This is an opinion editorial by Stephan Livera, host of the “Stephan Livera Podcast” and managing director of Swan Bitcoin International.
The debate rages on about what the proper roles of bitcoin, “crypto” and lending should be. What kind of credit should we have, if any? What is fiduciary media and do we need it? Or should it all be fully reserved?
In this article I will spell out some thoughts on this long-running debate and how it applies in a Bitcoin context.
The Short Version
For the impatient, the short answer is: We don’t need fractional-reserved fiduciary media for credit and commerce to exist in society. You can have commodity credit in a full-reserve banking system, it merely stops circulation credit and the creation of fiduciary media. The defense of “free” fractional-reserve banking amounts to a kind of special pleading, inflationist stance. This does not preclude the fact that there will be many who try to commit fractional-reserve banking fraud, but “the market” does not necessarily have to serve this demand, nor is it beneficial to society.
The Long Version
What Are The Key Sides Of This Debate?
Those who take the Rothbardian full-reserve view are generally arguing that:
- Fractional-reserve banking is fraud
- Fractional-reserve banking causes financial instability, this being due to malinvestment driving what’s known as Austrian business cycle theory
Now, some in the full reserve camp will downplay or skip over the first point around fraud, as they believe that even if we disregard the fraud argument, there are still negative economic consequences in a society that tolerates fractional-reserve banking.
Austrian economists in the full-reserve camp include Ludwig von Mises, Murray Rothbard, Jesús Huerta de Soto, Hans-Hermann Hoppe, Joseph T. Salerno, Jörg Guido Hülsmann, Philipp Bagus, David Howden and Robert P. Murphy. This camp would generally believe that reserve ratios of banks should and/or would remain at or near 100%.
Those who take the “free banking” view generally argue that “free market, fractional-reserve” banking regimes can be laissez-faire, and work in a stable way. They believe that bank reserve ratios could sustainably operate in the 2% to 5% range. There may be some bank failures but “free bankers” may put this down to bad government regulation. Well-known economists and proponents here include Larry White and George Selgin.
What Is Commodity Credit And What Is Circulation Credit?
As Mises spells out in “Human Action,” commodity credit is the kind permissible under a full-reserve system. It means banks are lending out their own funds or the funds entrusted to the banks by customers.
Imagine for a moment that a bank had 100 gold ounces in its vault. And it issues out paper tickets, each representing one gold ounce, for the community to trade around in place of carrying around the gold (and verifying it and measuring it, etc). So long as the bank only issues out up to 100 paper tickets, there is no fiduciary media. One customer could come and deposit five tickets with the understanding that they are relinquishing control for a given time period. The bank could loan those five tickets out to another customer, and this would be consistent with commodity credit.
Now, imagine that bank issued out 150 paper tickets (each purporting to represent an ounce of gold), but it only had 100 gold ounces in the vault. In this situation, we have a creation of fiduciary media. Those additional 50 tickets (above and beyond the genuine 100) represent claims to gold ounces that literally do not exist.
Banks creating loans and credit by issuing fiduciary media are granting circulation credit. This is what the Misesian and Rothbardian Bitcoiners are objecting to. We generally argue that a system of fractional reserve banking is only sustainable with government intervention, typically a central bank lender of last resort, or with government granted permission for banks to not grant in-specie redemption (i.e., not letting customers withdraw their coins).
How Long Has This Debate Been Going?
In a sense, this debate has raged for hundreds of years and even predates the Austrian school of economics. This debate has gone on between the currency school and the banking school. The currency school were some of the OG hard money men who wanted a full-reserve banking system. They even managed to put in the Bank Charter Act (aka, Peel Act) in the U.K. in 1844, which did mandate 100% reserves for bank note issuance, however, as they did not also mandate 100% reserves on bank demand deposits, the system of fractional-reserve banking still survived. The Peel Act was later suspended.
In terms of the full-reserve Austrians and the “free bankers,” most of this debate took place in the 1990s, but there have been occasional volleys back and forth even in recent years. Notably, George Selgin and Murphy debated this topic in 2018. Stephan Kinsella has a reading list post here for those interested. Also of interest will be this Kristoffer Hansen post at Mises.org, “Understanding The Rothbardian Critique Of Free Banking.” I can’t hope to cover every possible aspect of this debate in one post but I will attempt to summarize and respond to key points.
