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2024-05-20 13:47:26

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Niti: Non-custodial Interlinked Tokenization Infrastructure

DRAFT Version 0.1.3

@Dr. Caleb Isaac

Hyper-collateralized synthetics in Bitcoin via Lombard Credit using Discreet Log Contracts

1. Problem
Bitcoin is often seen as a strong candidate to become the world's reserve currency. However, despite its role as a store of value, it has not been widely adopted as a medium of exchange. This can be explained by two factors:

1.1 Currency Paradox

Derived from Gresham's Law, the "Currency Paradox" states:

"ceteris paribus, rational agents prefer to spend currencies with less potential as a store of value first while accumulating currencies with greater potential as a store of value for future transactions."

For example, if a rational market agent receives half of their salary in dollars and the other half in Venezuelan bolivars, they would spend the bolivars first and save the dollars for future purchases since the latter maintains purchasing power better over time.

Bitcoin, being the least inflationary currency and having the highest potential as a long-term store of value, tends to be hoarded rather than spent, reducing its use as a medium of exchange.

1.3 Layered Money

Using Bitcoin directly as a store of value and a medium of exchange contradicts the concept of Layered Money, extensively discussed by Alan Schramm in his article "Bitcoin, the final settlement system." Gold was not used in its raw form as a medium of exchange but through layers that made it useful as money.

Observing the evolution of gold as the basis of the monetary system, it can be divided into four layers: the first being the raw metal after extraction, the original gold nuggets. The second layer is the standardization of this material into gold bars with high purity, shape, measurement, and weight standards. The third layer comprises gold certificates, where these bars, difficult to transport and divide, were "tokenized" into possession certificates, greatly increasing the potential use of gold as a medium of exchange, although requiring third-party custody. The fourth layer was banknotes backed by these certificates, which circulated widely before the end of the gold standard.

Each of these layers has different attributes and focuses to perform their functions. The idea that Bitcoin in its raw form would maximize all necessary characteristics of a monetary system (store of value, medium of exchange, and unit of account) does not align with the history of money in humanity.

If we want Bitcoin to be used as a medium of exchange, it is necessary to recognize the Currency Paradox and the concept of Layered Money to create a monetary system based on Bitcoin that meets market needs.

2. Current Solutions

2.1 Centralized Stablecoins (IOU)

IOU stablecoins are digital assets backed by reserves of fiat currency or other traditional assets held by a centralized entity. Examples include USDT, USDC, and DePix. These stablecoins are essentially tokenized promissory notes issued by companies that carry counterparty risk by holding their bitcoins in custody. Trust in the issuer is necessary, ensuring they maintain complete reserves and redeem tokens as promised.

Additionally, these centralized stablecoins are subject to government regulations and can be censored or shut down at any time.

Despite the cited issues, they are widely used: Tether (USDT) is the third-largest cryptocurrency and is widely used as a medium of exchange in third-world countries as a tokenized dollar.

2.2 Algorithmic Stablecoins

In contrast to IOU stablecoins, algorithmic stablecoins, a priori, do not have a centralized issuer or fiat reserves. They are backed by digital assets, and conversion is mediated by smart contracts. Examples include USD by @get10101, @MakerDAO, and Terra (LUNA).

Although they have clear advantages over IOU stablecoins, they come with a significant additional cost: hyper-collateralization. These currencies require backing in assets greater than the value of the generated fiat stablecoin. Additionally, the user needs technical knowledge of the specific algorithm used to maintain parity, which differs for each currency.

For the common user, the perceived risk is high because these enterprises do not follow a standard protocol with a standard asset as collateral. In Terra (LUNA)'s case, the risk was so high that it collapsed: the collateral used was weak digital assets tied to the protocol. For this user, using a centralized and legalized solution is safer than an unknown one, despite having a supposedly safer mechanism.

For the common user, the cost-benefit of using a 1:1 centralized stablecoin, instead of the 2:1 required for hyper-collateralization of algorithmic stablecoins, is not perceived as positive. They prefer to take the temporary risk of holding Depix. Remember, they do not plan to accumulate Reais in the long term, only need to bet that Depix will not fail during the short period they need to hold the asset and use it effectively. They prefer this minimal risk over spending excess capital to create the collateral for their fiat stablecoin.

The current protocols' focus on competing directly with IOU stablecoins is not a viable market strategy.

