Solving Bitcoin’s Blind Spot

What is Bitcoin?

It’s a question that’s been debated ever since the original Bitcoin White Paper was published in October 2008.

To some, it’s a speculative vehicle. Others think it’s little more than a Ponzi. I’ve also heard it referred to as a work of art.

But to us, the answer to that question was always very easy. Bitcoin is sound money.

With a total supply cap of 21 million tokens hardcoded into the Bitcoin blockchain, the asset cannot be printed. We can’t say the same about fiat currencies.

Bitcoin is also easily divisible, portable, and censorship resistant. Each trait on its own is a benefit. Together, it makes Bitcoin a store of value the market seeks out.

But historically, it has lacked one feature. That would be the ability to unlock its value without trusting somebody.

Think of a home equity line of credit. The bank issuing the loan doesn’t really need to trust you. After all, the loan is backed up by the equity in your home. And data like your credit score provides more transparency on a borrower’s creditworthiness.

But that’s a powerful ability—unlock the value of an asset (your home) without an outright sale.

It’s also an ability Bitcoin has lacked…but maybe not for much longer.

What Exists Today

In recent years, the only way to unlock value from your bitcoin was by entrusting a custodian with the coins. These custodians have been entities like BlockFi, Celsius, or Voyager.

All three declared bankruptcy years ago.

Another option was to deposit bitcoin with centralized exchanges and trust they’d be good stewards of our assets. As we saw with FTX in 2022, that wasn’t always the case.

This trusted setup goes against the self-custody ethos of Bitcoin and digital assets. But there hasn’t been much choice.

That’s because the Bitcoin blockchain does not support smart contracts. This is a feature that allows protocols like Aave, Uniswap, or Polymarket to exist on the network. Smart contracts are essentially a way for software to exist on a blockchain network.

This is why wrapped Bitcoin (wBTC) is widely used. It’s a solution where a trusted third party holds bitcoin and mints wBTC on a network like Ethereum that the user can transact with.

But, again, anybody holding wBTC is trusting that the entity holding the true Bitcoin won’t do anything malicious.

wBTC is not the only flavor of wrapped Bitcoin in the market. Coinbase offers cbBTC. It’s the same deal. Coinbase holds your bitcoin and issues a new token that can be transacted on blockchains that support smart contracts.

The big difference here is that Coinbase is a public company that must file regulatory disclosures throughout the year.

wBTC and cbBTC make up more than 80% of the wrapped Bitcoin in circulation. There’s a long tail of other solutions like tBTC, hBTC, renBTC, and many more all attempting to provide the market with its own solutions.

Together, the wrapped Bitcoin solutions make up about $14 billion in market cap. That might seem like a decent amount until we consider Bitcoin has a $1.3 trillion market cap. In other words, it’s only about 1%.

But here’s what is so fascinating about that 1% market share…

Nearly $4 billion of it sits on Aave, the largest lending protocol. Approximately $13 billion of assets on its platform are various flavors of Bitcoin.

That shows us why the market seeks out these wrapped versions. It wants to use Bitcoin for solutions such as lending and borrowing.

What’s more is that the $4 billion of wrapped Bitcoin on Aave makes up more than 30% of all value sitting on its protocol. Which is to say Bitcoin is one of the most preferred assets to use, even though it has layers of trusted parties baked in.

The market is saying Bitcoin is a preferred store of value. And holders want to make it a more productive asset using DeFi.

Said differently, whoever can unlock Bitcoin’s value without needing to trust third parties might find themselves with an addressable market that’s $10-100 billion in size.

And based upon an ongoing vote taking place on Aave right now, it seems somebody is getting ready to give it a try.

Trustless Bitcoin

Babylon is a project backed by the industry’s top VCs like a16z, Paradigm, Polychain, and Galaxy.

The team behind the project has raised approximately $100 million in financing across several rounds. That makes it a project worth taking seriously.

Their initial solution was liquid restaking. It was a way for Bitcoin holders to essentially lend out their bitcoin for builders needing to rent security.

There’s about 51,000 BTC or $3.4 billion worth on the protocol. And the yield being earned is currently between 0.04% and 0.6%.

It’s a small yield. But the fact that $3.4 billion worth of assets are on the protocol shows the hunger for these types of solutions. And it’s the next solution from Babylon that really caught my eye.

It’s called Trustless Bitcoin Vaults.

Here’s how it works…

A user locks Bitcoin in something called a Taproot script. We don’t need to understand the technicality of Taproot signatures, what we should know is that it acts like a vault or an escrow account.

The Bitcoin is not sent to an exchange, not sent to a third party, nor sent to a combination of various nodes that splits up a private key into smaller chunks for safekeeping.

The vault sits on the Bitcoin network. Once Bitcoin is verified to be in the vault, Babylon mints vaultBTC on Ethereum. It’s a token that represents the collateral held on the Bitcoin blockchain. From there, vaultBTC can then be used as collateral in DeFi.

It might sound like a wrapper, but it’s not.

It’s more like a claim on the Bitcoin held in the trust. Meaning if vaultBTC were used as collateral for a loan, and that loan got liquidated, the holder of vaultBTC could withdraw their share of Bitcoin.

But, again, the important part is this: The original Bitcoin is not held by a third party that may or may not be a good steward of the asset.

It’s a novel solution that preserves self-custody and solves some of the friction that plagues the market today.

But here’s where things get really exciting…

Yesterday, Aave opened a vote on the topic of allowing the solution to exist on its protocol. We should know the results by next Monday.

By the time you read this, the results could already be in. Self-custody Bitcoin could be on its way to Aave.

It could be the solution that Bitcoin holders have been seeking out for years—a way to unlock your bitcoin’s value without trusting a third party.

If the vote on Aave is approved, we could see a significant chunk of bitcoin flow to the protocol by the end of the month.

That amount of capital is worth keeping an eye on. It can generate renewed interest in the market and give those building around Babylon a growing capital base to work with.

If this new solution gains scale, it could add a much-needed feature to Bitcoin. With time, that should help buoy the asset price.

I’m optimistic Babylon finds success. It has major backers and even a sign-off from Aave’s founder.

But a word of caution on Babylon’s native BABY token…

I’m skeptical. The token’s economics are lacking. The amount of supply coming to market over the next year is expected to nearly double. And the token lacks proper value accrual. Any success Babylon is likely to realize won’t flow back to the token.

That’s disappointing, especially coming from a project that is addressing such a critical blind spot in the world’s largest digital asset.

But this is all worth paying attention to.

Bitcoin is the largest asset in terms of market capitalization. And if a new opportunity can unlock its wealth, we need to be ready.

More to come on…

Your Pulse on Crypto,

Ben Lilly

Editor, Chain of Thought