So, What’s The Claim With This Recent ‘Crypto’ Credit Crunch?
Recently, Nic Carter has asserted that this recent “crypto” credit crunch is not the end of crypto lending. He is defending credit and the “free banker” position with some historical parallels to what happened recently with lenders, such as Celsius.
Point-By-Point Disagreements With Carter
“Today, bitcoiners are gleeful about the collapse of credit in the crypto industry.”
More like, there were Bitcoiners cautioning against high-risk platforms and encouraging self custody. Sometimes, people have to point to recent examples to teach their lesson. Just like how, after the fall of Mt. Gox or QuadrigaCX, it became a lot easier to sell the message of self custody.
“They often follow a Rothbardian ideal, believing fractional reserve banking to be ‘fraud,’ even though the idealized ‘full reserve banking’ generally never emerges in free market conditions.”
So, as mentioned above, yes I do believe fractional-reserve banking is fraud, but no, I disagree with what Carter is implying here. Fractional-reserve banking has had the backing of the State, and therefore this outcome we’re living in today was a result of political entrepreneurship, rather than genuine free market entrepreneurship.
When the government puts in central bankers, lenders of last resort, and provides special privileges to bankers e.g., allowing them to deny in-specie redemption to customers and deposit insurance, this gives an artificial privilege that would not exist under a genuinely free market. Hülsmann has written a paper on this idea titled “Has Fractional-Reserve Banking Really Passed The Market Test?” For example, see this section by Hülsmann:
“The banker turned fraud who issues the first uncovered money title is in fact a ‘political entrepreneur.’ He ‘tests the market’ to discover how far he can go in violating property rights without encountering resistance.”
See also this interesting section by Hülsmann:
“A large number of fractional-reserve banks, to say the least, have used such words intentionally in two mutually exclusive senses and that this usage has concealed underlying real differences. These banks’ customers were led to believe that they had bought a financial product of type A, but in legal settlements they were told that they actually had bought a product of type B.”
Doesn’t this sound familiar with what’s happening to Celsius customers? See this analysis from a business restructuring lawyer, for instance:
“Celsius has set the stage for conflict between its customers and its sophisticated institutional creditors — in particular, Celsius has pointed out in its pleadings that customers transferred ownership of crypto assets to Celsius, making those customers unsecured creditors. This detail may undercut customer expectations, who thought they were depositing their assets into a construct similar to a traditional bank.”
And see this video clip compilation of Celsius Network videos where CEO Alex Mashinsky is asserting that “Celsius is a safe place to store your coins” and that “a run on a bank cannot happen at Celsius because Celsius never lends more than what it has.”
For clarity here, Celsius may not have been running a fractional reserve banking operation. Instead, it may have been a poorly-run financial intermediary, which possibly degenerated into a ponzi scheme (at least that’s what is being alleged in this court case). Business and bank failures are a fact of life, whether we live in a full-reserve or fractional-reserve banking world.
“During Scottish ‘free banking,’ a fully laissez-faire, markets-based system, reserve ratios were commonly 2-5%, and the system worked swimmingly.”
Not so fast! There were entire stretches of time where some of these so-called “free market” free bankers were permitted to not redeem in specie (i.e., they could freeze customer withdrawals), while at the same time, still enforce payment obligations on other people. Isn’t this curious? How can the “free bankers” herald Scottish free banking when customer redemptions were not permitted for a period of over 20 years?
For evidence, see Rothbard’s writing in “The Myth Of Free Banking in Scotland,” his response to White:
“From the beginning, there is one embarrassing and evident fact that Professor White has to cope with: that ‘free’ Scottish banks suspended specie payment when England did, in 1797, and, like England, maintained that suspension until 1821. Free banks are not supposed to be able to, or want to, suspend specie payment, thereby violating the property rights of their depositors and noteholders, while they themselves are permitted to continue in business and force payment upon their debtors.”
Later, Carter is talking about credit in general:
“A world with no credit is a dismal one. Credit — responsibly extended — is the cornerstone of civilization. It unleashes savings and puts the money to work in productive areas of the economy. A world without credit is a sterile, stagnant one.”
So, as discussed above, the key distinction to understand here is commodity credit (OK) versus circulation credit (fraudulent and causes economic instability). Once we make this distinction, it is all much clearer.
