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What Are Stablesats? Creating Synthetic Dollars on the Bitcoin Lightning Network

On Wednesday, the Bitcoin banking platform Galoy announced a Bitcoin-based solution for sending, receiving, and storing USD. 

Unlike traditional solutions, the “Stablesats” feature does directly integrate fiat currency, nor does it involve issuing a new token, or “stablecoin.” 

Rather, Galoy’s service lets users of the Bitcoin Beach wallet effectively “freeze” the value of their Bitcoin to a specific dollar amount. How can this be?

How Stablesats Work

According to the firm’s explainer video, Galoy stabilizes users’ Bitcoin using financial derivatives called “perpetual inverse swaps.” These instruments let investors gain exposure to the future value of Bitcoin by either longing or shorting the asset. 

Unlike traditional futures contracts, perpetual swaps lack an expiration date, meaning holders can settle the contract with the counterparty exchange at any time. 

Inside the Bitcoin Beach Wallet, users may choose to store their Bitcoin in either a BTC or USD-denominated account. When using the former, their Bitcoin will remain stored with Galoy, as with any other custodial wallet provider.

However, when sats are transferred to a USD account, Galoy will transfer those funds to its partner exchange (ex. OKX). From there, it will open a short position, utilizing the customer’s Bitcoin as collateral. 

The short position ensures that, in dollar terms, a user’s BTC is hedged against any Bitcoin price fluctuations. In other words, the profit/loss on the contract will negate any potential appreciation or depreciation of the collateral’s value.

A Hypothetical Situation

For example, suppose a Beach Wallet user (Alice) stores 400,000 satoshis into her wallet’s USD account. A “satoshi” or “sat” represents a 100 millionth of a Bitcoin – its smallest divisible unit. 

Now assume the price of Bitcoin at that time is $30,000, making the satoshis in Alice’s account worth $120. Suddenly, Jerome Powell raises interest rates again, and Bitcoin drops to just $15,000. 

With Bitcoin’s price halved, Alice’s sats are now worth just $60. The bank now needs to secure twice the number of sats to cover the full $120 in Bitcoin owed to Alice.  

Thankfully, by opening a short position in advance, the bank made a $60 profit on Bitcoin’s price fall. This profit is used to buy the Bitcoin it needs to make Alice whole. 

Conversely, suppose the price of Bitcoin doubled from its original price, melting up to $60,000. While Alice’s collateral is now worth $240, the bank has to pay off the $120 loss incurred on its short position. Therefore, half of Alice’s sats must be sold by the bank so it may cover itself.

In this way, Bitcoin’s volatility bears no net impact on either Alice’s account or Galoy’s balance sheet.

Why Use Stablesats?

In a blog post on the matter, Galoy explained that stablesats resolve the price-fluctuation issues pertaining to a Bitcoin economy. Specifically, when Bitcoin’s price falls, it becomes more difficult for its holders to purchase dollar-denominated products. 

“This creates friction and uncertainty, causing merchants and consumers to frequently consider selling bitcoin for dollars to ensure they can meet their financial obligations,” the company continued. 

Stablesats VS The Competition

As Galoy notes, stablesats are hardly the first attempt by a Bitcoin bank to resolve issues related to price volatility for its customers. 

One solution is to implement trading of real dollars at the bank, allowing customers to trade their Bitcoin for fiat at any time. Another is to use stablecoins – crypto tokens price pegged to the dollar by an issuer with fully backed USD reserves.

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What tradeoffs do stablesats hold when compared to these other, arguably simpler models?

Pros:

  • No Banking Access Required: Stablesats do not require access to the traditional banking system as it is only dependent on Bitcoin. Real banking requires real dollars/credit for customers, as do stablecoins (for the issuer).This advantage can help people in third-world countries whom lack bank accounts gain access to dollars where it is otherwise impossible.
  • Low Fees: Transacting sats over the lightning network is virtually costless, and settles immediately. Meanwhile, use of stablecoins on Ethereum still feature unworkable fees for small payments, while international remittance transfers can be highly exploitative.
  • One Network: Synthetic dollars on the lightning network ensures that real-world economies can unite around one monetary network – Bitcoin.
  • Fully Collateralized: Every dollar liability held by Galoy is backed by an equivalent value in Bitcoin. This differs from algorithmic stablecoin models, which proved unstable and unreliable in the wake of Terra’s collapse. 

Cons:

  • Counterparty Risk: Stablesats do not overcome the counterparty risk plaguing the other two existing methods. Dollars require trust in a bank, stablecoins require trust in an issuer, and stablesats require trust in a centralized exchange.
    Should any of these institutions go bankrupt, their customers may lose access to the USD they once thought they owned. This eliminates one of Bitcoin’s core value propositions – that a person can personally hold and trade it without trust in centralized entities.
  • Auto De-leveraging: Stablesats may indeed hedge against volatility – but only to a point. Auto-deleveraging mechanisms may cause shorts at OKX to close on their own, despite being in profit. By extension, this can leave Galoy and its customer under-hedged in a volatile environment.
  • Sustained Negative Funding: When there are more short positions than long positions open at an exchange, shorts must pay longs. Historically, the opposite has usually been the case, but this could change in the future.
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