December 8, 2022
On 7th November 2022, Nasdaq published an op-ed by Tycho, cofounder of Zest Protocol. You can read the post here on the Nasdaq website or continue reading below.
2021 has shown that the time for institutional crypto adoption has come. Prominent players, from banks to big tech companies, have opened crypto divisions, and many fund managers hold crypto on their balance sheets. When institutions add cryptocurrency to their balance sheets for the first time, they look to Bitcoin. They consider it a unique reserve asset. To make institutional adoption go faster, we must consider ways to upgrade Bitcoin’s reserve asset status.
To understand how we can upgrade Bitcoin’s reserve asset status, we need to know what makes an excellent reserve asset. Not all reserve assets are created equal. To distinguish between reserve assets, we should look at two properties: liquidity and yield.
What should an excellent reserve asset look like?
The best reserve asset in the world is that of which with the highest liquidity. Liquidity implies a person can always sell the asset with minimal impact on the price. Currently, the reserve assets with the highest liquidity are US Treasuries. Institutions do not choose to hold US Treasuries because the Government backs them; however, they trade in the world's most profound and sophisticated market.
Whenever you choose to sell a billion worth of US Treasuries, you can rest assured that there are enough buyers on the other side to make sure you don’t move the price significantly. Notably, Bitcoin has unique properties which could potentially make it more liquid than US Treasuries. As you probably already know, cryptocurrency markets trade 24/7 and are globally accessible through the internet. Regarding daily trading volumes, crypto markets already reach about 10% of the US Treasury market on some days. However, Bitcoin lacks the second fundamental property that reserve assets share: yield.
In addition to trading in highly liquid markets, the best reserve asset in the world must also produce a yield or earnings on an investment. Yielding assets make up the majority of institutional investment portfolios because institutions have cash. Cash is nice because it pays for things like pensions or insurance claims in funds. Again, this is where US Treasuries win. US Treasuries pay a few percent or less and are perceived as reasonably riskless considering the size of the US tax base. So how does Bitcoin win the reserve asset race and come out on top? It needs to produce a yield.
Bitcoin yield will propel Bitcoin adoption
Bitcoin can produce yield through lending and borrowing. Similarly, US dollars produce yield when stored in US Treasuries or corporate bonds. So who is interested in borrowing Bitcoin? Participants in the Bitcoin economy, of course. Participants in the Bitcoin economy have future earnings in Bitcoin, which means that they can borrow Bitcoin to earn more Bitcoin.
Today, the major participants in the Bitcoin economy are market makers. Market makers borrow Bitcoin at scale to facilitate Bitcoin trading on crypto exchanges. In theory, lending to crypto market makers will create a flywheel for Bitcoin; it produces Bitcoin yield by providing capital to improve Bitcoin’s liquidity through market making.
As Bitcoin adoption grows, driven by its unique security properties and globally accessible liquidity, more and more participants will enter the Bitcoin economy — for example, by taking payments in Bitcoin. Businesses taking Bitcoin payments will look for Bitcoin credit to facilitate their growth. At the same time, the Bitcoin economy can only grow when avenues for Bitcoin credit are easily accessible. We need liquid and accessible Bitcoin capital markets to prepare for the next adoption phase.
Today’s avenues for lending and borrowing Bitcoin haven’t been able to reach scale. Until now, generating a yield on Bitcoin through lending requires giving a third-party full custody over your Bitcoin, who will then lend the Bitcoin out for you. Since there is not yet an established regulatory framework around crypto lending, there have been ‘bank run issues’ over the past few months for these crypto lenders — leading to epic blowups across the industry.
We have come to a crossroads — either Bitcoin lending must fit into a framework designed for Traditional Finance, or Bitcoin lending must move fully on-chain. It is clear which of these paths stays true to the ethos of a decentralized future. Now, it is time to build.