How can native Bitcoin and DeFi be combined?

This article is from Distributed Capital, originally titled: "Distributed Roundtable Episode 8: What Sparks Can Native Bitcoin and DeFi Ignite?"

On January 15, Stacks 2.0, upgraded from the distributed computing network Blockstack, was officially released. This upgrade will allow developers to build decentralized applications based on Bitcoin, helping to unlock the on-chain value of Bitcoin. On January 21, during the online live event "Goodbye Blockstack, Hello Stacks 2.0," investors from Distributed Capital, Hashkey Capital, and Spartan Group shared their insights on the possibilities of native Bitcoin + DeFi.

(The following is a summary of the roundtable discussion.)

Let's start with some self-introductions.

Melody: We are a financial consulting and investment group based in Asia, established in 2018. Besides investing, we have also been helping with the layout and investment connections in Asia.

Rem: Hello everyone, I am Remington, a partner at Distributed Capital. Distributed Capital is the first professional investment institution in China focused on blockchain. We support various application protocols at the infrastructure layer and began collaborating with Blockstack in 2018.

Rui: Hello everyone, I am Rui from Hashkey Capital. We are an independent brand backed by Wanxiang Blockchain, established in Hong Kong in 2018. We believed that the public chain track might produce a few more unicorn-level public chains, so we joined the Blockstack family in 2019.

First, let me ask a question that everyone is curious about: Many say that this wave of Bitcoin bull market was initiated by large institutions in Western countries, while the bull market in China has yet to begin. What are your thoughts on this?

Rem: First, in 2020, there were indeed some news from the West, with traditional institutions like Microstrategy and Square entering the market, which propelled the Bitcoin bull market. However, from a personal perspective, I believe Bitcoin itself is a borderless ecosystem. It's hard to distinguish between a Western bull market and a Chinese bull market. Overall, I think the bull market has a positive cycle.

The entry of large institutions increases retail investors' trust in the entire asset, which then attracts new retail investors into the market. The more retail investors there are, the larger the market scale grows, which will attract even more large institutions. Last year, Singapore's DBS Bank launched an exchange, and it is said that Standard Chartered Bank will also introduce some custody services. These signals indicate that institutions are not only investing in Bitcoin but also laying out the entire Bitcoin ecosystem services and infrastructure. Overall, I am optimistic about the positive cycle of Bitcoin in the long term. Looking back at the small-scale bull markets in 2013 and 2017, we found that those bull markets might have been driven unilaterally by the Chinese market. However, as Bitcoin's overall scale increases, it won't be so clear-cut to distinguish between countries.

Rui: I actually agree with Rem's statement. I think blockchain should not have boundaries, but the interactions between on-chain and off-chain still have boundaries. Some infrastructures in China are still different from those abroad (including the US, Europe, and Singapore). I believe that the core point of this institutional market is that there is a stable exit channel, which might be Grayscale in the US. If institutions want to buy, they can directly open an account with Grayscale, deposit money, and exchange it for GBTC. Although GBTC cannot be traded on the primary market, it has good liquidity in the secondary market.

I think the reason large Western institutions can enter the market is also because they have clear regulatory pathways and a thriving infrastructure channel domestically, which may take some time to achieve in China. Moreover, overseas, there are exchanges like Coinbase that cater to the retail end, allowing users to quickly deposit USD directly into BTC, which is something that still requires time to achieve in China. Furthermore, we have observed that during Asian trading hours, the overall price tends to stabilize; during European and American trading hours, the price tends to rise significantly, fundamentally due to some changes in the overall market structure.

In 2017, the market structure was more biased towards some Asian countries like China and South Korea, but from February to April 2019, during the 3000~14,000 market, it actually leaned more towards Western institutions. This wave of market has seen the entry of large American institutions, indicating a certain change in the overall market structure. China has produced some projects during this wave, and I believe these projects will gradually push Chinese investors to join the bull market. With improvements in the domestic deposit environment, custody services, and regulation, there will definitely be a Chinese presence in the future development path.

