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Why Bitcoin does not need DeFi, but DeFi needs Bitcoin
April 5, 2022

Hey Alexians,

In 2021 the crypto world saw “the summer of DeFi” with enormous growth in the TVL of DeFi protocols, mostly on Ethereum. The question naturally arises if we’ll eventually see the exponential growth of Bitcoin DeFi as well?

The reason Bitcoin DeFi hasn’t yet emerged as a game changing force is because DeFi requires fully expressive smart contracts which aren’t possible on the core Bitcoin protocol. There are several projects however, hard at work building layering solutions that allow the variety of smart contracts that have recently made Bitcoin DeFi a reality.

As Bitcoin DeFi grows it will allow sovereign communities to determine their own Bitcoin yield curve, increase the capital efficiency of Bitcoin as an asset and accelerate mass adoption by the public as well as institutional investors.

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 through 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 debt. The global debt will always exceed actual physical currency because of banking. Finance includes banking, leverage, credit, markets, investments and “currency” is just one of several activities. Consider that there is about $1.2 trillion dollars of USD in circulation, yet the U.S. national debt is approaching $30 trillion dollars.

The reason 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 lending it out until it is needed.

A favorite phrase among Bitcoiners is that it allows you to “become your own central bank” as you are holding hard assets and are the only one responsible for keeping your Bitcoin safe. A bank, however, is more than just a vault. A bank borrows funds from depositors at low interest rates, and then loans out the funds at a higher interest rate, profiting from the spread. To become your own central bank means you are responsible not only for the safety of your own Bitcoin, but also for maximizing their capital efficiency.

Capital efficiency, or maximizing the productivity of your capital over time, is the true 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 of course, 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 communities. Bitcoin DeFi will enable these communities to set sovereign interest rate curves through trustless and decentralized transactions. Through a decentralized Bitcoin yield curve, sovereign communities truly become their own central bank.

Fixed-rate and Fixed-term Lending and Borrowing

The lending/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.

What is needed is to recreate zero-coupon bonds in DeFi, analogous to a certificate of deposit that pays a fixed interest to its holder at a pre-defined maturity date. These financial properties can be coded into a yield token that can be bought and sold, making these transactions the equivalent to lending/borrowing activity on the protocol. Although that may not seem very exciting, in a sense that’s the point.

Lending/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 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 value, which is highly volatile (approximately 6x the average volatility of the SP500). If Bitcoin drops and your Loan-To-Value 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 is going up, the pool will shift towards risky to capture that upside gain. When the market is going down, the pool will shift towards riskless to minimize losses. And when the market falls and the pool value goes below a pre-set threshold, it triggers a “risk off” condition where the balance of the pool is entirely moved into riskless.

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. These treasuries will be obliged to shift to alternative asset classes like cryptocurrencies.

Fundamentally Bitcoin is regionally neutral. It is removed from regional monetary and economic policies that direct other asset classes and markets, such as bonds. Bitcoin allows 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 and cryptocurrencies 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 we believe that 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 rival traditional and centralized finance. Without making a single change to the base layer, Bitcoin DeFi uses the best form of sound money to establish the new gold standard of finance.