October 30, 2023
Bitcoin Amsterdam was already a little while ago - in October 2022. Yet after the FTX drama, the case for Zest Protocol has only grown stronger. I gave a talk to share Zest Protocol with the wider world for the first time and to educate Bitcoiners about Bitcoin capital markets.
Before I went on stage, the audience was already warmed up by some casual mentions of Zest Protocol on other stages. For example, Dan Held and Maurio di Bartolomeo (Ledn CEO) spent some time talking about Zest Protocol (more info here).
The title of the talk was ‘The case for Bitcoin decentralised finance (DeFi)’. To make the case for Bitcoin DeFi, it would make sense to make the case for Bitcoin finance first.
The case for Bitcoin finance
Bitcoin is money. Or to use Satoshi's words, Bitcoin is a peer-to-peer electronic cash system (i.e. money). As a result of Bitcoin being money, a Bitcoin economy exists with companies that have earnings in Bitcoin. As in any economy, these Bitcoin-earning companies benefit from bringing some of their future Bitcoin earnings to the present. This activity is called borrowing. When Bitcoin earning companies borrow Bitcoin against their future Bitcoin earnings to invest in their Bitcoin generating business, we have Bitcoin finance. Bitcoin finance is necessary to grow the Bitcoin economy, just as finance is necessary to grow any other economy.
The Bitcoin economy is not just a made-up concept. It exists today. The same goes for Bitcoin finance. It also exists today. So who are the participants in the Bitcoin economy?
Market makers are the largest borrowers of BTC today. They borrow this BTC to trade on exchanges (i.e. make markets). Market makers trade so much that they are responsible for price stability between crypto-exchanges, as well as most of BTC's liquidity as an asset (i.e. that you can buy and sell BTC in size without significantly moving the price). If you've ever bought or sold BTC on an exchange, it's very likely that a market maker was on the other side of your trade.
Market making is a highly profitable enterprise that benefits from leverage: in this case borrowed BTC. The best market makers deploy the most profitable trading algorithms in a way that doesn't leave them exposed to BTC price movements (i.e. they are delta neutral). As a result, lending BTC to market makers is a common practice in the Bitcoin economy that leads to predictable real yield.
Bitcoin miners are a second, more well-known, participant in the Bitcoin economy. Miners secure the Bitcoin network and with that the wealth of Bitcoin holders. Miners qualify as a participant in the Bitcoin economy because they have future earnings in BTC (the Bitcoin mining reward).
On the other hand, miners' input costs are denominated in fiat currencies (primarily electricity costs and machines). This difference in the type of money earned (BTC) and spent (fiat) leads to significant issues. Over the course of 2022, miners were faced with a collapsing Bitcoin price as well as rising energy costs. This adverse shock turned many public Bitcoin mining companies into forced sellers of BTC at the moment when BTC price was already collapsing. Not good. To make the Bitcoin mining sector more resilient, miners would benefit from reducing their long exposure to BTC during the good times by selling borrowed BTC.
Any company taking BTC payments
Even though this segment of the Bitcoin economy is still small, it's growing at rapid pace. The Lightning network is coming of age, with it’s BTC locked growing almost 200% in 2022.
Companies taking payments in Bitcoin would benefit from access to Bitcoin capital markets to a) leverage their future earnings or b) borrow and sell any BTC they earn in order to continuously hedge out any price risk from taking Bitcoin payments. The latter strategy is especially suitable for companies that believe that taking Bitcoin payments could boost their business, but don't want to hold BTC on their balance sheet (essentially a currency swap). Luxury goods companies would fall in this category.
The case for decentralized Bitcoin finance
So now that we’ve made the case for Bitcoin finance, why would anyone be interested in decentralised Bitcoin finance?
The case for Bitcoin DeFi has become significantly easier to make after the implosion of centralised Bitcoin lenders like BlockFi after the FTX drama. We’re currently witnessing a total implosion of the financial ecosystem around Bitcoin where credit has almost disappeared. Even the most credit-worthy publicly listed market makers are struggling to access Bitcoin capital.
Decentralised Bitcoin lending platforms are a better alternative because they are transparent by design & don’t require a third party to custody assets or collateral. Centralised Bitcoin lenders like BlockFi operate like a black box. Users send their BTC in and are unable to trace who it is being lent to. Traditional banks operate in the same way, but they have lenders of last resort in most countries (i.e. the government). Without a lender of last resort, full transparency into lending activities is required which decentralised lending platforms can offer using the power of the blockchain. Similarly, a decentralised Bitcoin lending platform doesn’t require a third party to hold any funds. Smart contracts hold funds instead. As a result, it’s not possible that ‘an accounting error’ by a group of kids on a faraway island can lead to users losing all their funds.
When we started building Zest Protocol, the problems of centralised Bitcoin lenders with transparency and third-party custody were theoretical. Today, they are all over every major news outlet in the world.
Zest Protocol is the underlying infrastructure that will make decentralised Bitcoin capital markets possible for the first time. We will use the technical breakthroughs that the Stacks programming layer offers to build decentralised capital markets into the Bitcoin blockchain.
There hasn’t been a better time to rebuild Bitcoin credit markets for a durable Bitcoin economy. Traditional market makers are entering the space at rapid pace and miners are shifting their business models after getting burned for their long-exposure. Both will need Bitcoin credit to ultimately succeed in securing Bitcoin’s network and liquidity. It’s time that we - as Bitcoiners - start to put our Bitcoin where our mouth is.
Watch the full talk here:
Zest Protocol is on testnet & aims to hit Bitcoin mainnet in Q1 2023.