Melody: I think everyone has covered it quite comprehensively, but I would like to add one point: there is still a lack of regulatory friendliness domestically. Last year was a relatively tight regulatory year; if it weren't for a few incidents with exchanges, people wouldn't be so anxious. Foreign regulations are indeed moving towards a more transparent and clearer direction, which may not be the case in China. Even if we say that Chinese funds can enter Bitcoin as overseas assets, there won't be particularly legal funds entering the market domestically in the near future.

Therefore, from last year to this year's market rise, much of it has been due to large family offices (which can be understood as family trusts), family businesses, and institutions hoarding Bitcoin abroad. We know that many family offices have been buying, and the entire narrative abroad is very mature, with everyone recognizing the impact of this round of QE. With the experience from the last bull market, many Western institutions now recognize the functionality of Bitcoin.

What do you think Bitcoin holders can do to utilize their Bitcoin more effectively?

Melody: From what I understand, many American institutions or family businesses buy Bitcoin for custody purposes. They have high standards for conducting some business and applications on Bitcoin. It might be until one day when Gavin Wood suggests they buy derivatives on BTC that they would dare to do so. I know some family businesses only purchase Bitcoin through very large private banks, and these private banks are still hesitant to engage in derivatives. Therefore, institutions buying BTC derivatives still have a relatively high risk tolerance, while most institutions have not reached this stage. The institutions I refer to are large banks, enterprises, or family businesses, not OTC desks or teams specifically engaged in trading.

For retail investors, everyone needs to assess their specific risk tolerance. People around me who hold Bitcoin do not take all their Bitcoin out for yield. Even if it's for wealth management or trading through OTC desks, there is still centralized risk. So they would only take out a small portion for such wealth management.

Rui: Let me add a bit more. There are two types of institutions in the market: one is the newly entered institutions from the US, whose demand is to create something like macro hedging or asset allocation. Given this, they certainly won't use that money for mining or using DeFi products, as these financial products face risks: first, there are code issues; second, oracle risks; and finally, liquidity risks, which are difficult to measure.

Moreover, they do not have compliant channels to do this. In fact, large institutions must operate compliantly; if they cannot comply and something goes wrong, who will take the blame? If they can comply, custody must develop towards DeFi, but overall progress has not been very smooth.

The other type of large holders is domestic miners, who undeniably have a significant impact on the Bitcoin world. They hold a lot of coins and mostly have a certain faith in Bitcoin. They might take out a portion of their coins for innovation. In fact, they are also following market trends; previously, large miners like Fish God would engage in DeFi. In summary, DeFi may still face various audits and have very high requirements for security and liquidity.

Currently, everyone still views Bitcoin as a popular asset—primarily for asset allocation. I suggest retail investors engage in some stable coin wealth management. In fact, the price of Bitcoin has seen significant increases whether from ten years ago, five years ago, or three years ago to now. We believe that as a new generation of anti-risk and anti-inflation products, its price can catch up with gold in the next 3 to 5 years. I think there are opportunities to participate in Bitcoin derivatives, but it's not necessary; the prerequisite for participation is that you consider safety issues. In this industry, I personally believe that holding Bitcoin steadily is the best way to capture the industry's largest dividends.

Rem: The previous two have covered it quite well. Personally, my background is more traditional, and I am not very professional in trading, so I dare not give too many suggestions, but I can make some simple observations.

I think, first from the institutional perspective, as the two mentioned earlier, it can be divided into two categories: one is outsiders, some large institutions that have slowly entered the market in the past year or two. Since these outsiders have not been in contact with digital currencies much before, they may only hold Bitcoin at a very basic level. Compared to traditional wealth management or government bonds and other investment options, their returns from holding Bitcoin may have been substantial.

Second, as Rui mentioned earlier, many of these infrastructures, especially compliant infrastructures, are not fully built yet, but they are actively being constructed in the past two years. Last week, Anchorage became the first licensed bank in the US authorized by the federal government to hold digital currencies. Previously, many compliant exchanges played the role of currency service providers rather than banks. Now, not only will bank licenses for digital currencies (especially Bitcoin) be issued, but compliant institutions are also beginning to offer some BTC-based services, so I believe the future will continue to move in this direction.

