Can Bitcoin lead the new wave of DeFi?

One of the key factors in Ethereum's massive success is its thriving smart contract-driven Web3 ecosystem, which offers a range of decentralized platforms and applications. Through various smart contracts and token projects built on top of Ethereum, cryptocurrency users are provided with new ways to interact economically and without permission.

Through decentralized platforms and P2P interactions, the growing multi-chain Web3 ecosystem has triggered the birth of a circular crypto economy that spans multiple EVM-based blockchains. Decentralized exchanges (DEX), decentralized finance (DeFi) and decentralized applications (dApp) allow users to trade, lend, and create and mint assets through peer-to-peer transactions. Token/NFT passively earns money by providing liquidity. earn income, etc.

As the first and largest cryptocurrency by market capitalization, Bitcoin deserves to be one of the pioneering projects of Web3. However, the strange thing is that Bitcoin has never been included in this Web3 circular economy system. The reason is that Bitcoin's design does not allow Turing-complete smart contracts and related data to be stored on the base layer of its blockchain. Although Bitcoin has struggled to implement smart contracts and tokenization through the Omni Layer protocol, Bitcoin has still been slow to implement Web3-style features and use cases at scale. This is actually due to the philosophy of conservative design decisions made by Bitcoin developers rather than a lack of technical ability.

Until November 2021, Bitcoin underwent a Taproot upgrade, which compressed complex transactions, reduced fees, and improved the efficiency of the network. This upgrade of Bitcoin changes the way transactions are verified, making it possible to develop DeFi on Bitcoin. The emergence of Ordinals, inscriptions and stamps since the beginning of 2023 also poses challenges to Bitcoin’s development scalability. But due to its limited native smart contract functionality, Bitcoin developers instead opted for Layer 2-based scaling methods.

With several rapidly growing DeFi platforms launching on Bitcoin, Bitcoin sidechains, and Layer 2 development, more complex use cases are implemented on top of the base layer with Layer 2 layers that can handle logic, data, and off-chain throughput. Volume, these projects provide smart contract functionality, EVM compatibility and other Web3 use cases, ensuring Bitcoin’s scalability, security and on-chain growth of the blockchain.

In this article, we will explore the relationship between Bitcoin and DeFi, and the use cases that Bitcoin DeFi brings to the network.

Taproot upgrade makes Bitcoin DeFi possible

Smart contracts allow parties to exchange value without the need for a third party, ensuring that every transaction is legal, transparent and credible. When smart contracts are executed, they are published on the blockchain, where a record of completed transactions is available for anyone to view.

Bitcoin’s base layer is very simple, which makes it the most secure, decentralized, and censorship-resistant blockchain, but it also lacks complete smart contract programming capabilities.

Due to the non-Turing completeness of Bitcoin’s script, before DeFi applications are launched on the Bitcoin network, BTC holders will convert their holdings to encapsulation on other blockchains. Such as the Wrapped BTC (wBTC) asset on the Ethereum network. wBTC is an ERC-20 token that enables BTC holders to participate in Ethereum-based DeFi protocols by locking their assets in smart contracts and receiving an equivalent amount of derivative assets, which can then be used to save, borrow, and earn Passive income is earned through liquidity mining on these platforms.

It’s not that the Bitcoin network can never have DeFi. In fact, Bitcoin’s good fundamentals are the basis for it to become the most trustworthy final settlement layer for smart contracts.

After the Taproot upgrade was implemented in November 2021, the upgrade implemented more powerful functions in complex scripts and can develop decentralized applications (dApps) based on the Bitcoin blockchain. Specifically, the Taproot upgrade contains 3 BIPs:

1. BIP340 (Schnorr Signatures): Schnorr signatures facilitate a faster and more secure way of verifying transactions on the Bitcoin network. It allows the aggregation of multiple keys into a single key, that is, the completion of aggregate signatures, thereby improving the privacy of Bitcoin and reducing the size of transactions so that each block can accommodate more transactions.

2. BIP341 (Taproot): Based on the SegWit upgrade, Taproot uses the Merkelized Alternative Script Tree (MAST) to expand the amount of transaction data in the Bitcoin blockchain. Taproot not only provides greater scalability and efficiency to the Bitcoin blockchain, but also provides greater privacy to Bitcoin users.

