Philosophies and Speculation around the Use of Bitcoin as Collateral
Crypto was founded to let individuals securely hold the assets they own and to make decisions with these assets without needing permission from custodians like governments or institutions. The lightning-fast growth of crypto, however, has led to the creation of powerful new financial entities, some of which act as custodians of a different nature. Centralized organizations often develop faster than decentralized networks and tend to have access to larger marketing budgets, which makes them much more visible. However, custodians are thus also subject to hacking, poor decision-making and human error, which has led to well over $100Bn in losses just in the last decade. Will the future of crypto be centralized or decentralized? In this article, we seek to present various competing projections of the future and present our philosophy around where we see crypto evolving as well as the role that we anticipate Bitcoin to take.
Bitcoin’s surging success led the way to Bitcoin maximalism, which broadly defined is the worldview that Bitcoin is the most capable digital asset, due to its “hard” monetary policy, its extensive network of proof of work miners, its broad recognizability and its initial adoption by some national and local governments. Often, “Bitcoin Maxis” believe that most or all major crypto technologies will eventually be rebuilt on Bitcoin and Lightning.
In contrast, various forms of Ethereum maximalism have also emerged, representing the belief that Ethereum will become the world’s foremost settlement layer and Bitcoin will lose its competitive edge. Proponents of this view cite proof of work as leading to centralization and preferential treatment due to varying energy costs and hardware accessibility in different geographies. In contrast, they present Ethereum’s upcoming proof of stake system as a development that will encourage diverse ownership and lead to further decentralization.
We believe that there is a middle ground between these two divergent views. The progress that Ethereum and other chains have made is unquestionable and has naturally emerged from the desire to enable greater utility for Bitcoin and other digital assets. But in contrast to choosing one network over another, we see a future where these two camps are interoperable and support each other. But how? For that, we’ll need to take a look at why Bitcoin exists and what its intended use might be.
Over ten years after its founding, perhaps the biggest challenge for many is understanding exactly what type of utility Bitcoin is meant to provide. Bitcoin’s advantage is that it enables free flow of capital irrespective of national borders. But Bitcoin is inherently different than traditional capital – it’s not interoperable with traditional financial institutions. Today, one cannot easily use BTC in a bank transaction or to take a traditional loan. Meanwhile, a plethora of applications have emerged across various chains that represent use cases but all are generally denominated in that chain’s particular token.
Our perspective is simply that Bitcoin is the world’s greatest form of digital collateral. Bitcoin is simple, widely-known, well-documented and mature. Unlike most other crypto projects that were designed by engineering teams this century, Bitcoin builds on and benefits from many decades of academic research. While individual tokens like ETH can be thought to represent investments in specific projects, Bitcoin is perhaps most similar to UNIX or TCP/IP as an uneventful but much-needed substrate that enables more specialized applications. All of these properties make it uniquely effective in storing value, both for speculation and as a self-sovereign digital asset that can be used elsewhere.
If Bitcoin is collateral, how would one use this collateral in various applications? More than ten years after the launch of Bitcoin, this still presents a major challenge. The market convention today is to send it to custodians or bridges, but any mechanism that sends Bitcoin to another chain invalidates Bitcoin’s core values in decentralization and user self-sovereignty.
The most common approaches to utilizing Bitcoin have centered around “wrapping” it, meaning that the Bitcoin is sent to a third-party custodian that locks it and mints a token that can be used elsewhere (e.g. on the Ethereum network). However, doing so subjects the Bitcoin collateral to counterparty risk, as the custodian is subject to human error, hacking and government intervention.
Another common technique is to send the Bitcoin to a bridge that then validates and secures it. Though bridges are designed by reputable protocols with strong engineering teams, the security guaranteed by a single team cannot compare to the decades of research backing Bitcoin itself. As these bridges grow in value, they become larger targets. Due to hacks of eye-popping magnitude, bridges have gained a reputation for being notoriously precarious places to store collateral value.
We propose that the most viable solution in utilizing Bitcoin revolves around placing it in escrow. In traditional finance, escrow is used to limit counterparty risk. Locking an asset fully into escrow ensures transfers the risk to the escrow agent, which a specialized entity that is designed to minimize trust. Traditional escrow predates cryptographic advancements and is extensively used in finance today.
Within the crypto world, we believe that Discreet Log Contracts (DLCs) are the safest method known to date by which to build escrow contracts around Bitcoin. DLCs were developed at MIT in 2018 by Tadge Dryja, who later co-invented the Lightning network. In place of a single escrow agent entity, DLCs utilize a 2-of-3 multisig approach where one party is an oracle (or a network of oracles) that attests to an observed outcome, thus unlocking the form of payout.
As with every escrow agreement, there is an “oracle problem” introduced by which there needs to be a third-party that validates that the escrow has been satisfied. Any interface by definition cannot be fully “trustless” – since it runs on trusted server providers on trusted hardware and in trusted operating systems. However, in the context of a financial transaction, escrow provides a method of minimizing trust between counterparties. We will develop this idea further in subsequent blog posts, but we see Bitcoin escrow as being a foundational enabling technology that will let users adopt Bitcoin and utilize it in diverse ways across multiple chains.