DeFi-built bitcoin-backed credit is a more robust and realistic interpretation of Hal Finney’s 2010 “bitcoin free banking” thesis.
The dollar and bitcoin work together. Bitcoin and dollars give equilibrium, like yin and yang. One way that bitcoin protects against excessive credit creation is as a decentralised, rare, scarce, and counterparty-free digital bearer asset. On the other hand, the free market is driven by an insatiable need to issue credit-based money that serves as both a “stable” currency and a “account unit and an elastic financial layer.
As a result, the market faces conflicting demands for a stable unit of account and an asset with a fixed supply “and can grow to accommodate economic demands. This reality makes us think that a variety of credit-based, bitcoin-backed dollars supported by bitcoin collateral will naturally pave the way for hyperbitcoinization. A similar notion is described by Nik Bhatia in his book “Layed Money.” Simply said, credit money will exist because the market demands it, but it will also be supported by and thus constrained by the fixed quantity of bitcoin because the market similarly demands it. The end outcome is that the demand for bitcoin and dollars backed by bitcoin will start to work together in a synergistic flywheel.
Such a scenario, where banks backed by bitcoin might “create their own digital cash currency, payable for bitcoins,” was outlined by Hal Finney in 2010. On George Selgin’s Free Banking research, this hypothesis was developed. In his article “Bitcoin Banking Systems,” Eric Yakes summarises Free Banking as follows:
“Consider a world in which banks were permitted to issue their own private currencies in a competitive manner and markets were permitted to determine if these currencies were useful. This system is predicated on the tenets that (1) information is highly transparent, (2) there is market competition, and (3) there are few laws in place. Who’s to say that it wouldn’t be just if such a system developed and was based on voluntary agreement and interchange among market actors?
Unfortunately, none of the three requirements can be fulfilled by the current legacy system, hence it is doubtful that the legacy system will ever see a true bitcoin “free banking” revolution. Specifically:
- Transparency of Information: Large financial institutions are able to issue their own private currency and already do so, but they do so on shadow ledgers that are not regulated. The inability to control these shadow ledgers prohibits the legacy banking system from ever having widespread information transparency.
- Competitiveness: Obtaining a banking licence is a time-consuming, expensive, and difficult process. It is not competitive because it is heavily confined to a small group of people.
- Due to the Great Financial Crisis of 2008 (“GFC”), banks are now subject to greater regulation than ever before. There is no basis for anticipating a change in this. There is no guarantee that it would persist even if it did.
Decentralized Finance (“DeFi”) could, however, get around these problems in a “sly roundabout fashion,” in the words of Friedrich Hayek. A small portion of DeFi is prepared to lead the bitcoin free banking movement, despite the fact that the majority of it is rife with fraud and gambling.
Smart contracts would specify the precise mechanics, which could differ depending on the protocol. However, it would perform as Finney had initially described. Take this passage from Finney’s initial forum post and replace “protocol,” “smart contract,” and “stablecoin” with the appropriate terminology:
Different banks (protocols) may have various policies (smart contracts), some being more aggressive than others. Some might be fractional reserve, while others might be entirely backed by bitcoin. The interest rate can change. Some banks’ (protocols’) stablecoins may trade at a discount to those of others in the market.
DIFFERENCES BETWEEN DEFI AND LEGACY FREE BANKING
Building these “bitcoin free banks,” or protocols, using DeFi rather than the conventional system has a number of benefits:
- Transparent: DeFi-issued stablecoins would exist on-chain, or on an open, unalterable ledger. Particularly, pending claims and supporting collateral would always be open to the public and auditable cryptographically. Building on-chain is a more effective way to demonstrate reserves.
- Permissionless: DeFi eliminates gatekeepers in line with the idea of free banking. Anyone theoretically has the ability to develop and introduce a new protocol. As a result, experimentation with bitcoin-backed credit could take off like a Cambrian boom. No intrinsic limitations, such as KYC, would prevent anyone from the entire world from engaging with the protocol for individual users.
- Non-Custodial: Using DeFi, users can keep control of their own keys (subject to the conditions of the smart contract) rather than entrusting them to centralised entities that might rehypothecate the assets or even honest actors who might be subject to regulatory capture and be forced to hand over the keys.
- Better Wording: Users can establish better conditions for themselves by removing banks from the middle. One illustration of this is “Zero” (explained below), which offers customers the ability to borrow stablecoins at 0% interest against bitcoin collateral, with no defined loan period and high capital efficiency.
EXAMPLES IN THE WILD
Fuji built on the Liquid sidechain and Sovryn’s Zero protocol built on the RSK sidechain are two current instances of bitcoin free banking. They both serve as quasi-decentralized borrowing and stablecoin services. In particular, Zero enables users to enter RBTC (a pegged form of bitcoin on the Rootstock “RSK” sidechain) as collateral into a smart contract, which will then issue dollar-denominated stablecoins to themselves.
Because the stablecoins are created instead of being taken from another usage, there is technically no cost to issue them (more specifically, the protocol does not incur any costs to mint tokens, but users are charged an origination fee to borrow, which typically hovers at 0.5%) and no interest. With the exception of the freshly produced tokens having a value tethered to the dollar, this is comparable to how free banks operated when issuing private bank notes against their collateral. In contrast to the traditional system, where banks issued private money notes, protocols now create stablecoins backed by bitcoin. Users individually interacting with the protocol control their own credit generation mechanism, as opposed to free banks controlling the collateral and credit allocation.
