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Why Bitcoin Does Not Need DeFi, But DeFi Needs Bitcoin6 min read

Jun 1, 2022 5 min

Why Bitcoin Does Not Need DeFi, But DeFi Needs Bitcoin6 min read

Reading Time: 5 minutes

Bitcoin is the most secure network in human history. Without the security and immutability unique to Bitcoin, DeFi will never achieve mass adoption.

Dr. Chiente Hsu is CEO and cofounder of ALEX (Automated Liquidity Exchange), the first complete DeFi exchange on Bitcoin.

Bitcoin is the only way to get truly decentralized finance (DeFi). DeFi hasn’t yet emerged as a game-changing force because it requires fully expressive smart contracts which aren’t possible on the core Bitcoin protocol due to their security trade-offs. However, there are several projects hard at work building layering solutions that allow the variety of smart contracts that have recently made DeFi on Bitcoin a reality.

As Bitcoin DeFi grows, it will allow sovereign collectives to determine their own bitcoin yield curve, increase the capital efficiency of bitcoin as an asset, and accelerate mass adoption and the development of the bitcoin economy.

Truly Become Your Own Central Bank

We want to be clear that Bitcoin does not need DeFi. Bitcoin existed years before DeFi emerged and Bitcoin will remain should DeFi ever disappear. DeFi, however, needs Bitcoin; without the security and immutability unique to Bitcoin, DeFi will never achieve mass adoption.

Only recently have we discovered bitcoin, the ultimate form of money. What we recognize as modern civilization, however, is not built on top of money but rather on top of finance. Global debt will always exceed physical currency in circulation because of banking systems. Finance includes banking, market places, financial instruments, credit and leverage; currency is just one of several asset classes. Consider that there is about $1.5 trillion dollars of physical USD in circulation, yet the U.S. national debt alone is over $30 trillion dollars.

The reason for this is that time — not money — is the most valuable resource. Debt — specifically in the form of yields and interest rates — is the medium of exchange for the time value of money. There are people who need money today and are willing to pay a premium to receive it. There are people who will only need their money in the future and are willing to receive a premium in exchange for the risk of lending it out until it is needed.

A favorite phrase among Bitcoiners is that it allows you to “become your own central bank,” because you are holding hard assets and are the only one responsible for the safekeeping of your bitcoin. A bank, however, is more than just a vault. A bank borrows funds from depositors at low interest rates and then invests by loaning out the funds at a higher interest rate, profiting from the spread. Becoming your own central bank means you are responsible not only for the safety of your own bitcoin but also for its productivity as an asset.

Capital efficiency — or maximizing the productivity of your capital over time — is the engine of modern finance and, at its core, are interest rates. Who currently determines interest rates? Central banks control overnight rates with the bond market pricing determining the rest of the yield curve (different yields at different maturity dates). By raising interest rates, borrowing becomes more expensive and the economy slows. By lowering interest rates, the opposite occurs. Persistent inflation now threatens the stability of the whole system.

Bitcoin has allowed for sovereign individuals, and it is inevitable these individuals will join and form sovereign collectives. Bitcoin DeFi will enable these collectives to determine their own sovereign interest rate curves through trustless and decentralized transactions. Through the emergence of a bitcoin yield curve, sovereign collectives will become the “Decentralized Bank of Bitcoin.”

Fixed-Rate And Fixed-Term Lending And Borrowing

The lending and borrowing that currently exists in DeFi is variable, meaning the yield you are receiving today is not the same as the yield tomorrow or the week after, causing significant uncertainty.

Recreating zero-coupon bonds in DeFi, analogous to a certificate of deposit that pays a fixed interest to its holder at a predefined maturity date is needed to lessen uncertainty. These financial properties can be coded into yield tokens that can be trustlessly exchanged, making swaps of these tokens the equivalent to lending and borrowing activity. Although that may not seem very exciting, in a sense, that’s the point.

Lending and borrowing should be a boring, not “risky” activity, in order for there to be mass adoption of DeFi. Bonds are the brick and mortar of finance and, by mastering these building blocks, we will be able to progressively recreate all of higher finance in the DeFi space.

Bitcoin Borrowing Without Liquidation Risk Through Dynamic Collateral Rebalancing Pools

Lending on all other DeFi platforms works with your collateral being in a single asset pool. If the collateral is bitcoin, the value of your collateral is directly bitcoin’s value, which is highly volatile (approximately six times the average volatility of the S&P 500). If the price of bitcoin drops and your loan-to-value ratio falls below the protocol minimum, you are liquidated, your position sold and you are charged fees as high as 50% of collateral value.

With the risky asset, say bitcoin, going up, the pool will shift toward risk to capture that upside gain. When the market is going down, the pool will shift toward less risk to minimize losses. When the market falls and the pool value goes below a preset threshold, it triggers a “risk off” condition where the balance of the pool is entirely moved into less risk.

This is like having a seatbelt and airbags for your collateral; in an emergency, it will protect the value of your collateral so you don’t run the risk of liquidation.

DeFi And The Power Of Bitcoin Capital Management

When it comes to funding, the traditional asset class for corporate treasuries are corporate bonds. Soaring U.S. inflation will lead to high yields on bonds, meaning current bond holders will race for the exits as prices plummet (bond yields and prices are inversely related). These treasuries will be obliged to shift to alternative asset classes like cryptocurrencies.

The recent market downturn and bitcoin’s price correlation with tech, shows us that institutional investors perceive bitcoin as a speculative high-risk/high-return asset rather than as a store of value. Fundamentally, they are wrong. Bitcoin is regionally neutral. It is removed from regional monetary and economic policies that direct other asset classes and markets, such as bonds.

As Bitcoin’s market cap grows and regulatory clarity is provided, it will increasingly allow corporate treasury managers to navigate the traditional financial markets during periods of distress or market uncertainty.

The bond market, however, is very expensive for most small- to medium-sized corporate treasury managers to enter. The requirements of paying investment banking, legal and operational fees makes it difficult to access the bond market for many small to midsize companies.

Bitcoin can resolve this dilemma. Bitcoin’s decentralized foundations ensure that holders do not necessarily need to jump through all the flaming hoops associated with traditional centralized financial services, but the current high volatility is a challenge for treasury management. Therefore, something like dynamic collateral rebalancing, which acts as a smoothing function and limits downside risk, will be a very interesting solution for corporate treasuries to better manage volatility and their cash flow.

In Conclusion

At the core of finance is security. As Bitcoin is the most secure network in human history, DeFi needs Bitcoin to displace traditional and centralized finance. Without making a single change to the base layer, Bitcoin DeFi uses the best form of sound money as the foundation for building the new gold standard of finance.

This is a guest post by Dr. Chiente Hsu. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc. or Bitcoin Magazine.

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