming more prevalent. More and more projects are building financial infrastructure and applications directly based on Bitcoin. Will this once again raise the issues we have already witnessed in the broader crypto space?

Very likely. That is the nature of the game. Since Bitcoin is a permissionless protocol, anyone can build on it, including those who wish to build financial products based on Bitcoin. And finance cannot avoid the need for credit and leverage.

It is a historical fact that in any prosperous society, the need for credit and yield will naturally emerge as a catalyst for economic growth. Without credit, it is difficult for underdeveloped economies to escape the shackles of survival. Only through access to credit can more complex and productive economic structures be formed.

To realize the vision of a Bitcoin economy, proponents recognize that credit and yield mechanisms need to be developed on top of the Bitcoin protocol. While Bitcoin is often praised as a form of money, the reality is that for it to work effectively as a currency, a native economy is needed to support it.

This highlights the importance of Bitcoin yield products in promoting the growth of a Bitcoin-centric economy. Such an ecosystem would use Bitcoin as its digital base currency while leveraging yield products to drive adoption and usage.

A Bitcoin-Powered Financial System

A Bitcoin-powered financial system is necessarily structured in layers. From a systemic perspective, this is not much different than today's financial system, where there is an inherent layered structure in monetary assets. In order to properly understand the inevitable trade-offs that result from this layering, a high-level framework is needed to distinguish between Bitcoin implemented on different layers.

When it comes to Bitcoin yields, it is important to understand that these options can be constructed along a "triple trust spectrum" with the main areas of focus being:

• Consensus Mechanism

• Asset Nature

• Yield Mechanism

Evaluating Bitcoin-like assets and Bitcoin yield products based on Bitcoin Essentiality provides a valuable framework for evaluating their alignment with the Bitcoin philosophy. Assets and products that score higher on this spectrum are generally more trust-minimized, with less reliance on intermediaries and more towards transparent and resilient code.

This shift reduces risk because reliance is shifted from off-chain intermediaries to code. Transparency in code increases the resilience of the system compared to intermediaries that must be trusted.

This development deserves further discussion, and the direction of creating Bitcoin-native yields should become the standard and ultimate goal of the Bitcoin community.

Consensus Perspective

Bitcoin yield products are divided into four categories based on the degree of alignment with the Bitcoin blockchain consensus:

No consensus: This category represents centralized platforms whose infrastructure remains off-chain. Examples include centralized platforms such as Celsius or BlockFi, which have full custody of user assets, exposing users to counterparty risk and dependence on intermediaries. While these platforms leverage Bitcoin, their yield strategies are primarily executed off-chain through traditional financial mechanisms. Despite being a step towards Bitcoin adoption, these platforms are highly centralized, similar to traditional financial institutions, and are often unregulated.

Independent consensus: In this category, the infrastructure is decentralized and represented by public blockchains such as Ethereum, BNB Chain, Solana, etc. These blockchains have their own consensus mechanisms independent of Bitcoin and do not explicitly rely on Bitcoin's consensus.

Inherited consensus: Here, the infrastructure is decentralized and represented by Bitcoin sidechains or Layer-2 solutions with distributed consensus. These sidechains have their own consensus mechanisms, but they are designed to be more closely aligned with the Bitcoin blockchain. Examples include federated sidechains such as Rootstock, Liquid Network, or Stacks.

Native Consensus: This category relies on Bitcoin’s native consensus mechanism as an underlying security model. Rather than being a separate blockchain or sidechain, it utilizes off-chain state channels that are cryptographically linked to the Bitcoin blockchain. The Lightning Network is a prime example of this approach, offering a high degree of trust minimization by relying solely on Bitcoin’s consensus.

The closer a Bitcoin yield product is to Bitcoin’s native consensus, the more aligned it is with Bitcoin and the more trust minimization it is generally considered. However, there are nuances within the independent consensus and inherited consensus categories, where the level of decentralization and security of the infrastructure varies.

Overall, yield products without consensus have the lowest levels of decentralization and trust minimization, with local consensus being considered offering the highest levels of trust minimization, although considerations of consensus security and decentralization require further analysis.

Source: https://bricktowers.medium.com/how-to-properly-understand-bitcoin-as-a-productive-asset-8d1ac9a3b813

Asset Perspective

When considering the assets used by Bitcoin yield products, the degree of alignment with Bitcoin can be divided into three main categories.

Non-Bitcoin: This category includes solutions that use non-Bitcoin assets, which results in a lower degree of alignment with Bitcoin. For example, in Stack's stacking option, Stack's native coin STX is used to generate Bitcoin yield.

Tokenized Bitcoin: The asset used here is tokenized Bitcoin, which improves the degree of alignment with Bitcoin compared to non-Bitcoin assets. Tokenized Bitcoin can be found on public blockchains such as Ethereum (WBTC, renBTC, tBTC), BNB Chain (wBTC), Solana (tBTC), and others. Additionally, tokenized Bitcoin is hosted on Bitcoin sidechains with inherited consensus mechanisms such as sBTC, XBTC, aBTC, L-BTC, and RBTC.

Local Bitcoin: Assets in this category are on-chain Bitcoins without any tokenized version, providing the highest level of alignment with Bitcoin. Various CEX solutions and Babylon’s Bitcoin staking protocol use Bitcoin directly. Babylon aims to extend Bitcoin’s security by adopting a proof-of-stake mechanism for Bitcoin staking. Additionally, projects like Stroom Network leverage the Lightning Network to enable staking, where users can earn Lightning Network revenue by depositing Bitcoin and minting wrapped tokens such as stBTC and bstBTC on EVM-based blockchains for use in the broader DeFi ecosystem.

Source: https://bricktowers.medium.com/how-to-properly-understand-bitcoin-as-a-productive-asset-8d1ac9a3b813

The Yield Perspective

When looking at the yield side of Bitcoin yield products, the question of Bitcoin alignment also arises, leading to a similar classification as the asset side: non-Bitcoin, tokenized Bitcoin, and local Bitcoin.

Non-Bitcoin Yield: Babylon provides yield by making Bitcoin a staked asset on a PoS blockchain, enhancing the security of the blockchain through Babylon’s staking mechanism.

Tokenized Bitcoin Yield: Stroom Network provides yield in the form of lnBTC tokens. Sovryn operates on Rootstock and uses tokenized Bitcoin (RBTC) as yield for lending. On Liquid Network, Blockstream Mining Note (BMN) provides yield in the form of Bitcoin or L-BTC upon maturity, providing qualified investors with access to Bitcoin hashrate through EU-compliant USDT tokens.

Local Bitcoin Yield: Stacks offers a variety of options, including yield paid in tokenized Bitcoin in some yield applications. However, for Stacks' stacking option, yield accumulates in local Bitcoin. Similarly, some centralized yield products offered by centralized exchanges pay local Bitcoin as yield to users.

Source: https://bricktowers.medium.com/how-to-properly-understand-bitcoin-as-a-productive-asset-8d1ac9a3b813

The Best Standard for Bitcoin: Fully Native

When thinking about the ideal Bitcoin income product, the best standard product should combine the following three attributes: native Bitcoin consensus, native Bitcoin assets, and native Bitcoin income. Such a product will be almost perfectly aligned with Bitcoin.