To spell this out: From a Rothbardian Bitcoiner point of view, in principle there could be a bitcoin bank that takes in bitcoin, and loans out commodity credit loans denominated in bitcoin — and there’d be no issue as there is no fiduciary media created. It’s just that today, such a proposition would be extremely high risk as very few entrepreneurs and businesses have successfully ROI’ed in bitcoin terms over longer periods of time. In this sense, there would be very few customers and very few lenders willing to take this kind of risk for appreciable bitcoin sums over an appreciable time period. In practice, this kind of thing might more realistically occur post-hyperbitcoinization or closer to it.
Carrying on with Carter’s article, Carter quotes from my recent article on Bitcoin Maximalism, speaking of how most Maximalists are simply not interested in non-monetary uses, and commenting on the recent failures of lenders in the space. I commented that there’s a case to say that the Maximalists who encouraged self custody and not putting bitcoin on high-risk platforms were right.
“But were they? If their victory condition is ‘no credit is ever extended based on a crypto asset ever again,’ they guarantee a loss.”
So, as above, the distinction to keep in mind is commodity credit versus circulation credit. I believe that commodity credit could theoretically work under a Bitcoin standard with full-reserve banking. Therefore, my point is not “no credit ever” and Carter’s statement here is overly reductive.
Also while we’re here, it’s worthwhile pointing out that this specific debate about “free banking” fractional reserve versus full reserve isn’t really a question of Maximalism per se. It’s an orthogonal debate as a person could conceivably be a “free banker” and Maximalist, or they could be in favor of full reserve and Maximalist.
“The desire for leverage and a lower cost of capital on one hand, and yield on the other, is inherent to free, capitalist enterprise, and that urge will never disappear.”
Of course people want leverage. The question is, can it be ethically and sustainably provided? And would it be beneficial to society? Under a fractional-reserve banking system with fiduciary media, sure, it can be provided — the challenge and question is more about whether such a thing is ethical or desirable for the overall economy. I say no, it’s not. It does not enrich society on the whole, it merely enriches those getting the newly-printed tokens first, and bankers servicing those interests.
Speaking of Bitcoin Maximalists warning about fractional-reserve practices, Carter mentions:
“They cannot extinguish the demand for credit or yield — and entrepreneurs will always emerge to fill this need.”
And I’d respond that such a system would be unethical and it would be inherently unstable without a lender of last resort. And if that lender of last resort cannot print tokens (which obviously can’t be done in Bitcoin beyond 21 million coins), then the system won’t be long-term sustainable.
It could even seem sustainable for a period of time, but such a system cannot possibly be useful for the economy as a whole. If fractional reserve banks are permitted to increase the quantity of money titles (e.g., bitcoin IOUs), this merely enriches some market participants at the expense of all others.
What Are Some Of The Potential Risks Based On How The Industry Develops?
From my perspective, people will need to learn the difference between bitcoin for which they hold the private keys, and mere bitcoin IOUs. If people blur the line here, or perhaps even equivocate the different IOUs of different providers (say a Celsius bitcoin IOU with a Voyager bitcoin IOU), this more easily opens the door to widespread fractionally-reserved coins that effectively go above the 21 million cap.
Of course, this risk may not be systemic, it would be localized to those individuals who are overly trusting of other peoples’ IOUs. Nevertheless, it’s worthwhile for bitcoin HODLers and users to understand this crucial difference.
Does This Mean We Shouldn’t Even Use Fiat Credit Today?
Not necessarily. As my friend Pierre Rochard wrote eight years ago in his prescient article, “Speculative Attack,” we may well see individuals leverage up using the fiat system. In this way, they are using the fiat system against itself to stack more sats and perhaps help advance the process of hyperbitcoinization. Now of course this carries risks and costs, but for certain individuals or entities who can access cheap credit, such as MicroStrategy, it might well be reasonable.
Where Might There Be Some Common Ground?
I believe both sides of the “free banking” versus full reserve debate would welcome the development, commercialization and widespread use of proof-of-reserves techniques. Credit to Carter for being a vocal proponent of proof-of-reserves technology. This has been implemented in various places in the Bitcoin and “crypto” world, such as at Kraken, Ledn and at previous Bitcoin exchange Coinfloor U.K. (since purchased by Coincorner).
The disagreement in this case would be on what the reserve ratio should be, as “free bankers” may conceivably be fine with a reserve ratio of 2%, while full-reserve Bitcoiners want a 100% reserve ratio.
