Bitcoin for Savings, Stablecoins for Spending

physical bitcoin with dollars in the background
featured image via wuestenigel
Posted on September 28th, 2020 by Kyle Torpey and filed under Bitcoin.

Key Points

Combining the disruptive nature of Bitcoin as a censorship-resistant digital money and the short-term price stability of the U.S. dollar has been viewed as a Holy Grail of sorts by many in the cryptocurrency space since the days when the majority of the people talking about this stuff were users. While there have been a number of different attempts to create censorship-resistant crypto-dollars, the reality is that it has proven difficult to remove all of the counterparty risk associated with digital currencies pegged to the U.S. dollar.

And despite what cryptocurrency exchange Coinbase has claimed about their USDC token in the past, simply putting dollars on a public blockchain does not mean they work in a manner that is at all similar to bitcoin.

That said, Bitcoin has also struggled when it comes to making this new financial technology easy to use for the average Joe on the street. The complexities involved with secure storage of private keys and the short-term price volatility of bitcoin in terms of U.S. dollars have proven difficult to overcome from a user experience perspective.

Due to these issues, it could make sense to merge the worlds of Bitcoin and stablecoins in a way that allows users to store long-term savings in bitcoin and use stablecoins for their everyday spending wallets.

Bitcoin for Savings

As a financial technology for long-term savings, it’s hard to compete with Bitcoin. Users are in complete control of their own bitcoin holdings (as long as they’re storing their private keys themselves), which means there is no counterparty risk in terms of the potential seizure of funds. Additionally, there is no risk in terms of potential future dilution of bitcoin holdings, as bitcoin’s monetary policy was “set in stone” when the network launched in 2009.

Stablecoins are comparatively worse as a long-term savings technology. Whether you’re talking about tokens backed by U.S. dollars, some other fiat currency, or even gold, the reality is the real assets backing these tokens must be handled by a centralized, third-party custodian. These trusted third parties are vulnerable to corruption, nefarious attacks, and regulations.

Of course, there have also been attempts to create synthetic U.S. dollars and other real-world assets through derivatives backed by cryptocurrency held i smart contracts. While these synthetic stablecoins, such as DAI, are often touted as decentralized and censorship resistant, the reality is they also have to deal with a potential centralized point of failure due to the existence of the oracle problem.

In terms of inflation, stablecoins are obviously subject to the monetary policy of the underlying assets. On a long-term basis, modern fiat currencies tend to get devalued. For example, the U.S. dollar has lost nearly 20% of its value relative to various consumer goods and services over the past 10 years, according to the U.S. government’s official numbers (these numbers likely understate the problem for a variety of reasons). During this same time, bitcoin has increased in value at astronomical levels.

Of course, bitcoin was also going from 0 to 1 during this time, so that needs to be taken into account. Past performances are not necessarily indicative of future trends. But of course, the bitcoin price only needs to increase relative to inflation-adjusted U.S. dollars to outperform the most prominent fiat currency in the world as a savings technology.

Stablecoins for Spending

As a payments technology, Bitcoin has some issues. This is no secret to those who remember the Bitcoin block size wars of the mid-2010’s. Many of the large exchanges and wallet providers that were behind the aggressive push for a hard-forking increase to Bitcoin’s block size limit have since adopted stablecoins and other alternative digital currencies for their payment-focused use cases. Many of these companies were motivated by a desire to improve Bitcoin as a payments technology, even if it would potentially sacrifice Bitcoin’s utility as a savings technology along the way.

As described in the previous section, stablecoins come with a degree of long-term uncertainty; however, they’re helpful to high time-preference companies that just want to focus on the use of this technology for improving online payments for their users right now. Ironically, the failed push by large Bitcoin companies to sacrifice Bitcoin’s uncontrolled, apolitical monetary policy for coffee payments helped prove Bitcoin’s usefulness as a savings technology.

