The Revolution Will Be Financialized

Financialization Mar 06, 2020

Not only is this okay for Bitcoin, but it’s desirable

Inspired by the Satoshi Nakamoto Institute crash course, the following is the Knox index of the best work towards the principled and ethical financialization of the Bitcoin communications protocol. While I have argued that Bitcoin itself should not be defined legally within financial frameworks, its scarce information space has nonetheless accrued subjective value. It is thus primed for financialization on top of the base protocol. Aside from a few pieces that position Bitcoin against its aspiring usurpers, this list is Bitcoin-only. We will share more on that later.

Native opportunities

Bitcoin is, first and foremost, a distributed communications protocol. This opens it up to some novel native opportunities that would traditionally require third-party intermediaries and auditors:

It’s the settlement assurances, stupid by Nic Carter is a tour de force that builds on his previous work (here and here) to make the case that the Bitcoin network dominates at enforcing final settlement.

Source: It’s the settlement assurances, stupid by Nic Carter

Making Bitcoin Exchanges Transparent by Christian Decker, James Guthrie, Jochen Seidel and Roger Wattenhofer is a 2015 research paper that, among other things, lays out the why and how for Bitcoin custodians to provide proof-of-reserves. There is also a good outline by Blockstream, Standardizing Bitcoin Proof of Reserves, which describes the tools being developed to provide these assurances.

Bitcoin vaults with anti-theft recovery/clawback mechanisms by Bryan Bishop is a proposal sent to the bitcoin-dev mailing list that outlines how it is possible to hold UTXOs in a self-custodied “vault” that only allows very specific transactions, even allowing the user to effectively undo a transaction.

Open data value modelling

Bitcoin’s unprecedented open data-set has allowed for the proposal of novel value modelling methodologies:

Modeling Bitcoin’s Value with Scarcity by PlanB models an idea proposed by Saifedean Ammous in The Bitcoin Standard. The value and soundness of a money can be derived from its stock-to-flow ratio (the amount of new supply coming onto the market as a fraction of the pre-existing supply). The model has surprised many with its fit to price data and prompted a lot of debate about the efficiency of markets and whether Bitcoin’s halving cycles are priced in.

Bitcoin Risk Spectrum from The Lightning Network Reference Rate by Nik Bhatia

The Lightning Network Reference Rate (part one, two, three, and four) by Nik Bhatia is a series exploring the use of Lightning Network routing nodes to earn a risk- and trust-minimized return on Bitcoin through routing fees. The series explores how to calculate an individual Node Accrual Rate (NAR) and implores participants to share this data such that a Lightning Network Reference Rate (LNRR) can be derived. As Nik says, the LNRR could “pave the way for a world of relative value calculations and be instrumental in the pricing of off-chain bitcoin lending.”

Experiments on Cumulative Destruction by Willy Woo is an exploration in using Bitcoin Days Destroyed to derive the value of the Bitcoin network. It proposes a striking correlation between the cumulative value of Bitcoin Days Destroyed and the bottom of past market cycles.

Source: Experiments on Cumulative Destruction by Willy Woo

HODL Waves by Dhruv Bansal analyzes the age distribution of Bitcoin’s UTXO set over time to propose a feature of Bitcoin’s infamous parabolic bull runs: that they encourage new participants to enter the market … and many never leave.

Source: HODL Waves by Dhruv Bansal

Transaction count is an inferior measure by Nic Carter, meanwhile, exposes how some apparent data insights from the Bitcoin information space can be misleading. Caution is needed to ensure that models recognize how the Bitcoin protocol is used and which measures are easily spoofed.

Regulatory encounters

Because Bitcoin is a communications protocol first and foremost, it is often at odds with pre-existing financial regulatory regimes:

Why Bitcoin is Not a Security by Elisabeth Préfontaine addresses a very common misunderstanding about the nature of Bitcoin and thoroughly debunks it.

Two Things That Don’t Mix Well: Bitcoin Rehypothecation And Chain Forks by Caitlin Long introduced many Bitcoiners to the idea of rehypothecation — that through financial trickery more than a single party can have a legal claim on a single underlying asset, and that this creates fragility. This piece focuses on the particular context of chain forks but explores wider implications.

Emerging derivatives markets and technology

The scarce information space encumbered by Bitcoin UTXOs is only a small part of the protocol that can be valued. Miners, traders and other participants might want to trade futures derived from the Bitcoin hashrate:

Hedging mining difficulty by the late Tamas Blummer is an introductory exploration of how to calculate and hedge mining difficulty.

POWSWAP by Jeremy Rubin is still nascent, with the best exploration in the form of a tweetstorm. POWSWAP is a method to trade Bitcoin hashrate derivatives using only the Bitcoin protocol itself as an oracle, thus having no reliance on trusted third parties.

To manage expectations, Jack Mallers of Zap fame has some thoughts on the difficulties this project might face being a difficulty market-maker:

Building financial infrastructure

Finally, infrastructure is being built that adds to the weight of Bitcoin’s nascent financial system and bridges the gap to the legacy one:

Discrete Log Contracts by Thaddeus Dryja introduced the concept of Discrete Log Contracts (DLCs), which enables a peer-to-peer Bitcoin derivatives protocol. This protocol has been extended by Suredbits who have a four-part explainer series (part one, two, three and four) and an excellent Discrete Log Contract Demonstration in action.

Liquid Technical Overview by Blockstream outlines how the Liquid federated side-chain works to add an extra layer that connects key players in Bitcoin’s financial infrastructure, such as exchanges and custodians for inter-exchange settlements, given a different set of trade-offs notably improved confidentiality and velocity with reduced block mining time.

A Brief Introduction to Bisq by the Bisq team explains why the decentralized exchange is needed and how to “be your own exchange”, paving the way to a novel decentralized market infrastructure for order books and execution venues.

Thanks to Thib and Daskalov for their help with this introduction to the financialization of Bitcoin. If you want to talk further about responsible Bitcoin custody for your fund, exchange, or other vehicles, have strict LP and risk management requirements, or otherwise appreciate a trust-minimized profile, we’d love to talk. Please contact us at

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