CVS

Early Exploration of DeFi#

Here we need to distinguish between two types of "Bitcoin": one is the commonly understood Bitcoin, which is the protocol-based token circulating in decentralized networks; the other refers to the Bitcoin network, which is the operational mechanism of the Bitcoin blockchain. To make a clear distinction, the latter will be referred to as the "Bitcoin network" in the following text.

After the emergence of Bitcoin, participants in the cryptocurrency community soon discovered that the Bitcoin network could achieve more than just issuing and circulating Bitcoin. Similar to the internet, we can consider Bitcoin as a underlying protocol and build other protocols on top of it. At this point, the Bitcoin network only serves as a "consensus layer," and its blockchain serves as a data storage layer. The exploration of applications beyond the basic functions of issuance and transactions was later incorporated into the concept of "Bitcoin 2.0".

Bitcoin#

"Bitcoin 2.0" means that it can serve as a more fundamental protocol layer for applications other than transfers. Although financial applications were almost the most important exploration direction under this concept, there was still no clear concept of which applications were suitable for the Bitcoin network at that time. As the Bitcoin network was seen as a protocol layer for recording consensus data, it seemed that many fields could build applications on it: asset ownership, intellectual property rights, logistics, contracts, crowdfunding, voting, etc. It seemed that as long as Bitcoin's blockchain was used along with some other functions - such as privacy protection and simple transaction functions - the Bitcoin network could unleash more potential.

It is important to note that at this time, it was still 5 to 6 years before "DeFi" truly became a concept. However, the concepts formed during this historical stage laid the foundation for the later popularity of DeFi. The concepts discussed at that time included:

1. Dapp. Referring to decentralized applications (Decentralized Application), which are applications built on top of the blockchain. This is a broad concept, and the applications later referred to as DeFi are just one type of Dapp.

2. Smart assets. At that time, smart assets referred to tokens issued on the blockchain, representing various assets. These assets could be intangible, such as stocks and bonds, or they could represent ownership of tangible assets such as real estate and cars. They could even represent certain rights to be used, such as concert tickets or hotel room stays. The concept of smart assets was almost equivalent to "asset tokenization," emphasizing the significant increase in asset liquidity through tokenization. As this characteristic became well-known among participants after several years, it is no longer discussed by everyone.

Innovation in applications during this stage mainly focused on the years 2013-2015. Here are a few representative projects briefly introduced.

Colored Coins#

Colored Coins refer to a way of representing real-world assets on the Bitcoin blockchain. The implementation involves issuing and circulating tokens through additional data attached to Bitcoin. The term "Colored" is simple, meaning that when issuing new tokens, they are represented by new token identifiers to differentiate them from other tokens, giving them different colors. Users of Colored Coins need to use another client to read the data of Colored Coins and send transactions according to the data format requirements, in addition to accessing Bitcoin blockchain data.

Projects related to Colored Coins did not succeed, but they represented a minimal functionality of smart assets: asset transfer.

Bitshares#

One direction to achieve decentralized financial functions is to develop directly based on the Bitcoin network, while another direction is to start a new decentralized network separately. The representative project of the former is MasterCoin, and the latter is Bitshares.

Let's start with Bitshares. The original intention of Bitshares' development was to create an "asset trading system." Its founder is the controversial figure Dan "Bytemaster" Larimer. Charles Hoskinson, the founder of another well-known public chain Cardano, also played an important role in the history of this project.

The most important innovation of BitShares is BitAsset. By collateralizing other assets with at least 1.5 times the value of the protocol token BTS, corresponding assets can be issued. For example, to issue BitUSD, one can collateralize BTS worth $200 to obtain 100 BitUSD. When the value of the collateral falls below a set threshold, such as when the BTS price drops and the value of the collateral falls below 150% of the collateral ratio, miners will initiate forced liquidation, sell the collateral to repurchase and destroy 100 BitUSD, and return the excess to the collateral holder.

This token pegged to the US dollar is called a "soft-pegged" USD token. In contrast, a "hard-pegged" USD token, such as USDT issued by Tether, can be considered. Compared to "hard-pegged" tokens, "soft-pegged" tokens have greater volatility because for BitUSD to function, three conditions need to be met:

1. The market needs to "believe" that 1 BitUSD is equal to 1 USD. In fact, BitUSD only specifies the conditions for forced liquidation and repurchase, and does not have any other binding relationship between BitUSD and the USD. Market belief is an important factor, meaning that the market believes that the symbol BitUSD corresponds to a token with the same value as the USD.

2. Arbitrageurs in the market need to generate and redeem BitUSD. When 1 BitUSD is less than 1 USD, collateral holders can buy BitUSD with fewer USD and redeem the collateral, thereby profiting from arbitrage. For example, if 100 BitUSD is issued when the exchange rate is 1:1, selling it will yield 100 USD. When BitUSD drops to 0.9 USD, one can buy back 100 BitUSD with only 90 USD and redeem the collateral. Ignoring interest, a net profit of 10 USD is made. If the BitUSD price is higher than the USD, one can simply reverse the operation and release more BitUSD, waiting for the price to drop for arbitrage. Through this mechanism, arbitrageurs can adjust the total amount of BitUSD and dynamically adjust its price to achieve the effect of pegging it to the USD.