Using a permissionless, distributed credit creation system prevents privileged gains from the Cantillon effect and control over the distribution of new credit money from being enjoyed by a few, central actors.
STABLECOINS AND BITCOIN-BACKED CREDIT: THEIR IMPORTANCE
Stablecoins are unquestionably the “killer app” in cryptocurrency, excluding Bitcoin itself. Stablecoins’ significance as a tool for humanitarianism, according to Alex Gladstein, “is impossible to ignore.” The market capitalisation of stablecoins significantly supports stablecoins’ pivotal position.
Some Bitcoiners find it difficult to acknowledge the value of money since it can appear at odds with the Bitcoin ethos. These concepts are compatible, though, thanks to credit backed by bitcoin. It is effectively a short against the dollar when stablecoins are created as claims against bitcoin collateral. We would anticipate that, over an extended period of time, as the purchasing power of the dollar declines, the value of bitcoin will rise, making debt repayment simpler.
The capacity to establish a flywheel and synergy between dollars and bitcoins is the essential element of bitcoin-backed credit. For example, when the market’s demand for censorship-resistant dollars rises, more bitcoin collateral must be bought and secured in smart contracts in order to mint stablecoins and satisfy that need. Separately, when organic demand for issuance of bitcoin-backed tokens rises (for example, through borrowing against it at 0% interest rate), more liquidity of censorship-resistant stablecoins is produced. Loans secured by bitcoin have shown to be in high demand, as have censorship-resistant stablecoins. By combining these two in-demand products, dollar and bitcoin proponents may work together to sustain each other’s growth.
THE CIRCULAR ECONOMY AND THE TECH STACK
Projects like Zero and Fuji now need to be created on Bitcoin sidechains that offer smart contract capability because Bitcoin’s scripting capabilities are still limited. Users must lock their bitcoin in a federated multisignature address in exchange for RBTC or L-BTC, a bitcoin derivative.
This trust restriction, however, is not entirely consistent with the Bitcoin ethos. However, we can investigate the research on trustless alternatives like drivechains and validity rollups while using these federated models to demonstrate product-market fit (aka “zk rollups”). In order to establish a trustless two-way peg that one day replaces the functionality of federations and gets around the existing trust assumptions of sidechains without changing the fundamental principles of the Bitcoin base layer, validity rollups are particularly intriguing. Here is a thorough analysis of Bitcoin’s validity rollups.
The creation of a trust-minimized bridge between stablecoins created on a validity Rollup and then used for payments on the Lightning Network could be an eventual reality. The innovations of Taro and RGB, which permit token issuance on the Lightning Network but have limited smart contract capability in part because they lack a global state, may make this possible. Currently, Taro and RGB’s goal is to introduce reputable stablecoins like USDT and USDC to Lightning. However, the ability to send bitcoin-backed stablecoins over the Lightning Network rather than centralised fiat stablecoins, which are more censorship resistant and encourage demand for the underlying bitcoin collateral, would be the next development in the creation of stablecoins.
Stablecoins backed by bitcoin allow users to hold onto their bitcoins indefinitely while also enjoying the short- to medium-term benefits of a bitcoin-backed dollar unit of account and the better Lightning payment rails. Decentralized bitcoin-backed credit collaborates with the dollar and its widespread acceptability as a unit of account to create a superior system that uses Bitcoin as its foundation.
CONSEQUENCES OF BTC-BACKED CREDIT
According to the site, bitcoin-backed credit utilising DeFi enables Bitcoiners to obtain dollar-denominated loans without having to sell their cryptocurrency, in a non-custodial manner, and without undergoing KYC. That, however, would greatly underestimate its significance.
A deeper bridge to hyperbitcoinization will be motivated by bitcoin-backed credit. As the dollar loses its relevance, it will make it easier to go from dollars to dollars backed by bitcoin and finally to entirely new credit instruments backed by bitcoin.
We will dismantle centralised authorities’ monopoly on money production by employing DeFi to remove obstacles and opaqueness to credit generation. It is not enough to simply be able to possess and transfer the asset known as bitcoin. The layers that provide financial services and generate money must also be decentralised. If we neglect these monetary layers, Bitcoin will actually live a life of gold 2.0, where centralised authorities would leverage the constant need for credit to usurp our monetary sovereignty through custody.
The paradigm of top-down, centralised money generation will change to distributed bottom-up with the adoption of Bitcoin DeFi. People will have the ability to create their own credit, in particular.The ability of the banks and the government to unilaterally control the creation and distribution of credit will end. As opposed to a few centralised allocators, this will produce a distributed model of capital allocation with an endless number of isolated trials that more accurately reflects the demands of the market.
Decentralized Bitcoin-backed Stablecoin Loans via DeFi are quite significant. It serves as the connecting link between Bitcoin as the singularity and the many components of the ecosystem (store of value, credit, smart contracts, and payments).
Without this understanding, I don’t think Bitcoin will succeed to its full potential.