NITI has a different strategy: creating a universal protocol for users to create stablecoins, focusing on assets that centralized stablecoins cannot create.

2.3 Niti's Proposal

NITI proposes implementing Hayek's monetary system proposed in 1976 in "Denationalization of Money," creating a platform where various stablecoins can freely compete, all following the same protocol to ensure their quality.

2.3.1 Hayek's Monetary Model and NITI's Implementation

Hayek proposed that state monopoly over currency issuance is the root of many economic problems, such as inflation, boom-bust cycles, and economic crises. In his last work, he created a monetary system, a solution allowing free competition in currency issuance.

In this model, private institutions could issue their own currencies, which would circulate freely in the market. Users would choose to use the currencies they deemed most stable and reliable. Currencies that did not maintain their value would lose public trust and be abandoned in favor of better alternatives.

According to Hayek, this monetary competition system would lead to more stable currencies suitable for market needs. Issuing institutions would have strong incentives to maintain their currencies' value, as their reputation and business would depend on it. They would seek to meet users' demands for currencies with different characteristics, such as greater or lesser stability, backed by different assets, etc.

NITI's mission is to implement Hayek's proposed system.

We will use the Discreet Log Contracts protocol proposed by Lightning Network co-author Tadge Dryja (@tdryja).

NITI is a maximalist protocol. We will never touch KYC. We will never follow AML. We will never have a governance token. We are a 100% Bitcoin open-source protocol.

Through Discreet Log Contracts (DLCs), anyone or institution can create algorithmic stablecoins (called "synthetics" in NITI, as coined by Renato Amoedo @R38TAO) backed by a wide variety of assets, far beyond what traditional stablecoins pegged to fiat currencies can offer.

These synthetics can have their value pegged to commodities, stocks, indexes, rates, or any asset with a publicly verifiable price. Each issuer can choose the basket of assets backing their synthetic, seeking to meet specific market niches. Users, in turn, can choose to use the synthetics that best meet their needs for stability, hedge, exposure to certain sectors, etc.

Unlike current algorithmic stablecoins, which have their own complex and risky stabilization mechanisms, all synthetics in NITI will follow the same standard model. This will bring transparency, security, and ease of use for users. They will know that all synthetics, regardless of the issuer, follow the same operating logic.

2.3.2 Token Diversity

Instead of competing directly with IOUs, our proposal is to implement something they cannot do due to their system's nature: token diversity. Tether has direct reserves for its backing, and this is possible because there is high liquidity in the traditional market for the Dollar, futures contracts, bonds, etc. However, if they wanted to create a token that copies the value of Diesel, which would be very useful for truck drivers to hedge against their costs, for example, they would face difficulties. They might try to use fuel stocks as collateral, but this has high costs and would make monetizing this reserve unfeasible. It would even be possible to use a dynamic basket of traditional assets to simulate this price, but it is possible to see how this system would quickly increase in complexity and reduce profitability.

In the case of creating a stablecoin that has parity with the transaction fee variation (sat/vB) of Bitcoin, there are no legal instruments in the traditional financial market to create this reserve or monetize it. This type of stablecoin cannot be created by IOUs, and we believe this is where algorithmic stablecoins have a competitive advantage.

Niti synthetics can have parity with weather variations, crop yields, political events, Bitcoin transaction fees, price averages (e.g., 200-week Bitcoin average price), stock indices, and any other asset with public data and reliable information sources accepted by both contract parties. Unlike IOU stablecoins, their system does not depend on direct collateral but only on a private contract between two parties using Bitcoin as collateral, allowing the creation of synthetics for specific peculiar use cases. Niti has found this market gap, as although algorithmic stablecoins theoretically can generate tokens for anything with public prices, they still focus their peg on fiat currencies and try to compete with IOU stablecoins.

2.3.3 Standardization

Algorithmic stablecoins are complex because they don't follow an open, community-decided standard protocol. Each uses its own models, which can fail, like Terra (LUNA). Users must deeply study each process to understand risks and economic viability, which is impractical for non-technical users, making them highly risky.

With companies following the NITI protocol, clients use a secure platform regardless of the token purchased. Standardizing algorithmic stablecoins reduces complexity and perceived risk for clients. Terra (LUNA) couldn't operate on NITI due to not following the standard accepted protocol.

2.3.4 NITI's Blue Ocean Strategy

According to KIM and MAUBORGNE (2008), blue ocean strategies create undisputed market spaces, making competition irrelevant. They focus on different customers with expanded market proposals, not necessarily defeating existing competitors.