Full-reserve Bitcoiners also appreciate the explicit no-rehypothecation approach of lenders such as Unchained Capital. Because Unchained loans use Bitcoin multisignature technology, the coins may not be rehypothecated as all three key holders (borrower, unchained and third-party key agent) can confirm exactly what’s happening to the bitcoin on-chain.
The fiat USD being loaned out for these loans is obviously still a part of the broader USD fractional-reserve banking system.
In Practice, Where Are We Going With Debt And Equity Anyway?
Now you could believe that in practice, over the longer term, there won’t be much or any commodity credit extended. Saifedean Ammous argues a similar point in his book “The Fiat Standard: and discussed this with me on “SLP296.”
Without fractional-reserve lending subsidized by cheap debt, investors may reach a saturation point sooner with their capital. If time preference and interest rates are genuinely very low, investors may not want to take the risk of loaning out bitcoin via a debt instrument, given that the interest rate offered is very low. Investors may very much prefer to give some bitcoin in exchange for an equity share in a business.
So, on this basis, there may legitimately be an argument that there would be very little commodity credit extended anyway. In this world, we’d see far less debt issued, and more equity investment.
If you believe in the Bitcoin saying “not your keys, not your coins,” then you too are in favor of full-reserve bitcoin. The view implied by those who want to permit “free” fractional-reserve banking is one where there are multiple claimants to the same coins or same resources of society. This difference cannot be squared in my view.
It’s also important to understand that there are legitimate arguments as to how and why we ended up in a fractional-reserve system that was not the result of a free market. Of course, bankers are always trying to do this, because it allows them to profit massively! The “free-banking” movement is special pleading on behalf of inflationary commercial banks.
Society would not be less vibrant in a world without fractional reserve banking. If anything, the society we live in today is more sterile and stagnant because of the artificial boom and bust conditions that capitalist investors and entrepreneurs have to deal with. Moving to a bitcoin full reserve system could in practice make society far more prosperous with continued sustainable growth, rather than “lumpy” artificial booms followed by busts.
Thanks to my friend Pierre Rochard for his feedback on this article.
This is a guest post by Stephan Livera. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.
El Salvador Takes First Step To Issue Bitcoin Volcano Bonds
El Salvador’s Minister of the Economy Maria Luisa Hayem Brevé submitted a digital assets issuance bill to the country’s legislative assembly, paving the way for the launch of its bitcoin-backed “volcano” bonds.
First announced one year ago today, the pioneering initiative seeks to attract capital and investors to El Salvador. It was revealed at the time the plans to issue $1 billion in bonds on the Liquid Network, a federated Bitcoin sidechain, with the proceedings of the bonds being split between a $500 million direct allocation to bitcoin and an investment of the same amount in building out energy and bitcoin mining infrastructure in the region.
A sidechain is an independent blockchain that runs parallel to another blockchain, allowing for tokens from that blockchain to be used securely in the sidechain while abiding by a different set of rules, performance requirements, and security mechanisms. Liquid is a sidechain of Bitcoin that allows bitcoin to flow between the Liquid and Bitcoin networks with a two-way peg. A representation of bitcoin used in the Liquid network is referred to as L-BTC. Its verifiably equivalent amount of BTC is managed and secured by the network’s members, called functionaries.
“Digital securities law will enable El Salvador to be the financial center of central and south America,” wrote Paolo Ardoino, CTO of cryptocurrency exchange Bitfinex, on Twitter.
Bitfinex is set to be granted a license in order to be able to process and list the bond issuance in El Salvador.
The bonds will pay a 6.5% yield and enable fast-tracked citizenship for investors. The government will share half the additional gains with investors as a Bitcoin Dividend once the original $500 million has been monetized. These dividends will be dispersed annually using Blockstream’s asset management platform.
The act of submitting the bill, which was hinted at earlier this year, kickstarts the first major milestone before the bonds can see the light of day. The next is getting it approved, which is expected to happen before Christmas, a source close to President Nayib Bukele told Bitcoin Magazine. The bill was submitted on November 17 and presented to the country’s Congress today. It is embedded in full below.
How I’ll Talk To Family Members About Bitcoin This Thanksgiving
This is an opinion editorial by Joakim Book, a Research Fellow at the American Institute for Economic Research, contributor and copy editor for Bitcoin Magazine and a writer on all things money and financial history.
