Bitcoin doesn’t need DeFi, but DeFi needs Bitcoin

Dr. Chiente Hsu is CEO and co-founder of ALEX (Automated Liquidity Exchange), the first fully-featured Bitcoin-based DeFi exchange.

Bitcoin is the only way to achieve truly decentralized finance (DeFi). DeFi has yet to emerge as a breakthrough force, as it requires fully expressive smart contracts that are not possible on the core Bitcoin protocol due to their security trade-offs. However, several projects are hard at work creating overlay solutions that enable the variety of smart contracts that have recently made DeFi on Bitcoin a reality.

As Bitcoin DeFi grows, this 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 doesn’t need DeFi. Bitcoin existed years before DeFi emerged, and Bitcoin will remain if DeFi were to die out. DeFi, however, needs Bitcoin; without Bitcoin’s own security and immutability, DeFi will never achieve mass adoption.

It was only recently that we discovered bitcoin, the ultimate form of money. What we recognize as modern civilization, however, is not built on money but rather on finance. Global debt will always exceed physical currency in circulation because of the banking systems. Finance includes banking, marketplaces, financial instruments, credit and leverage; currency is just one of many asset classes. Consider that there are approximately $1.5 trillion physical USD in circulation, but the US national debt alone is exceeded $30 trillion.

The reason is that time – not money – is the most valuable resource. Debt – especially 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 for the risk of lending it out until they need it.

A favorite phrase among Bitcoiners is that it allows you to “become your own central bank” because you hold durable assets and are solely responsible for the safekeeping of your bitcoin. A bank, however, is more than just a safe. A bank borrows funds from depositors at low interest rates and then invests by lending the funds at a higher interest rate, profiting from the spread. Becoming your own central bank means you are responsible not only for the security 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 bond market pricing determining the rest of the yield curve (different yields at different maturities). By raising interest rates, borrowing becomes more expensive and the economy slows down. By lowering interest rates, the opposite happens. Persistent inflation now threatens the stability of the whole system.

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

Fixed-rate and fixed-term loans and borrowings

The lending and borrowing that currently exists in DeFi is variable, meaning the return you receive today is not the same as the return tomorrow or the following week, leading to significant uncertainty.

Recreating zero-coupon bonds in DeFi, analogous to a certificate of deposit that pays fixed interest to its holder on a predefined maturity date, is necessary to reduce uncertainty. These financial properties can be encoded into yield tokens that can be traded with confidence, making trading of these tokens the equivalent of lending and borrowing activity. While that might not sound very exciting, in a way, that’s the point.

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

Bitcoin Borrowing Without Liquidation Risk Through Dynamic Collateral Rebalancing Pools

Loans on all other DeFi platforms work with your collateral in a single pool of assets. If the collateral is bitcoin, the value of your collateral is directly the value of bitcoin, which is highly volatile (about 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 is sold, and you are charged a fee of up to 50% of the collateral value.

With the risky asset, say bitcoin, going up, the pool will move to risk to capture that upside gain. When the market is down, the pool will move towards less risk to minimize losses. When the market drops and the pool value drops below a predefined threshold, this triggers a “risk-free” condition in which the pool balance is shifted entirely to less risk.

It’s like having a seatbelt and airbags for your warranty; 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 financing, the traditional asset class for corporate treasuries are corporate bonds. Soaring US inflation will lead to high yields on bonds, meaning current bondholders will rush for exits as prices fall (bond yields and prices are inversely related) . These treasuries will be forced to turn to alternative asset classes like cryptocurrencies.

The recent market downturn and the correlation of bitcoin prices with technology shows us that institutional investors view bitcoin as a high-risk/high-reward speculative asset rather than a store of value. Basically, they are wrong. Bitcoin is regionally neutral. It is distant from the regional monetary and economic policies that guide other asset classes and markets, such as bonds.

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

The bond market, however, is very expensive for most small and medium sized cash managers. Requirements to pay investment banking, legal, and operational fees make it difficult for many small and medium-sized businesses to access the bond market.

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

In conclusion

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

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

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