As many of you know, I am a huge supporter of self-custody. I’ve written an entire series of articles dedicated to helping you understand self-custody basics, and I thoroughly believe that most, if not all, of our Bitcoin should be held by us.
We won’t convince everyone though. Some people will want to use custodians for one purpose or another. For example, earlier this week I wrote about the future of Bitcoin banks and how they may contribute to rewarding Bitcoin miners as the block subsidy ends.
Not So Stable Stablecoins
In a concerning turn of events, people have used custodians and technologies over the past few years to attempt to recreate Bitcoin’s utility on other blockchains. The most popular example is “bridging” Bitcoin over to the Ethereum blockchain in order to use one’s Bitcoin within Ethereum’s DeFi ecosystem, which occurs through the use of so-called Bitcoin “stablecoins”.
Trading your Bitcoin for an Ethereum-based token opens you up to a number of different risks that simply wouldn’t exist otherwise. For example, users expose themselves to risks inherent to the Ethereum blockchain, such as centralization and censorship. Ethereum-based stablecoins also rely heavily on smart contracts, many of which are infamous for being glitchy and susceptible to hacking.
The biggest risk of course stems from the fact that most Bitcoin stablecoins require users to give their Bitcoin private keys to someone else. There are a few different ways to create a Bitcoin stablecoin, and quite frankly they leave a lot to be desired in terms of allowing you to maintain sovereignty over your Bitcoin:
The most popular Bitcoin stablecoin is called “Wrapped BTC” or “wBTC” for short. Wrapped BTC can only be minted by sending your Bitcoin across its native blockchain to the wallet of a custodian enabled to “mint” wBTC tokens. Once the custodian has your Bitcoin in hand, it can send the minted wBTC to you across the Ethereum blockchain.
Proponents of custodial Bitcoin stablecoins claim that all is well because public blockchains allow some visibility into the underlying smart contract. I find it hard to agree with them though. The power structures behind the “Decentralized” Autonomous Organizations (DAOs) and custodians are often opaque, and it’s hard to understand exactly what their service entails without reading the fine print and without having the ability to review and debug their smart contracts.
Another common type of Bitcoin-based stablecoins on Ethereum are so-called “decentralized” stablecoins. Users call them decentralized because, rather than sending your real Bitcoin to a custodian, you send them to wallets controlled by a network of signers selected at random.
Contrary to what people might think, I actually find “decentralized” stablecoins to be a worse option than custodial stablecoins. At least you can look into the background of a custodian to perform some level of assessment of counterparty risk. Good luck trying to understand the motives and background of random people around the world to whom you’ve handed over your Bitcoin private keys.
Synthetic stablecoins have been created that attempt to peg their token to the value of Bitcoin without actually using any Bitcoin as collateral. Instead, their underlying protocols use native tokens as collateral.
On the one hand, users aren’t required to hand over any Bitcoin in order to access synthetic Bitcoin stablecoins. That isn’t necessarily better though, since instead of having the possibility of getting actual Bitcoin back when they want to exit the stablecoin or if the protocol fails, users are forced to buy niche crypto tokens that risk imploding from one moment to the next.
Bitcoin “Stablecoins” Are Not Real Bitcoin
The most important fault of all with Bitcoin-based stablecoins is the fact that they aren’t really Bitcoin to begin with. The only real Bitcoin is one on its native blockchain for which you hold the private keys. Bitcoin-based stablecoins are nothing more than IOUs, with all the risks we discussed above, and countless more that we didn’t.
Why trade Bitcoin for IOUs?
Read the next article in this series:
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This is not financial or business advice. This newsletter and related content are for informational purposes only. Cryptocurrencies and digital assets can be risky. Always do your own research before making any sort of investment.