That’s it. That’s the article.
In all sincerity, that is the full message: Just don’t do it. It’s not worth it.
You’re not an excited teenager anymore, in desperate need of bragging credits or trying out your newfound wisdom. You’re not a preaching priestess with lost souls to save right before some imminent arrival of the day of reckoning. We have time.
Instead: just leave people alone. Seriously. They came to Thanksgiving dinner to relax and rejoice with family, laugh, tell stories and zone out for a day — not to be ambushed with what to them will sound like a deranged rant in some obscure topic they couldn’t care less about. Even if it’s the monetary system, which nobody understands anyway.
If you’re not convinced of this Dale Carnegie-esque social approach, and you still naively think that your meager words in between bites can change anybody’s view on anything, here are some more serious reasons for why you don’t talk to friends and family about Bitcoin the protocol — but most certainly not bitcoin, the asset:
- Your family and friends don’t want to hear it. Move on.
- For op-sec reasons, you don’t want to draw unnecessary attention to the fact that you probably have a decent bitcoin stack. Hopefully, family and close friends should be safe enough to confide in, but people talk and that gossip can only hurt you.
- People find bitcoin interesting only when they’re ready to; everyone gets the price they deserve. Like Gigi says in “21 Lessons:”
“Bitcoin will be understood by you as soon as you are ready, and I also believe that the first fractions of a bitcoin will find you as soon as you are ready to receive them. In essence, everyone will get ₿itcoin at exactly the right time.”
It’s highly unlikely that your uncle or mother-in-law just happens to be at that stage, just when you’re about to sit down for dinner.
- Unless you can claim youth, old age or extreme poverty, there are very few people who genuinely haven’t heard of bitcoin. That means your evangelizing wouldn’t be preaching to lost, ignorant souls ready to be saved but the tired, huddled and jaded masses who could care less about the discovery that will change their societies more than the internal combustion engine, internet and Big Government combined. Big deal.
- What is the case, however, is that everyone in your prospective audience has already had a couple of touchpoints and rejected bitcoin for this or that standard FUD. It’s a scam; seems weird; it’s dead; let’s trust the central bankers, who have our best interest at heart.
No amount of FUD busting changes that impression, because nobody holds uninformed and fringe convictions for rational reasons, reasons that can be flipped by your enthusiastic arguments in-between wiping off cranberry sauce and grabbing another turkey slice.
- It really is bad form to talk about money — and bitcoin is the best money there is. Be classy.
Now, I’m not saying to never ever talk about Bitcoin. We love to talk Bitcoin — that’s why we go to meetups, join Twitter Spaces, write, code, run nodes, listen to podcasts, attend conferences. People there get something about this monetary rebellion and have opted in to be part of it. Your unsuspecting family members have not; ambushing them with the wonders of multisig, the magically fast Lightning transactions or how they too really need to get on this hype train, like, yesterday, is unlikely to go down well.
However, if in the post-dinner lull on the porch someone comes to you one-on-one, whisky in hand and of an inquisitive mind, that’s a very different story. That’s personal rather than public, and it’s without the time constraints that so usually trouble us. It involves clarifying questions or doubts for somebody who is both expressively curious about the topic and available for the talk. That’s rare — cherish it, and nurture it.
Last year I wrote something about the proper role of political conversations in social settings. Since November was also election month, it’s appropriate to cite here:
“Politics, I’m starting to believe, best belongs in the closet — rebranded and brought out for the specific occasion. Or perhaps the bedroom, with those you most trust, love, and respect. Not in public, not with strangers, not with friends, and most certainly not with other people in your community. Purge it from your being as much as you possibly could, and refuse to let political issues invade the areas of our lives that we cherish; politics and political disagreements don’t belong there, and our lives are too important to let them be ruled by (mostly contrived) political disagreements.”
If anything, those words seem more true today than they even did then. And I posit to you that the same applies for bitcoin.
Everyone has some sort of impression or opinion of bitcoin — and most of them are plain wrong. But there’s nothing people love more than a savior in white armor, riding in to dispel their errors about some thing they are freshly out of fucks for. Just like politics, nobody really cares.
Leave them alone. They will find bitcoin in their own time, just like all of us did.
This is a guest post by Joakim Book. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.