2.3.4 Current Analysis

Value Assessment Matrix

Four Actions Framework

According to the four strategic questions by Kim and Mauborgne (2008):

What industry attributes should be eliminated?

Niti eliminates the individual separation of tokenization services, acting as an open and free technological infrastructure for creating and monetizing synthetics. Unlike platforms like MakerDAO, Niti promotes a safer and more transparent operation by removing barriers to understanding platform risks.

What attributes should be reduced well below industry standards?

Niti plans to significantly reduce Capital Expenditure (CapEx) by using multiple synthetic assets as collateral in hyper-collateralized Bitcoin loans, simplifying the process and reducing complexity and operational risks.

What attributes should be raised well above industry standards?

Ease of use will be enhanced through standardization, facilitating user choice among different coin issuers. Niti aims to serve a broad market, including non-traditional sectors like agriculture and industry. The diversity of assets will also be significantly expanded, focusing on offering a wide range of synthetics with various price parities rather than directly competing with IOU stablecoins.

New Value Curve

3. Model

3.1 Discreet Log Contracts

Discreet Log Contracts (DLCs) are a type of smart contract on Bitcoin that allow two parties to make bets or agreements privately, using real-world data to determine the outcome. Their function is similar to the Lightning Network, but instead of creating off-chain micropayment channels, they create conditional payment channels.

Source: Interdax, “Discreet Log Contracts: Scalable Smart Contracts for Bitcoin”

DLCs use a model similar to the Lightning Network but are designed for conditional payments based on external data. Alice and Bob retain custody of their Bitcoins, analogous to a Lightning Network channel. Only one of the thousands of pre-signed transactions can be executed, the one where the oracle's signature confirms the bet's outcome (price, political event, weather, etc.). The first DLC bet was between the creator of @BTCPay Server and the co-founder of @Suredbits on the 2020 US presidential election results.

3.2 How NITI Uses DLCs to Implement Hayek's Monetary System
NITI is neither Alice, Bob, nor the Oracle. Instead, NITI acts as a coordinator, providing the technological infrastructure for Alice and Bob to connect and choose a set of high-reputation oracles, overcoming the challenge of “Decentralized Matching” cited in the Discreet Log Contracts whitepaper.

3.2.1 Decentralized Matching

NITI uses decentralized communication protocols like nostr to facilitate pairing between parties interested in creating a DLC (Alice and Bob) and the oracle providing the necessary external data for contract execution.

Nostr (Notes and Other Stuff Transmitted by Relays) allows users to securely and privately publish content, interact, and exchange messages without relying on centralized platforms. Users maintain full control over their identity and data using public-key cryptography.

Through Nostr, Alice and Bob can anonymously publish their intent to create a contract, specifying the desired terms (asset, expiration date, price range, etc.). These announcements are visible to other Nostr users, who can then express interest if they have compatible intentions. Once Alice and Bob find each other and verify that their interests align, they can proceed with creating the DLC.

Oracles periodically publish their data on Nostr, with their reputation based on the accuracy and frequency of data transmission. Alice and Bob then define a set of reputable oracles to provide the external data necessary for contract execution.

This entire pairing process happens in a decentralized manner, without Alice and Bob needing to trust intermediaries with their information. NITI acts only as a facilitator, enabling parties to find each other and choose an oracle efficiently and privately.

In addition to facilitating decentralized matching between Alice, Bob, and a mutually trusted oracle, the Nostr protocol allows NITI to interlink multiple DLCs in sequence or cascade. This architecture enables the creation of complex and automated financial instruments on Bitcoin. The verified result of one DLC can automatically trigger the next pre-configured DLC, creating a chain of conditionally interlinked contracts. For instance, Alice and Bob might set up an initial DLC dependent on the BTC/USD variation over a period. They preconfigure potential transactions T = {T1, T2, ..., Tn} using Adaptor Signatures, where each transaction Ti corresponds to a possible BTC/USD variation interval, encoded in condition Ci. At the end of the period, the oracle signs the observed result, e.g., Ck = "BTC/USD varied between 10% and 20%." NITI, as the coordinator, verifies and republishes this oracle-signed message on Nostr. Alice and Bob can then derive the private key corresponding to the winning transaction Tk through the formula:

where α and β are the private secrets of Alice and Bob, respectively, and H is a cryptographic hash function. Suppose Alice and Bob want to activate a second DLC if the result Ck is observed. They prepare a new set S = {S1, S2, ..., Sm} of potential transactions for this second DLC, where each Sj represents a periodic purchase of bitcoin. The public keys for these transactions are derived by incorporating the condition Ck from the first DLC:

where G is an elliptic curve generator, α' and β' are new secrets, and Dj encodes the details of the periodic purchase. When NITI publishes the signed message with result Ck on Nostr, Alice and Bob can derive the private key for a specific Sj transaction and activate the second DLC:

