Bitcoin-Based Stablecoins: Bridging Security and Stability for a Decentralized Future
What are Stablecoins?
Stablecoins are cryptocurrencies pegged to fiat currencies (like the US dollar), a commodity (like gold), or a basket of digital assets. They provide stability by minimizing volatility in the crypto market, making them ideal for various use cases.
Stablecoins are highly suitable for payments, remittances, and as a store of value. Users can freely use stablecoins without worrying about the value of their holdings fluctuating, unlike Bitcoin or Ether, where price volatility can complicate everyday use. Stablecoins solve this problem by ensuring price stability, making them easier to use in day-to-day transactions.
Types of Stablecoins
There are four main types of stablecoins: fiat-collateralized stablecoins, crypto-collateralized stablecoins, commodity-collateralized stablecoin, and algorithmic stablecoins.
Fiat-collateralized Stablecoins
Fiat-collateralized stablecoins are cryptocurrencies backed by reserves of fiat currency, such as the US dollar or Euro. For each stablecoin issued on the network, an equivalent amount of fiat currency is held off-chain in a bank account or by a financial institution at a 1:1 ratio. This reserve mechanism helps maintain price stability.
Holders of fiat-backed stablecoins can redeem their coins for the equivalent amount of fiat currency at any time, which ensures the stablecoin’s value remains consistent with its fiat counterpart. However, the reserves are controlled by a centralized authority, which introduces a degree of centralization risk. To mitigate this risk, many fiat-backed stablecoin projects publish regular audits and transparency reports. These reports provide summaries of the reserves, indicating to what extent the stablecoins are backed by fiat currencies. Also, most fiat-collateralized stablecoins are subject to regulatory frameworks, requiring compliance with KYC (Know Your Customer) and AML (Anti-Money Laundering) policies.
Examples of Fiat-Collateralized Stablecoins:
- Tether (USDT): One of the first and most widely used fiat-collateralized stablecoins, pegged to the US dollar.
- USD Coin (USDC): Another popular US dollar-backed stablecoin, issued by regulated entities, and known for its regular audits and transparency.
- TrueUSD (TUSD): A stablecoin that is also pegged to the US dollar, and its reserves are held by independent third-party custodians.
Fiat-backed stablecoins play a critical role in the crypto ecosystem by providing a stable medium of exchange, a store of value, and a bridge between traditional finance and decentralized applications.
Crypto-collateralized Stablecoins
Crypto-collateralized stablecoins are digital assets backed by reserves of other cryptocurrencies instead of fiat currencies. The goal is to achieve price stability by leveraging the transparency and censorship resistance of blockchain technology, using an over-collateralization method to mitigate volatility risks.
To obtain crypto-collateralized stablecoins, users deposit cryptocurrency into a smart contract and receive stablecoins at a ratio defined by the over-collateralization requirement. For example, if the over-collateralization ratio is 150%, a user needs to lock up $150 worth of cryptocurrency to mint $100 worth of stablecoins. This over-collateralization acts as a buffer against the inherent price volatility of crypto assets. If the collateral value falls below a certain threshold, the smart contract will automatically liquidate a portion of the collateral to maintain the stablecoin’s peg.
These stablecoins are governed by smart contracts, ensuring transparency and decentralization, which eliminates the need for trust in third parties. However, since the collateral itself is volatile, there is a risk of liquidation events that could disrupt the stablecoin’s peg. Additionally, they tend to be more complex than fiat-collateralized stablecoins and require a significant amount of over-collateralization, which can be capital-inefficient.
Examples of Crypto-Collateralized Stablecoins:
- DAI: The most prominent example of a crypto-collateralized stablecoin is DAI, issued by the MakerDAO protocol. DAI is soft-pegged to the US dollar and backed by a basket of cryptocurrencies locked in MakerDAO’s smart contracts. Users can generate DAI by locking up assets like ETH, WBTC (Wrapped Bitcoin), and other tokens.
- sUSD: Issued by the Synthetix protocol, sUSD is backed by SNX tokens that are staked as collateral. Like DAI, it relies on over-collateralization to ensure stability.