RGB Magic: Client-Side Contracts On Bitcoin
This is an opinion editorial by Federico Tenga, a long time contributor to Bitcoin projects with experience as start-up founder, consultant and educator.
The term “smart contracts” predates the invention of the blockchain and Bitcoin itself. Its first mention is in a 1994 article by Nick Szabo, who defined smart contracts as a “computerized transaction protocol that executes the terms of a contract.” While by this definition Bitcoin, thanks to its scripting language, supported smart contracts from the very first block, the term was popularized only later by Ethereum promoters, who twisted the original definition as “code that is redundantly executed by all nodes in a global consensus network”
While delegating code execution to a global consensus network has advantages (e.g. it is easy to deploy unowed contracts, such as the popularly automated market makers), this design has one major flaw: lack of scalability (and privacy). If every node in a network must redundantly run the same code, the amount of code that can actually be executed without excessively increasing the cost of running a node (and thus preserving decentralization) remains scarce, meaning that only a small number of contracts can be executed.
But what if we could design a system where the terms of the contract are executed and validated only by the parties involved, rather than by all members of the network? Let us imagine the example of a company that wants to issue shares. Instead of publishing the issuance contract publicly on a global ledger and using that ledger to track all future transfers of ownership, it could simply issue the shares privately and pass to the buyers the right to further transfer them. Then, the right to transfer ownership can be passed on to each new owner as if it were an amendment to the original issuance contract. In this way, each owner can independently verify that the shares he or she received are genuine by reading the original contract and validating that all the history of amendments that moved the shares conform to the rules set forth in the original contract.
This is actually nothing new, it is indeed the same mechanism that was used to transfer property before public registers became popular. In the U.K., for example, it was not compulsory to register a property when its ownership was transferred until the ‘90s. This means that still today over 15% of land in England and Wales is unregistered. If you are buying an unregistered property, instead of checking on a registry if the seller is the true owner, you would have to verify an unbroken chain of ownership going back at least 15 years (a period considered long enough to assume that the seller has sufficient title to the property). In doing so, you must ensure that any transfer of ownership has been carried out correctly and that any mortgages used for previous transactions have been paid off in full. This model has the advantage of improved privacy over ownership, and you do not have to rely on the maintainer of the public land register. On the other hand, it makes the verification of the seller’s ownership much more complicated for the buyer.
How can the transfer of unregistered properties be improved? First of all, by making it a digitized process. If there is code that can be run by a computer to verify that all the history of ownership transfers is in compliance with the original contract rules, buying and selling becomes much faster and cheaper.
Secondly, to avoid the risk of the seller double-spending their asset, a system of proof of publication must be implemented. For example, we could implement a rule that every transfer of ownership must be committed on a predefined spot of a well-known newspaper (e.g. put the hash of the transfer of ownership in the upper-right corner of the first page of the New York Times). Since you cannot place the hash of a transfer in the same place twice, this prevents double-spending attempts. However, using a famous newspaper for this purpose has some disadvantages:
- You have to buy a lot of newspapers for the verification process. Not very practical.
- Each contract needs its own space in the newspaper. Not very scalable.
- The newspaper editor can easily censor or, even worse, simulate double-spending by putting a random hash in your slot, making any potential buyer of your asset think it has been sold before, and discouraging them from buying it. Not very trustless.
For these reasons, a better place to post proof of ownership transfers needs to be found. And what better option than the Bitcoin blockchain, an already established trusted public ledger with strong incentives to keep it censorship-resistant and decentralized?
If we use Bitcoin, we should not specify a fixed place in the block where the commitment to transfer ownership must occur (e.g. in the first transaction) because, just like with the editor of the New York Times, the miner could mess with it. A better approach is to place the commitment in a predefined Bitcoin transaction, more specifically in a transaction that originates from an unspent transaction output (UTXO) to which the ownership of the asset to be issued is linked. The link between an asset and a bitcoin UTXO can occur either in the contract that issues the asset or in a subsequent transfer of ownership, each time making the target UTXO the controller of the transferred asset. In this way, we have clearly defined where the obligation to transfer ownership should be (i.e in the Bitcoin transaction originating from a particular UTXO). Anyone running a Bitcoin node can independently verify the commitments and neither the miners nor any other entity are able to censor or interfere with the asset transfer in any way.