This process can be repeated, chaining multiple Discreet Log Contracts (DLCs) where the result published by Niti for one contract serves as the pre-image condition to activate the next in the chain, all operating decentralized via signed messages on Nostr. NITI does not mediate the execution of individual DLCs but facilitates publishing oracle-signed results, allowing Alice and Bob to activate new DLCs as needed. This combination of DLCs with Adaptor Signatures and Nostr paves the way for a decentralized network of programmable financial contracts directly on Bitcoin's base layer.

3.2.3 Use of Multiple Collaterals

In DLCs, typically only one digital asset is used as collateral, especially Bitcoin. However, NITI employs Lombard Credit, allowing a diversified basket of Bitcoin-backed synthetic assets as collateral.

This approach offers significant advantages since Bitcoin is volatile in the short term. Diversifying collateral with uncorrelated synthetic assets like gold, the dollar, stocks, etc., all hyper-collateralized in Bitcoin, reduces the overall collateral basket's volatility, mitigating margin call risks.

Lombard loans are traditional loans where liquid assets are used as collateral. Typically offered by private banks to high-net-worth clients, Lombard loans allow borrowers to access liquidity without selling their assets.

In traditional markets, a Lombard loan works as follows: the client provides liquid assets (stocks, bonds, fund shares, etc.) as collateral for a loan. The bank then lends a fiat amount based on the proportion of the collateral assets' value and expected volatility. The client pays periodic interest on the loan amount. If the collateral assets' value falls below a predetermined threshold relative to the loan value, a margin call occurs. In this case, the client must deposit more assets as collateral to restore the required margin. If the client cannot restore the margin, the bank liquidates the initially collateralized assets to repay the loan.

At NITI, Lombard loans are the foundation for generating Bitcoin-backed synthetic assets. For example, Alice can use a combination of:

- 1/3 Gold Synthetic
- 1/3 Dollar Synthetic
- 1/3 Bitcoin

as collateral to create a Real Synthetic via a DLC. If Bitcoin's price drops sharply, but gold and the dollar remain stable, Alice's total collateral value is less impacted, significantly reducing the likelihood of a margin call forcing premature closure of her Real Synthetic contract.

Additionally, users can create custom collateral baskets that best suit their risk profile and expectations for the specific contract.

In Value-at-Risk (VaR) analyses, diversification's benefits in risk reduction using multiple assets as collateral were quantified. Using only Bitcoin as collateral, with a 1-day period, 99% confidence, and daily data since 2014, the amount at risk of loss is 8.25%. With only the dollar as collateral, it's 1.81%, and with only gold, it's 2.14%. Using all three assets together in a 1/3 proportion each results in the lowest risk: only 1%. Although counterintuitive, this occurs because these assets' prices have low correlation: they tend to rise and fall at different times. Thus, it is mathematically determined to be 8 times safer to use multiple assets as collateral than just Bitcoin.

5. References

- Dryja, T. (2018). Discreet Log Contracts. Whitepaper. Available at: [Discreet Log Contracts](https://adiabat.github.io/dlc.pdf)
- Schramm, A. Bitcoin, the final settlement system. Article. Available at: [Livecoins](https://livecoins.com.br/bitcoin-sistema-de-liquidacao-final/)
- Bhatia, N. Layered Money. Book.
- Hayek, F. A. (1976). Denationalization of Money. Book.
- Aristophanes. Complete Works. Specific reference on the use of currencies in Ancient Greece.
- Kim, W. C., & Mauborgne, R. (2005). Blue Ocean Strategy. Harvard Business Review Press.
- Credit Suisse. Lombard Loans. Available at: [Credit Suisse](https://www.credit-suisse.com/ch/en/private-clients/investments/lombard-loan.html)
- Investopedia. Gresham's Law. Available at: [Investopedia](https://www.investopedia.com/terms/g/greshams-law.asp)
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