The second category of institutions refers to existing crypto institutions, including miners, OTC desks, and funds trading digital currencies. For these institutions, in addition to holding Bitcoin, they can also engage in other derivatives (including collateralized lending and options, etc.). At the same time, they also conduct lending business through some CeFi institutions. So even though derivatives are still in the early stages, we do see some small-scale products moving in this direction.

Rem: As for retail investors, I am hesitant to give too many suggestions. However, Bitcoin has always been conceptualized as digital gold, which is quite different from the ecosystem of public chains like Ethereum, leading to the fact that holding Bitcoin may not necessarily allow for operations on Ethereum. In fact, last year, the wave of DeFi driven by Ethereum prompted some teams to develop solutions, such as WBTC, TBTC, etc. These solutions have achieved simple cross-chain asset value transfers, allowing some people holding BTC to participate in DeFi applications on Ethereum.

Rem: The Stack 2.0 we are discussing today is also moving in this direction. Blockstack allows Bitcoin to no longer just be digital gold but to be utilized to run different smart contracts. This is why we are optimistic about the ecosystem within Blockstack: First, the world has recognized Bitcoin as the most stable, experienced, and secure blockchain network; second, anyone who adds a smart contract layer to Bitcoin enhances its value, providing more operational methods for Bitcoin's value.

What do you think DeFi on Bitcoin should look like?

Melody: I think Rem just articulated it very well. Bitcoin has become the entry point for everyone into digital assets. So what will everyone look at after acquiring Bitcoin? First, I think after looking at Bitcoin, everyone is looking at Ethereum. Currently, large institutions in the West have not bought anything other than Bitcoin, and I believe this situation will change significantly this year.

Second, will Ethereum become the only main chain to carry all future decentralized financial applications? I actually think that its network effect is very strong right now. I saw on Twitter that three or four months ago, most Ethereum projects were still working individually; however, in the past month or two, everyone has started collaborating, and true composability is becoming increasingly evident. Additionally, the speed of innovation in Ethereum projects is very fast, so I think releasing Stack 2.0 at this juncture is very good, though there is still much to catch up on.

We hope to see very native applications on Bitcoin, just like we see on Ethereum, right? In fact, it should be treated as a custodial asset, allowing for various services such as lending, cross-chain, and asset transfers. I believe Bitcoin is the largest asset chain in the world, and using it solely for asset storage is quite wasteful. I don't know if everyone knows, but during 2016 and 2017, there was a time when everyone said Bitcoin was failing and that Ethereum would surpass Bitcoin, claiming Bitcoin had no innovation. In fact, it wasn't Bitcoin that changed; it was the world that changed.

I believe that if Bitcoin does not have more innovation and lacks native applications built on it, relying on another chain to increase its energy would be particularly regrettable. Therefore, I hope to see applications on Bitcoin that are similar to those on Ethereum. Blockstack does not excessively occupy Bitcoin's resources but instead sets many security and bilateral features on Bitcoin, adding many imaginable application scenarios to the entire chain.

Rui: I would like to add that in my understanding, each chain has its own style or final application scenarios. Blockstack may rely more on the security of the Bitcoin public chain and its final confirmation method to run some secure applications native to Bitcoin.

Many people believe that even though current cross-chain bridging solutions tend towards decentralization and efficiency, they inherently lack security. Whether it's WBTC or renBTC, these solutions may encounter issues. I actually think that Blockstack's approach of running a second-layer network relying on Bitcoin is a very good method.

Regarding applications, I believe whether the entire ecosystem on the chain can thrive depends on whether there is a blockbuster application, such as Uniswap driving the issuance of many long-tail assets on Ethereum. I think Bitcoin or Blockstack also needs some blockbuster or high-quality applications. The core lies in two points: one is capital efficiency, and the second is the profit-making effect; these two points are also what DeFi taught us last year. As long as the profit effect is well managed, even if your project is only doing some innovation, it can still achieve success.