3. The collateral should not experience a significant drop. Once the collateral experiences a significant drop in a short period of time, causing the total USD value of the collateral to be less than the total issuance of BitUSD, the mechanism fails, and the final assets exchanged for each BitUSD holder will be less than 1 USD.

Bitshares can be said to have pioneered a new way of issuing stablecoins: using tokens as collateral to issue tokens pegged to the USD. It can also be used to issue tokens pegged to other assets, such as BitGOLD pegged to gold. This mechanism has also been adopted by later projects such as Maker and Synthetix. In addition, BitShares also provides asset issuance and trading (including derivatives such as options trading). It can be said that BitShares is one of the earliest decentralized exchanges (DEX) implemented on the blockchain.

MasterCoin had a similar vision to Bitshares, but its approach was to add another layer of protocol on top of the Bitcoin network. In this sense, it can be seen as an advanced version of Colored Coins - in addition to asset issuance, it also implemented stablecoin issuance, decentralized trading, futures contract trading, and oracle functions. Of course, this protocol also has its own protocol token MSC, which was initially issued through Bitcoin crowdfunding.

The way MasterCoin implements stablecoins is different from Bitshares. MasterCoin uses a programmatic mechanism to operate the buying and selling of collateral assets for the issuance assets to ensure their binding to the underlying assets. For example, to issue GoldCoins pegged to the price of gold, the issuer needs to deposit a certain amount of MSC as a "custodial fund." This fund is a kind of "smart contract" that operates the collateral assets based on a series of parameters, and also needs to specify a "registered data feed" to obtain the price of gold in exchange for MSC. The "registered data feed" is a mechanism for publishing the transaction price of a certain asset in Bitcoin transactions, which is later referred to as an "oracle" mechanism.

The basic operation of the custodial fund is as follows: comparing the price from the oracle with the price from on-chain transactions, if the price of GoldCoins is lower than the oracle's quote, it means that the price of GoldCoins is undervalued. The custodial fund will use the MSC in the fund to buy GoldCoins and increase its price to bring it back to the actual price of gold. The aggressiveness and frequency of equalizing the price difference are controlled by the parameters of the custodial fund. Since this mechanism is deterministic, when the price of GoldCoins is too low, market arbitrageurs expect the custodial fund to buy GoldCoins, so they will buy GoldCoins before the custodial fund takes action and wait for the price to rise to sell and make a profit. If the price of GoldCoins is higher than the price of gold, the custodial fund will perform the opposite operation and directly mint and sell GoldCoins in exchange for MSC to be stored in the custodial fund.

According to this model, in the case of minimal fluctuations in the price of gold against MSC, the custodial fund will always buy low and sell high, theoretically increasing the reserves of the custodial fund and increasing the amount of collateral. Does this mechanism resemble the operations of central banks in various countries - releasing expectations to the market through monetary policy to smooth price fluctuations?

However, this mechanism can only ensure that the issuance assets and the underlying assets are consistent when there is sufficient collateral. When the value of the collateral is not enough to support the issuance assets, even if all the tokens in the custodial fund are used, it is still impossible to completely repurchase and destroy all the issuance assets, and the mechanism fails. In this case, taking GoldCoins as an example, the custodial fund will distribute the MSC in the fund proportionally to the holders of GoldCoins according to their holdings, based on a set threshold. Specifically, for example, when the MSC total value in the custodial fund is only 98% of the issued GoldCoins, the custodial fund will automatically distribute all the MSC in the fund to the holders of GoldCoins in proportion and recover all the GoldCoins. At this time, all GoldCoins will have a net loss of 2%.

The oracle, futures trading, and decentralized trading of MasterCoin are not elaborated here. Those interested can refer to the MasterCoin whitepaper. Like Colored Coins, MasterCoin also requires the use of special clients to read additional block data and send transactions. MasterCoin eventually did not succeed and was renamed Omni Layer, with its functionality simplified to asset issuance. The most widely used USD token from 2017 to 2020 - USDT issued by Tether - was initially issued on Bitcoin and used Omni Layer. The irony here is that the protocol originally designed to issue stablecoins with decentralized collateral assets eventually became the protocol used for centralized stablecoin issuance.

Although from today's perspective, the various mechanisms implemented by Bitshares and MasterCoin are still in a relatively early stage, various basic functions required by DeFi - or, in legal terms, "constituent elements" - have begun to take shape: stablecoins, oracles, decentralized exchanges, and asset issuance.

At the same stage, another group of people was thinking and trying another path. Some participants believed that the Bitcoin network was designed as a decentralized network primarily for sending Bitcoin and may not be suitable for developing decentralized applications. Perhaps we should go back and first develop a better platform for developing decentralized applications. This was obviously a more ambitious path with greater risk of failure. Fortunately, history has proven that this approach is not only correct but also makes the history of cryptocurrencies unfold in a more dramatic way.