Crypto-collateralized stablecoins like DAI offer a decentralized and transparent alternative to fiat-backed stablecoins, making them a cornerstone of the DeFi ecosystem. However, their reliance on over-collateralization and exposure to market volatility present challenges that need to be managed carefully. As DeFi continues to grow, the role of crypto-collateralized stablecoins is likely to expand, providing a decentralized solution for price stability in the crypto market.
Commodity-Collateralized Stablecoins
Commodity-collateralized stablecoins are a type of stablecoin backed by physical commodities like gold and silver, instead of fiat currencies or cryptocurrencies. The goal is to provide a hedge against the volatility of the crypto market, while maintaining value stability through tangible assets. This approach also offers investors diversification by giving them exposure to well-established stores of value like precious metals.
In commodity-collateralized stablecoins, each token represents a specific amount of a physical commodity. For instance, PAX Gold (PAXG) corresponds to one ounce of physical gold. These commodities are securely stored in trusted facilities and are subject to independent audits. However, this model requires reliance on a central authority for the safekeeping and verification of assets, which introduces some centralization risks. Despite this, these stablecoins allow access to assets like gold and silver, which have proven themselves as reliable stores of value over thousands of years, and they typically experience lower volatility compared to cryptocurrencies.
Examples of Commodity-Collateralized Stablecoins:
- PAX Gold (PAXG): Backed by one ounce of London Good Delivery gold. Token holders have ownership rights to the gold and can physically redeem it.
- Tether Gold (XAUT): Issued by Tether, each XAUT token is backed by one ounce of physical gold. The gold is stored in secure vaults, and token holders can verify the gold’s existence.
Digix Gold Token (DGX): Each DGX token is equivalent to one gram of gold stored in secure vaults in Singapore.
Commodity-collateralized stablecoins bridge the gap between digital assets and traditional finance, providing investors with a unique opportunity to diversify their portfolios. However, the challenges related to centralization and storage costs remain significant barriers to their widespread adoption.
Algorithmic Stablecoins
Algorithmic stablecoins operate without holding reserves in fiat currency or cryptocurrencies. Instead, they function based on a series of smart contracts and algorithms that adjust the token supply according to demand. The goal is to maintain price stability by increasing or decreasing supply as needed.
When the price of an algorithmic stablecoin exceeds its target peg, the protocol mints new tokens to increase supply. These newly created tokens are either distributed to current token holders or sold to bring the price back down to the target level. Conversely, when the price falls below the target peg, the protocol burns tokens to reduce the supply. This process may also include incentivizing holders to lock or burn their tokens by offering future rewards. The goal is to decrease the supply and return to the target peg.
Because algorithmic stablecoins do not require reserves, they offer higher capital efficiency. Managed by smart contracts and algorithms, they are decentralized but come with increased complexity. The history of algorithmic stablecoins includes cases like the de-pegging of UST and its subsequent death spiral, highlighting the potential risks of their fragile and complex structure.
Types of Algorithmic Stablecoins:
- Rebase Model: In this model, the total supply is periodically adjusted. For instance, when the price is above the peg, token holders will see an increase in their balances without changing their ownership percentage. An example of this model is Ampleforth.
- Seigniorage Model: This model uses a dual token system, consisting of a stablecoin and a share token. When the stablecoin’s price is above the peg, new stablecoins are minted and distributed to share token holders. If the price is below the peg, the protocol issues “debt” or bonds that can be purchased with stablecoins, thereby reducing the circulating supply.
- Fractional Algorithmic Model: This is a hybrid approach combining partial collateralization with algorithmic mechanisms. Frax is an example of this type, where the stablecoin is partially backed by collateral (like USDC) and partially stabilized by an algorithmic mechanism.
Algorithmic stablecoins represent an innovative approach to achieving price stability in decentralized finance (DeFi) without relying on traditional collateral. However, they come with significant risks due to their reliance on market dynamics and user behavior. While they offer benefits like decentralization and capital efficiency, their volatility and susceptibility to collapse make them a high-risk, high-reward option in the stablecoin landscape.
Current Market Landscape
The stablecoin market currently stands at a remarkable $180 billion, a significant milestone reflecting the growing role of stablecoins in the broader cryptocurrency ecosystem. This market is fueled by a wide variety of stablecoins — 202 different tokens in total — which range from well-established projects like Tether (USDT) and USD Coin (USDC) to newer, emerging solutions.
