Incentives of Stablecoins on Bitcoin – Bitcoin Magazine
Since the announcement of the Taro protocol by Lightning Labs, the topic of stablecoins issued directly on the Bitcoin blockchain has become the center of conversation once again. In reality, this is nothing new. Tether, the first stablecoin, was originally issued on the Bitcoin blockchain using the Mastercoin (now called Omni) protocol that enabled the issuance of other tokens on the Bitcoin blockchain. Stablecoins literally began on the Bitcoin network, but due to the limitations of the block size limit and the 2017 fee event, they have migrated to other blockchains. It started with Ethereum, and then spread to more centralized and cheaper fee blockchains as time went on. Ultimately, centrally issued stablecoins are centralized, and no matter how decentralized the blockchain on which you issue them, their value is ultimately derived from the ability to redeem them from a single centralized entity that may refuse to do so. That is issuing them on a decentralized blockchain is complete theater in the sense that it does nothing to decentralize the stablecoins themselves; the only benefit of doing so is easy interoperability with native stuff on that blockchain.
I actually think progression to other blockchains was a good thing, there is no real benefit to processing stablecoin transactions on the Bitcoin blockchain in terms of censorship resistance. The issuer can simply refuse to redeem coins involved in illegal activity, coins that were stolen, or for any arbitrary reason they have a legal basis to act on. Issuing and trading them on Bitcoin only uses block space which provides no real censorship resistance for stablecoins and only provides a marginal benefit of making things like atomic swaps for Bitcoin a little less complex.
However, it introduces new variables into the incentive structure of the Bitcoin system as a whole. There have been discussions about the impact of stablecoins on the consensus layer of the Ethereum network in relation to the upcoming merger and transition to proof-of-stake. Circle, the issuer of USDC, has announced that they will only support USDC and honor redemptions on the PoS network. They will ignore and refuse to honor redemption requests for USDC on other parts of the post-merge Ethereum network. This is a perfectly rational thing to do – USDC is a reserve-backed stablecoin tied to actual bank dollars held in reserve by Circle. It is completely insane and impossible to honor redemptions on more than one side of any fork, as they only have enough dollars in reserve to redeem a single set of stablecoins issued on a network. When that network splits, it doesn’t magically double the reserve dollars like it does the USDC tokens on that network.
However, this dynamic gives stablecoin issuers an outsized influence on the consensus of the network on which they have issued their coins. USDC is a major driver of utility and transaction volume for Ethereum. All Ethereum users trading with USDC will have no choice after the merge and fork but to switch to that chain to use their UDSC, regardless of their feelings or attitudes regarding PoW versus PoS, or the split in general and which chain they will use. To make use of their USDC they must interact with the PoS chain. This creates a kind of mandated demand for that token, as it requires paying transaction fees to use USDC.
Stablecoins issued on Bitcoin will create exactly the same dynamic. If Taro, or even the resurrected original Omni Tether token, leads to the widespread issuance and transaction of stablecoins on the Bitcoin blockchain, the issuers of those stablecoins have exactly the same leverage to throw around in the event of Bitcoin forks. If Bitcoin becomes a widespread platform for the issuance and use of stablecoins, this becomes a major driver of both the demand for Bitcoin itself – as it is necessary to pay transaction fees – and miner income – again, because it pays transaction fees. All of this demand for the asset, and the generation of income for miners, is held hostage to the whims of the stablecoin issuer.
In the event of a fork, all demand and miner earnings are moved to whichever fork the issuer decides to honor redemptions on. This can occur during a chain split, a hard fork, even a soft fork if the issuer decides a feature is unwanted and they engage in a fork to prevent activation. The more stable coins demanded by the asset and the block space, the more effect they have in such an event. If 10% of miner revenue is to use stablecoins, then during a fork where the issuer chooses a different side than everyone else, 10% of miners’ hashpower will have to shift to that fork to keep that revenue stream. If it’s 40%, 40% of the hash power will have to shift.
The same is true for Lightning Node operators in terms of their routing fee revenue. If a large part of the activity on the network is driven by people exchanging BTC for stablecoins on the edges and routing dollar payments, then all that revenue will dry up on the side of a fork stablecoin issuers don’t honor redemptions for. These node operators must run and service nodes on the second fork to earn the revenue that comes from using the stablecoin.
Bitcoin is not magically immune to the problems Ethereum has because of how dominant the use of stablecoins is on the network simply because they don’t have a complicated and insecure scripting system, or they don’t have the decentralized on-chain exchanges that are used every day. The problems Ethereum faces in this regard are rooted entirely in financial incentives, and certainly equally applicable to the Bitcoin network.
Bitcoiners should think long and hard about whether they should encourage and use such systems built directly on Bitcoin, and whether the risks of such systems are worth it in the long run given how they interact with the incentives of the network. Other blockchains exist, even systems like Elements (the codebase Liquid is based on) exist that can operate quasi-centralized blockchains. Atomic swapping is not that difficult. The tools exist to build systems for stablecoins that can host them externally to the Bitcoin network and enable easy interaction with it.
Do we really want to introduce a massive new centralized variable to the incentives of the entire network just because atomic swapping on one blockchain is slightly easier than atomic swapping across two blockchains? I can only speak for myself, but I don’t.
This is a guest post by Shinobi. Opinions expressed are entirely their own and do not necessarily reflect the opinions of BTC Inc or Bitcoin Magazine.