Since on the Bitcoin blockchain we only publish a commitment of an ownership transfer, not the content of the transfer itself, the seller needs a dedicated communication channel to provide the buyer with all the proofs that the ownership transfer is valid. This could be done in a number of ways, potentially even by printing out the proofs and shipping them with a carrier pigeon, which, while a bit impractical, would still do the job. But the best option to avoid the censorship and privacy violations is establish a direct peer-to-peer encrypted communication, which compared to the pigeons also has the advantage of being easy to integrate with a software to verify the proofs received from the counterparty.
This model just described for client-side validated contracts and ownership transfers is exactly what has been implemented with the RGB protocol. With RGB, it is possible to create a contract that defines rights, assigns them to one or more existing bitcoin UTXO and specifies how their ownership can be transferred. The contract can be created starting from a template, called a “schema,” in which the creator of the contract only adjusts the parameters and ownership rights, as is done with traditional legal contracts. Currently, there are two types of schemas in RGB: one for issuing fungible tokens (RGB20) and a second for issuing collectibles (RGB21), but in the future, more schemas can be developed by anyone in a permissionless fashion without requiring changes at the protocol level.
To use a more practical example, an issuer of fungible assets (e.g. company shares, stablecoins, etc.) can use the RGB20 schema template and create a contract defining how many tokens it will issue, the name of the asset and some additional metadata associated with it. It can then define which bitcoin UTXO has the right to transfer ownership of the created tokens and assign other rights to other UTXOs, such as the right to make a secondary issuance or to renominate the asset. Each client receiving tokens created by this contract will be able to verify the content of the Genesis contract and validate that any transfer of ownership in the history of the token received has complied with the rules set out therein.
So what can we do with RGB in practice today? First and foremost, it enables the issuance and the transfer of tokenized assets with better scalability and privacy compared to any existing alternative. On the privacy side, RGB benefits from the fact that all transfer-related data is kept client-side, so a blockchain observer cannot extract any information about the user’s financial activities (it is not even possible to distinguish a bitcoin transaction containing an RGB commitment from a regular one), moreover, the receiver shares with the sender only blinded UTXO (i. e. the hash of the concatenation between the UTXO in which she wish to receive the assets and a random number) instead of the UTXO itself, so it is not possible for the payer to monitor future activities of the receiver. To further increase the privacy of users, RGB also adopts the bulletproof cryptographic mechanism to hide the amounts in the history of asset transfers, so that even future owners of assets have an obfuscated view of the financial behavior of previous holders.
In terms of scalability, RGB offers some advantages as well. First of all, most of the data is kept off-chain, as the blockchain is only used as a commitment layer, reducing the fees that need to be paid and meaning that each client only validates the transfers it is interested in instead of all the activity of a global network. Since an RGB transfer still requires a Bitcoin transaction, the fee saving may seem minimal, but when you start introducing transaction batching they can quickly become massive. Indeed, it is possible to transfer all the tokens (or, more generally, “rights”) associated with a UTXO towards an arbitrary amount of recipients with a single commitment in a single bitcoin transaction. Let’s assume you are a service provider making payouts to several users at once. With RGB, you can commit in a single Bitcoin transaction thousands of transfers to thousands of users requesting different types of assets, making the marginal cost of each single payout absolutely negligible.
Another fee-saving mechanism for issuers of low value assets is that in RGB the issuance of an asset does not require paying fees. This happens because the creation of an issuance contract does not need to be committed on the blockchain. A contract simply defines to which already existing UTXO the newly issued assets will be allocated to. So if you are an artist interested in creating collectible tokens, you can issue as many as you want for free and then only pay the bitcoin transaction fee when a buyer shows up and requests the token to be assigned to their UTXO.
Furthermore, because RGB is built on top of bitcoin transactions, it is also compatible with the Lightning Network. While it is not yet implemented at the time of writing, it will be possible to create asset-specific Lightning channels and route payments through them, similar to how it works with normal Lightning transactions.
RGB is a groundbreaking innovation that opens up to new use cases using a completely new paradigm, but which tools are available to use it? If you want to experiment with the core of the technology itself, you should directly try out the RGB node. If you want to build applications on top of RGB without having to deep dive into the complexity of the protocol, you can use the rgb-lib library, which provides a simple interface for developers. If you just want to try to issue and transfer assets, you can play with Iris Wallet for Android, whose code is also open source on GitHub. If you just want to learn more about RGB you can check out this list of resources.
This is a guest post by Federico Tenga. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.