Upon analyzing the stablecoin market share, it is evident that two projects dominate the scene, collectively holding over 90% of the total market share: USDT and USDC. Tether (USDT), with nearly a 70% market share, stands as the indisputable leader in the stablecoin sector. This is followed by USD Coin (USDC), which commands around 20% of the market. Meanwhile, DAI, the decentralized stablecoin, holds a modest share of approximately 2.66%.
The overwhelming dominance of USDT presents a potential risk for the market’s stability. If USDT were to experience any internal issues or regulatory scrutiny, it could trigger a market-wide crisis, given its outsized influence. This concentration risk underscores the need for diversification and resilience within the stablecoin ecosystem to mitigate systemic threats.
According to DefiLlama, over 50% of all stablecoins are currently hosted on the Ethereum blockchain. Ethereum’s dominance in this space is a testament to its robust DeFi infrastructure, which attracts stablecoin issuers due to its security, liquidity, and developer-friendly environment. Following Ethereum, other blockchains like Tron, Binance Smart Chain (BSC), Arbitrum, and Solana also hold significant portions of the stablecoin supply. Tron, in particular, has become a notable player, primarily driven by its lower transaction fees and growing adoption in markets with high demand for USDT.
When examining the top 10 blockchains by stablecoin market cap, USDT exhibits clear dominance on seven of these chains, while USDC leads on three. This pattern indicates that while USDT maintains a stronghold across multiple networks, USDC has carved out substantial market share in specific ecosystems, especially where compliance and regulatory considerations are prioritized.
The stablecoin sector remains a cornerstone of the crypto economy, offering liquidity, stability, and interoperability across various blockchains. However, the heavy concentration of market share in the hands of a few stablecoins, particularly USDT, introduces systemic risks that could have far-reaching implications in the event of a disruption. As the stablecoin landscape continues to evolve, monitoring these dynamics will be crucial for understanding the broader implications on the DeFi sector and the crypto market as a whole.
This highlights the need for both diversification and innovation to build a more resilient stablecoin ecosystem that can withstand potential shocks and adapt to regulatory developments.
The Rise of Bitcoin Layer-2 Solutions and Bitcoin DeFi
The number of transactions that can be conducted on the Bitcoin mainnet is limited. Currently, Bitcoin operates at an average of 7 TPS (Transactions Per Second). This limitation, despite Bitcoin being a secure, decentralized, and distributed solution, causes issues with scalability. To overcome these scalability problems, Layer-2 solutions have emerged on Bitcoin.
In particular, the Lightning Network, introduced in 2015 by Joseph Poon and Thaddeus Dryja, brought a new perspective to scalability on Bitcoin. The Lightning Network is a state-channel solution that allows high-frequency and low-fee transactions by moving them off-chain. Two users can open a channel and make as many transactions as they wish within that channel. Once the transactions are completed and the channel is closed, the net transaction result is recorded on the main chain. This method is especially suitable for payments. However, this solution is not open to public participation as each channel is formed between two users. Nevertheless, previously opened channels can be reused. For example, if user A has a channel with user B and user B has one with user C, user A can make a payment to user C using the existing channels, even if there is no direct channel between A and C. In this solution, the parties to the channel must remain online continuously, and there is no general programmability. These disadvantages limit the widespread use of this solution beyond payments. Particularly, the integration of the SegWit (Segregated Witness) protocol into Bitcoin in 2017 increased the usability of the Lightning Network. From 2018 onward, it gained wider adoption. Today, the capacity of the Lightning Network has reached millions of dollars and is supported by thousands of nodes globally.
Apart from the Lightning Network, there are other Layer-2 solutions on Bitcoin. For instance, the Liquid Network, developed by Blockstream in 2018, is one such solution. The Liquid Network is a sidechain solution. Sidechains are independent chains linked to Bitcoin’s main chain, allowing the transfer of Bitcoin to other chains. The Liquid Network supports fast and private large-scale transactions and uses L-BTC tokens, representing BTC. It is primarily used between exchanges and financial institutions. Another Bitcoin Layer-2 solution is RSK (Rootstock). RSK is a Bitcoin-based smart contract platform that aims to bring smart contract capabilities to Bitcoin using an Ethereum Virtual Machine (EVM)-like virtual machine. While these solutions bring progress to Bitcoin in terms of scalability, they face various challenges in becoming general-purpose solutions. Bitcoin still requires Layer-2 solutions that are secure, decentralized, and allow programmability for complex DeFi operations similar to those on Ethereum. This is where new-generation Bitcoin Layer-2 solutions come into play.
