Understanding the Bitcoin risk spectrum: How is it different from the dollar risk spectrum?

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Bitcoin’s risk spectrum has two unique blocks: cold storage and lightning network, they do not have any counterparty risk.

Written by: Joe Burnett, analyst at Mimesis Capital Compiled by: Stacey Lee

US government bonds are the cornerstone of all financial markets.

Data source: treasure.gov

From this yield curve, we can gain insight into the yield of US government bonds, an asset that Wall Street calls “risk-free”. In short, this chart represents the expected annual rate of return for purchasers of US government bonds.

Usually, in order to encourage investors in U.S. government bonds to lock their funds here for a long time, bonds with longer maturities can logically provide higher interest rates.

Since the US government bond yield curve is the foundation of our current financial system, all financial assets are priced based on the interest rate of the US government bond.

Why has it become the cornerstone of all financial markets? Because it provides a “risk-free” rate of return.

For example, if you could buy ten-year US government bonds with an annual yield of 5%, would you still be willing to buy Amazon bonds with a 1% yield? But if Amazon tries to issue new bonds to raise funds, the market will use this formula to value their bonds: 5% risk-free interest rate + [Amazon’s “credit risk”].

It can be seen that investors use this yield curve to price various financial assets, including stocks, bonds, and real estate.

Here comes the problem

The problem with using US government bonds as global “risk-free” assets is that they are actually risky.

There are two reasons:

  1. The US government may break the contract (without giving you money), but the probability is still relatively small.
  2. What is more likely to happen than the first is currency risk. If you buy a ten-year bond with a yield of 8%, the money you get back after 10 years is likely to be greatly depreciated, or even less than the money you put in at the beginning.

This means that the foundation of the current global financial system is unstable because it is controlled by politicians and central banks. Historically, they are not so credible.

Dollar risk spectrum

Unfortunately, the entire financial system is based on such an unstable system.

Since interest rates are now at historical lows, the market is moving further in the high risk direction of the dollar risk spectrum to obtain high returns (refer to the figure below).

Understanding the Bitcoin risk spectrum: How is it different from the dollar risk spectrum?Dollar risk spectrum

Changed bitcoin

Instead of letting our financial system be under the control of politicians and central banks, it is better to let Bitcoin replace all of this.

This new system is very different from before. Instead of trusting politicians or central banks to maintain people’s purchasing power, we only need to trust the laws of mathematics and thermodynamics.

This also means that you don’t need to trust anyone who owns Bitcoin.

Bitcoin is a non-rare asset with no counterparty risk. It is one of the greatest inventions in human history and is the foundation of the next global financial system.

Bitcoin risk spectrum

Bitcoin’s risk spectrum has two unique blocks. These two blocks are also the foundation of this new financial system.

Understanding the Bitcoin risk spectrum: How is it different from the dollar risk spectrum?Bitcoin risk spectrum

Unlike the blocks of each dollar risk spectrum, these two blocks do not have any counterparty risk. This means that you can hold these assets forever without worrying about any dilution or default.

Bitcoin in Cold Storage is the best deposit tool. It is unprecedented because it can maintain and grow its purchasing power without counterparty risk. It will likely account for a large part of the asset allocation of all investors.

The foundation of the Bitcoin system will become stronger and stronger, and it will account for an increasing proportion of each investor’s asset allocation.

Lightning Channel Leases & Lightning Pool

The second block of this Bitcoin risk spectrum is about the Bitcoin Lightning Network. It is used to make small bitcoin payments. Since there is no third party, the payment is fast and the handling fee is low.

In order for the Lightning Network to function properly, some payment channels must be established and used to increase the liquidity of the network to facilitate both parties to conduct Bitcoin transactions.

Lightning Network Pool (a new open source technology) has created a non-custodial market to trade Lightning Network liquidity. This means that if you are willing to lock bitcoin in several bitcoin blocks in the Lightning Network channel, you can open some channels and then earn bitcoin revenue without counterparty risk.

This technology allows you to earn income that will not be diluted without a counterparty.

You can think of these Lightning Network channel leases as “virtual roads” for sending and receiving Lightning Network payments.

The Lightning Network Pool is nothing but a non-custodial market for open source code. It helps this market participant build virtual roads for busy network channels.

Currently, the buyers of Lightning Network pool (people who buy liquidity) include merchants, exchanges, popular Lightning Network applications and routing nodes. Bitrefill , Bitfinex, and Strike are several Bitcoin companies that use the Lightning Network. They need to balance the liquidity of their inbound and outbound accounts on a regular basis in order to make payments and receive large amounts of payments.

The seller of the Lightning Network pool (the person who sells outgoing liquidity) has routing nodes, Bitcoin companies and Bitcoin holders. They want to lock up Bitcoin for a period of time to earn revenue without counterparties.

This technology is likely to become the basis of a new financial system in the future. Investors will use their income in the Lightning Network pool as a reference for all other potential investment opportunities.

Just like if the yield on the 10-year US government bond is 5%, you would not lend Amazon money at a 1% yield. If you can use the Lightning Network pool without counterparty risk to obtain a 3% return, you will naturally not lend any Bitcoin to Amazon at a 1% yield.

This Bitcoin curve will be the basis for investors to evaluate the value of Bitcoin debt and securities (through discounted cash flow analysis).

We are still in the infancy of this Bitcoin yield curve. Let us look forward to the establishment of this new financial system on Bitcoin!

Special thanks to Nik Bhatia (@timevalueofbtc) and Ryan Gentry (@RyanTheGentry) for their contributions on Time Value of Bitcoin and Lightning Network Pool. In addition, special thanks to the developers of Lightning Labs (@lightning) and Bitcoin Core.

Reference link

https://medium.com/@timevalueofbtc/the-time-value-of-bitcoin-and-lnrr-e0c435931bd8

https://medium.com/@timevalueofbtc/the-lightning-network-reference-rate-98e41a9dadfa

https://lightninglabs.substack.com/p/lightning-pool-is-open-for-business

https://lightning.engineering/posts/2020-11-02-lightning-pool/

https://lightning.engineering/posts/2020-11-02-pool-deep-dive/

https://lightning.engineering/lightning-pool-whitepaper.pdf

https://anchor.fm/tales-from-the-crypt/episodes/206-Ryan-Gentry-elvgsf

https://podcasts.apple.com/au/podcast/tales-from-the-crypt-67-nik-bhatia/id1292381204?i=1000436173902

Source link: mimesiscapital.medium.com