Of course, there are also various layer-two protocols available that enable more efficient bitcoin payments and transfers at the cost of greater centralization and weakened censorship resistance. Some examples of these alternative payment rails include the Lightning Network, Liquid, and RSK. Although, it should be noted the tradeoffs made with the Lightning Network are usually deemed as much more acceptable than those made with federated sidechains like Liquid and RSK.

Some have also started to wonder whether Ethereum is also just a layer-two technology for Bitcoin. Whichever layer-two protocol is chosen, the basic analogy to explain how these systems work with each other is on-chain Bitcoin as a savings account and the layer-two protocol of choice as a checking account.

On top of the base chain transaction fees being likely too expensive for most kinds of everyday payments, a lot of potential “mainstream Bitcoin users” don’t want so much volatility associated with their online payment accounts. In addition to creating general confusion among people who are new to Bitcoin and don’t understand that it involves a currency different from their local fiat currency, there are also usually tax implications involved with using bitcoin to buy goods or services. For example, if an individual buys some bitcoin and then uses it to buy a television later that year, capital gains will be owed on the profits made between the original purchase of the bitcoin and the purchase of the television in most jurisdictions (assuming the bitcoin price went up in terms of the local fiat currency).

Coin Center has been working on a solution to this tax issue for a number of years, at least for those living in the United States.

Of course, there are plenty of Bitcoin enthusiasts who prefer to live in a reality where the U.S. dollar has already been defeated, but pretty much everyone still uses USD or another fiat currency as their personal unit of account. The simpler on-chain BTC combined with Lightning BTC wallet can work for the hardcore bitcoiners who don’t want to see filthy fiat currency in their wallets.

For a wallet aimed at expanding the Bitcoin userbase rather than catering to the Bitcoin users that already exist, a setup where savings are held in on-chain BTC and the spending wallet can be denominated in USD or another fiat currency may make more sense. This could be why, which accounts for roughly a third of all daily Bitcoin transactions, has integrated this model. Although, they’ve also done some more questionable things with other alternative cryptocurrencies.

So, if stablecoins are the solution for spending wallets, what form should they take? There are a variety of different options here: USDT, USDC, DAI, DOC, Bitcoin debit cards, Abra’s old synthetic assets model, Lightning bitcoin hedged to U.S. dollars via discreet log contracts (DLCs), and many more.

All of these options come with their own set of tradeoffs. For example, some may be more censorship-resistant than others over the short term, but too much activity that is unapproved by various financial regulators around the world could also lead to an eventual shut down of the stablecoin with users left without immediate access to the funds they held in the stablecoin (or even never regaining access to their funds). Another possible scenario is a regulator effectively making a stablecoin worthless if users do not reveal their real identities. To reiterate a previous point, even DAI and DOC suffer from issues like this due to the persistence of the oracle problem.

For many, it may be an acceptable tradeoff to peg their spending wallet to the local fiat currency as long as their savings are kept in BTC. Any problematic situation that occurs with the stablecoin would end up being like losing a real wallet with physical cash in it as a worse case scenario. The user’s savings are still safely stored in bitcoin. Users who are uncomfortable with the risks involved in stablecoins can also still just use the Lightning Network for better security guarantees in their spending wallets (at the cost of greater price volatility).

Long term, it’s possible that something similar to smart bitcoin hedging contracts via DLCs will deliver the best collection of tradeoffs for users of spending wallets. Something like Bitcoin Hivemind could also eventually be useful as a further improvement if it’s proven to work in practice, but it would take a long time for this kind of decentralized system for oracles to become trusted.

Of course, many Bitcoin users also have no issue with having their spending wallets denominated in BTC, and something like Lightning, RSK, or Liquid could be more appropriate in those situations. The number of normal, everyday people who trust bitcoin more than fiat currencies could also dramatically increase this decade, as more central banks around the world come under greater levels of scrutiny for ever-increasingly loose monetary policies. As bitcoin adoption increases, the need for stablecoins decreases as greater liquidity should also lead to lower short-term value volatility.

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