Ethereum’s rollup-centric roadmap has played a significant role in the development and diversification of Layer-2 solutions. Rollups are more secure and decentralized compared to other Layer-2 solutions, as they conduct transactions off-chain and submit proofs of validity to the main chain. They are divided into Optimistic rollups and zkRollups, based on the proof mechanism they use. Optimistic rollups use fraud proof mechanisms, while zkRollups use zero-knowledge proof mechanisms. After years of development, rollup technology has evolved, leading to various rollup frameworks, prover-verifier mechanisms, proof types, and design variations. These advancements have significantly increased the possibility of developing rollups on Bitcoin. BitVM-based rollup solutions are being developed to provide programmability and complex DeFi operations on Bitcoin. BitVM is a system that enables Turing completeness on Bitcoin, allowing the execution of complex smart contracts. This system ensures the verification of computations without altering Bitcoin’s existing consensus rules. BitVM operates with a protocol between a “prover” and a “verifier.” The prover claims the result of a certain computation, while the verifier verifies this claim. If the claim is false, the verifier can provide a fraud proof to penalize the prover. This mechanism allows for the verification of any computable function on Bitcoin. All these advancements in rollup technology and BitVM pave the way for rollups on Bitcoin. For instance, Citrea, a BitVM-based zkRollup project, facilitates faster and cheaper transactions and the execution of smart contracts on Bitcoin. This project, which provides full EVM compatibility, enables Ethereum smart contracts to utilize Bitcoin’s block space without modification. Citrea also allows asset transfers between Bitcoin and Citrea via a two-way bridge based on BitVM. The use of zero-knowledge proof technology and batch processing of transactions results in increased transaction volumes while reducing costs. Projects like Citrea bring a new perspective to programmability on Bitcoin.
DeFi operations on Bitcoin are not solely reliant on rollup solutions. Currently, thanks to the Taproot upgrade, there is already minimal DeFi activity on Bitcoin. The Taproot update, implemented in 2021, brought scalability, privacy, and smart contract capabilities to the Bitcoin network. The post-Taproot period saw the emergence of Runes and Ordinals protocols, which introduced DeFi activity on Bitcoin. Ordinals allow individual satoshis (the smallest unit of BTC) on the Bitcoin blockchain to be defined as tokens and associated with media files such as text, images, and videos. This enables the creation and transfer of NFTs on Bitcoin. As a result, NFT collections have been minted on Bitcoin, and currently, the market value of these collections has reached $200 million. The BRC-20 tokens created via Ordinals have seen over 50 million transactions, with more than $520 million in fees paid. This introduction of NFTs to the Bitcoin network has been a significant development. Runes, on the other hand, is an open-source protocol that allows the creation and management of tokens on Bitcoin. This protocol facilitates the integration of ERC-20-like tokens into the Bitcoin ecosystem. Runes are built on Bitcoin’s UTXO (Unspent Transaction Output) model and enable the creation and transfer of tokens. To date, more than 170,000 Runes have been created, with nearly $5 million in transaction fees paid.
Both Ordinals and Runes have demonstrated that DeFi is possible on Bitcoin, creating DeFi activity on the network. However, this DeFi activity is not as advanced as that on rollups and does not allow for complex applications. All these developments are gradually increasing DeFi activity on Bitcoin and paving the way for more complex applications in the future.
The Need for Bitcoin-based Stablecoins
The need for Bitcoin-based stablecoins has become increasingly apparent as Bitcoin’s capabilities and its Layer-2 solutions continue to evolve. While Bitcoin is the most secure and decentralized blockchain, its high price volatility limits its use in everyday transactions and broader financial applications. Stablecoins, which maintain a fixed value typically pegged to fiat currencies like the US dollar, are essential for achieving stability in the crypto ecosystem. Integrating this concept within the Bitcoin network can bring unique advantages, enhancing its role in global finance and decentralized applications.
