Bitcoin free banking: from utopia to reality

In Galaxy’s November report on Bitcoin layer-2 (L2) solutions, the firm weighed DeFi’s prospects on Bitcoin. Analysts estimate the segment’s TVL at $50 billion by 2030 (2.3% of the annual supply of digital gold at today’s price).

Who will supply liquidity to Bitcoin-based L2s in the coming years, and how? Oleg Cash Coin investigates.

Bitcoin banking maximalism

In December 2010, Hal Finney, the recipient of the first bitcoin transaction, sketched a banking system built on Bitcoin. In a post on BitcoinTalk, he cited American economist George Selgin’s The Theory of Free Banking:

“Different banks may have different policies. Some more aggressive, others more conservative. Some will have fractional reserves, others may be 100% backed by bitcoin. Interest rates may vary. And money from some banks may trade at a discount compared to cash from others.”

Selgin’s book lays out a theoretical case for a decentralised financial system, free from centralised regulation and state interference. He offers numerous examples from different eras when economies managed without regulatory authorities.

Finney believed bitcoin could become a reserve asset underpinning banks’ issuance of their own currency. That is the route some of the largest and most influential crypto firms have taken.

Adam Back and his Liquid Network launched a clearing service for crypto exchanges in 2015. They effectively built a bitcoin-based settlement system, offering one of the earliest banking-style uses of digital gold for inter-exchange clearing.

Bitcoin and cryptocurrencies have proved well suited to Selgin’s free-banking vision—chiefly because there is no central issuer, no authority setting or policing lending rates.

Trust in such banks will likely rest on Proof-of-Reserve and ZKP technologies. These mechanisms are already used successfully by crypto exchanges, allowing anyone to verify the current state of their assets.

Turning to a free DeFi market on Bitcoin

DeFi’s trajectory on Bitcoin has been signposted by Tether, the issuer of USDT. Formally, stablecoin issuance can be regulated by the state, yet under ordinary conditions the minting and burning of tokens are not supervised by regulators.

Tether has long accepted bitcoin as collateral for issuing USDT. A case in point is the now-bankrupt Celsius, which pledged at least 57,428 BTC in exchange for stablecoins.

Celsius was ultimately wound down, but Tether did not suffer as a result. The very demand for loans in stablecoins is telling. It implies there will be appetite for similar services in a decentralised format.

In effect, Tether has already become one of the “free banks” envisioned by Selgin and Finney: USDT is no longer a speculative instrument but a currency used for payments and settlement worldwide.

Despite constant criticism, Paolo Ardoino’s company has edged into the heart of the financial system, underscoring the viability of a new DeFi model. Howard Lutnick, a candidate for US commerce secretary and CEO of financial firm Cantor Fitzgerald, is in talks on close co-operation with Tether to launch a lending platform. The idea, outlined so far, is a bitcoin-collateralised credit line—initially $2 billion.

Cantor Fitzgerald is one of roughly two dozen authorised institutions that trade directly with the FRB of New York. It is also the custodian of Tether’s US Treasuries, which anchor USDT’s dollar peg (about $100 billion’s worth).

At the end of November, it emerged that Cantor Fitzgerald owns 5% of Tether’s equity. In addition, according to Bloomberg, Lutnick’s son, Brandon, works as a trader at Cantor and previously interned at Tether’s Swiss unit.

All this suggests the trend toward crypto-banking and issuance outside the state’s reach may only strengthen.

How much can bitcoin hold

Given the possibilities of fractional-reserve banking, DeFi capacity on Bitcoin could easily exceed the market capitalisation of gold.

Even rough sums show that synthetic forms of digital gold on Ethereum total around $20 billion across WBTC, cbBTC and L2 bitcoin. That is already about 17% of the entire DeFi market. Add that Tether held more than 75,000 BTC on its balance sheet at end-September 2024, according to its report, and the figure grows further. Add, too, the WBTC locked in contracts—for example, backing DAI.

Thus, even without “live” L2s on Bitcoin, there is roughly $30 billion of TVL in a quasi-“banking” system built on the first cryptocurrency—by the most superficial estimate, and without decentralised exchanges.

Nor is it clear how much actually flows through Liquid Network or which institutions shape that market. In a interview with Forbes, Back mentioned such “hidden” processes. He said the company has already built an accounting system for credit institutions and their clients on Bitcoin; that several US public banks provide capital for such operations; and that there are already “hundreds” of individual and corporate clients.

One of bitcoin’s most prominent institutional backers, Michael Saylor, thinks along similar lines. The MicroStrategy chief noted that big banks such as JPMorgan and Citi could profit by issuing loans collateralised by digital gold. That is not the same as reserving bitcoin, but the direction of travel could prove right.