Introducing BTC10

A high-yield bond backed by bitcoin

This document is for general information purposes only. It provides a high-level introduction to a new DeFi protocol, but it does not constitute investment advice or a recommendation to buy or sell any investment.

Introduction

Over the last decade, bitcoin has been one of the best performing publicly traded assets, compounding at a rate of return unprecedented for an asset of its scale. This compounding is driven by a growing base of investors who treat the asset as a home for permanent capital and allocate a percentage of their wealth to it year after year.

As Albert Einstein put it, compounding is the "eighth wonder of the world." The problem is that bitcoin's rate of compounding is not directly measurable, and therefore not understood by many investors. Even among those who believe in bitcoin's long-term potential, many are turned off by the high volatility and lack of predictable returns, which make an investment challenging to enter.

BTC10 is a financial product designed for these investors, a high-yield bond backed by bitcoin, which returns a predictable dollar yield at a relatively high rate of return. This yield comes from the right to withdraw bitcoin from a pool, at a rate of $10 per month. This pool holds bitcoin put up by bond holders, matched by bitcoin put up by long-term investors, who expect the asset to compound at a faster rate than the return on the bond.

The advantage for these long-term investors is that they can go long more bitcoin than they own outright, without the risk of a margin call or liquidation if the price of bitcoin falls. BTC10 holders give up some of the upside, and in exchange, these investors take on the volatility of the downside.

The position that the long investors take, BTCX, can be redeemed for bitcoin at any time, or converted into BTC10, and vice versa. The creation, conversion, and redemption of the two positions is governed by an invariant akin to the rule used by Uniswap, such that creating BTC10 makes it cheaper to create BTCX, and vice versa, keeping the system in equilibrium.

A high-yield bond with explicit, predictable cash flows could be easier for many to invest in. The underlying mechanism does not require a centralized marketplace, and it can be implemented fully autonomously on Ethereum, with Chainlink used as a price feed and wrapped bitcoin (WBTC) used as the underlying collateral. The following sections provide more detail about how this works, and a demo video is available in the final section.

Setup

At a high-level, BTC10 starts with two classes of investors adding bitcoin to a shared pool. The first class of investors adds bitcoin in exchange for the debt position, BTC10, and the other adds bitcoin in exchange for the equity position, BTCX. In the illustrative example below, both investors add $500 of bitcoin to the pool, in exchange for 1 share of BTC10 and BTCX, respectively.

An illustrative example of a pool being set up

The debt investor receives a perpetual bond, BTC10, which gives them the right to claim $10 of bitcoin from the pool every month, at whatever price bitcoin is trading at. Since the investor paid $500 to create this bond, the effective annual yield is 24% ($120 / $500).

In exchange, the BTCX investor receives a long position on the bitcoin the bond holder added to the pool, plus a long position on the bitcoin they added themselves. This is rational if the BTCX holder expects bitcoin to compound at a faster rate than 24% per year.

The Invariant

Investors can create, redeem, and convert between BTC10 and BTCX at any time, but the rate at which holders can do so is not fixed. It is instead a function of the quantity of BTC10 and BTCX outstanding and the quantity of bitcoin in the pool. The idea is that as BTC10 is created, it becomes more attractive to create BTCX, or redeem BTC10, and vice versa.

A simple function that can be used is a constant sum-of-squares invariant, akin to the constant product rule used by Uniswap. This invariant ensures that the creation, conversion, and redemption rate between bitcoin, BTC10, and BTCX matches their relative market price:

$$X^2+Y^2=(K \cdot Z)^2$$

where $X$ and $Y$ are the quantity of BTC10 and BTCX outstanding, $Z$ is the quantity of WBTC in the pool, and $K$ is some constant before and after the trade.

Below is an illustrative example of a BTC10 investor redeeming 1 share of BTC10 and receiving the resulting amount of bitcoin from the pool:

An investor redeeming 1 share of BTC10 for BTC

Alternatively, an investor can convert directly from BTC10 to BTCX, and vice versa:

An investor converting 1 share of BTC10 to BTCX

No arbitrage ensures that the rate at which a trader can create, convert, or redeem shares will match the relative price of BTC10, BTCX, and BTC, assuming no transaction costs.

Visually, conversions between BTC10 and BTCX move along a quarter-circle with radius $K\cdot Z$:

The invariant governs the relative supply of BTC10 and BTCX

As a trader converts from BTC10 to BTCX, the quantity $X$ of BTC10 outstanding declines and the quantity $Y$ of BTCX outstanding grows. As a consequence, the trader receives less BTCX as more and more BTC10 is converted. The same holds true if the trader attempts to create only one type of position by adding bitcoin to the pool.

In practice, BTC10 and BTCX will likely be created simultaneously. There will be outstanding orders for BTC10, at or near the current price, and bitcoin holders who would like to hold BTCX will add bitcoin to the pool, create a proportional amount of BTC10 and BTCX, and sell the BTC10 to these investors. To the extent that incentives are needed, a small fee switch can be applied to the monthly BTC10 dividend, and the right to turn on and receive these fees can be given to early BTCX holders.

Pricing BTC10

Determining the "correct" price of BTC10 is not an easy task. At the end of the day, the yield on BTC10 reflects the return the market requires. If the BTC10 dividend is large relative to the value of the pool, the risk that the dividend will eventually not be paid will be higher, and the market will require a higher yield. Conversely, if the dividend is small, the risk the dividend cannot be paid will be lower, resulting in a lower yield. The dividend quantum cannot be changed once the pool is created, so it is incumbent on the initial market maker who seeds the pool to choose the dividend level such that BTC10 is attractive to investors.

Demo Video

Below is a brief demo video demonstrating the BTC10 protocol on the Ethereum testnet. Chainlink is used as the BTC/USD price feed, and a testnet version of WBTC is used as the underlying collateral. BTC10 holders can claim dividends each month, but they must hold BTC10 for 30 minutes prior to each dividend, to prevent a multi-block MEV attack.

Wrapping Up

Bitcoin is the natural home for investors of permanent capital, who take the rules of value investing seriously. The most prominent value investors prioritize one specific type of risk: the risk of permanent loss of capital. As Warren Buffett puts it:

We regard volatility as a measure of risk to be nuts. And the reason it's used is because the people that are teaching want to talk about risk. And the truth is, they don't know how to measure it in business. I mean, that would be part of our course on how to value a business. It would also be, how risky is the business? And we think about that in terms of every business we buy. And risk with us relates to -- Well, it relates to several possibilities. One is the risk of permanent capital loss. And then the other risk is just an inadequate return on the kind of capital we put in. It does not relate to volatility at all. (Warren Buffet)

Each investor must come to appreciate bitcoin in their own time, but one who spends time understanding the asset understands that the risk of true permanent loss is incredibly low, despite the volatility. This creates a certain margin of safety, in an asset that has been compounding at a high rate of return for a long period of time.

Despite the strong fundamentals, many investors are wary of bitcoin due to its high volatility. The asset is marked-to-market every day, and the only way for an investor to realize a return is through price appreciation, which is difficult to predict in the near term. As a consequence, an investor must be willing to accept the possibility of a significant short-term loss, without a clear line of sight as to how and when they recover their money.

A high-yield bond that produces predictable cash flows helps to mitigate these concerns, because investors can reasonably predict how long it will take to recover their money. This could help interested investors dip their toes in the water and gain exposure to bitcoin for the first time.