Advantages of Bitcoin-Based Stablecoins:
- Enhanced Security and Decentralization: Bitcoin’s blockchain is known for its unparalleled security and decentralization. A stablecoin built directly on Bitcoin or its Layer-2 solutions could leverage this robust infrastructure, providing users with a stable asset that inherits Bitcoin’s resistance to censorship and network reliability.
- Interoperability with Existing Bitcoin Infrastructure: A Bitcoin-native stablecoin could seamlessly integrate with established Bitcoin Layer-2 solutions like the Lightning Network and Liquid Network. This integration would enable fast, low-cost transactions in a stable asset, enhancing the network’s usability for regular commerce and financial interactions.
- Empowering Bitcoin DeFi: The introduction of a Bitcoin-based stablecoin could serve as a catalyst for decentralized finance (DeFi) on Bitcoin. Platforms like RSK and advancements enabled by BitVM already allow for smart contracts and more complex operations. A stablecoin could provide liquidity and stability within Bitcoin-native DeFi ecosystems, facilitating decentralized exchanges, lending protocols, and yield farming.
- Hedging Against Volatility: Bitcoin’s high volatility can be a deterrent for users who wish to engage in payments, savings, or financial contracts without the risk of significant value fluctuations. A Bitcoin-based stablecoin would allow users to transact and manage assets within the Bitcoin ecosystem while maintaining a predictable value, offering a balance between stability and the security of the Bitcoin blockchain.
Potential Use Cases for a Bitcoin-Based Stablecoin:
- Cross-Border Payments: With Bitcoin’s strong global presence, a stablecoin could simplify cross-border transactions, offering a stable, fast, and low-cost solution that reduces reliance on traditional fiat conversion and banking intermediaries.
- Microtransactions: The high speed and low transaction fees enabled by Layer-2 solutions like the Lightning Network make Bitcoin suitable for microtransactions. A Bitcoin-based stablecoin would enhance this capability by ensuring value stability, which is crucial for small payments in gaming, content creation, and other digital services.
- DeFi and Financial Products: Bitcoin’s entry into the DeFi space has been limited compared to Ethereum due to its original design constraints. A stablecoin can act as a bridge to further expand Bitcoin’s DeFi landscape, allowing it to compete with platforms that support borrowing, lending, and derivatives markets.
- E-commerce and Retail Payments: Merchants are often hesitant to accept Bitcoin due to its price volatility. However, a Bitcoin-based stablecoin would eliminate this concern, allowing them to accept payments in a stable currency while still engaging with the Bitcoin ecosystem.
A Bitcoin-based stablecoin could bridge the gap between Bitcoin’s unmatched security and the stability needed for everyday transactions and financial activities. It would empower the growth of Bitcoin’s DeFi ecosystem, facilitate cross-border trade, and open new opportunities for digital commerce. While technical and economic challenges exist, the development of such a stablecoin is a promising step toward enhancing Bitcoin’s utility and maintaining its position as a leader in the evolving crypto space.
Conclusion
The stablecoin market, currently valued at an impressive $180 billion, underscores its pivotal role in the broader cryptocurrency ecosystem. This growth reflects the increasing reliance on stablecoins as essential tools for liquidity, stability, and seamless financial transactions. As Bitcoin Layer-2 solutions and DeFi activity continue to expand, the demand for Bitcoin-based stablecoins has surged, highlighting their potential to fill a critical gap in the market.
With over 202 different stablecoin tokens, the dominance of major players like USDT and USDC, which collectively command over 90% of the market share, signals both opportunities and challenges for diversification. The introduction of a Bitcoin-based stablecoin would provide an innovative alternative that leverages Bitcoin’s unparalleled security and decentralization, aligning with the network’s foundational ethos while addressing the need for price stability.
The rapid increase in DeFi activities on Bitcoin further amplifies the need for stable assets that can support complex financial interactions without exposure to Bitcoin’s inherent volatility. By integrating stablecoins directly into the Bitcoin ecosystem, users would benefit from greater financial flexibility and resilience, fostering global commerce and enhancing Bitcoin’s utility beyond its traditional role as a store of value.
Ultimately, the development and adoption of Bitcoin-based stablecoins represent an important step towards a balanced and diversified crypto economy. This evolution will not only reinforce Bitcoin’s standing within the digital asset landscape but also contribute to a more inclusive, stable, and interconnected financial system.