3. BIP342 (Tap): Tap is an upgrade to the coding language of Bitcoin Script, which facilitates the other two Bitcoin Improvement Proposals (BIP), which are used to specify how to execute transactions. Tap improves the bit by improving the signature hash. The smart contract flexibility and freedom of the currency can promote the Bitcoin network to support and create smart contracts in the future.

Image source: Kraken Intelligence

All in all, the Taproot upgrade solves the problem that native Bitcoin does not support smart contracts by introducing Layer2 solutions and side chains, making it possible for Bitcoin to develop DeFi. Using Layer2 technology, users can create a DeFi ecosystem based on the Bitcoin blockchain, making Bitcoin available for a wider range of use cases. Sidechains can also support smart contracts on the Bitcoin network and connect them to other blockchains.

By adapting to DeFi, Bitcoin increases its utility while appealing to a wider user base. On the other hand, the security brought by Bitcoin is also valued by most DeFi investors and users. DeFi on Bitcoin solves the security problem of hacker attacks and improves the credibility of various solutions, which is also the necessity of developing DeFi on Bitcoin.

DeFi Applications for Bitcoin

Bitcoin DeFi application based on external links

But the problem here is that encapsulation is risky. Because the Bitcoin blockchain cannot react to external events, the process of locking and unlocking Bitcoin is challenging during use and requires someone to do the locking and unlocking. The process goes like this:

Holders first deposit their Bitcoins with an issuer on the Bitcoin blockchain. The issuer then confirms receipt of the target blockchain, minting “wrapped BTC” tokens of the target chain’s own chain at a 1:1 ratio. To redeem the token, users must return their wrapped BTC to the issuer on the target network, who then sends the BTC to their Bitcoin wallet at a 1:1 ratio. Finally, the packed BTC is deleted ("burned") by the issuer, which can be an individual, a group of people (multisig), or a smart contract (enforced by consensus).

Image source: @alexeizamyatin

Almost all packaged BTC relies on centralized solutions controlled by trusted intermediaries or exchanges, and holders using these solutions must give up the features that make Bitcoin decentralized. Therefore, in recent years, Bitcoin developers have continued to explore ways to build technologies, applications, and infrastructure on top of the Bitcoin blockchain to promote DeFi applications native to the Bitcoin ecosystem.

Bitcoin DeFi application based on Layer 2

With the release of the Bitcoin Taproot upgrade, DeFi can gradually be implemented on Bitcoin. Although the native Bitcoin blockchain still does not support smart contracts at this time, Taproot has introduced a second-layer solution to help it realize this function and increase Bitcoin A protocol for the functionality and scalability of the Coin blockchain. Currently, there are four most prominent projects in Bitcoin DeFi. Each project is unique in its connection to the Bitcoin basic network and the additional utility it brings to the network.

Bitcoin DeFi on the Lightning Network

The Lightning Network is a second-layer scaling solution that enables fast, secure, and cheap peer-to-peer payments. It inherits the security of Bitcoin while providing high-speed, real-time transaction processing capabilities off-chain. The Lightning Network creates "channels" between two parties, where many transactions can be sent back and forth off-chain. This system greatly reduces the strain on the underlying Bitcoin network and is key to the scalability of Bitcoin payments. Since the end of 2020, the use of the Lightning Network has increased significantly.

As of September 6, the number of Bitcoins in the Lightning Network reached 4,742, while approximately 16,000 nodes were running on the network.

Image source: Bitcoin Visuals

Bitcoin DeFi on RSK

RSK is a smart contract platform that runs on the Bitcoin blockchain. It enables faster transaction speeds and scalability while supporting decentralized applications and smart contracts on the Bitcoin network.

The RSK smart contract platform is compatible with the Ethereum Virtual Machine. This allows developers to create dApps on RSK using Solidity, the programming language used to develop Ethereum smart contracts.

RSK uses its native cryptocurrency called Smart Bitcoin (RBTC) as fuel for its platform, similar to how Ethereum uses ETH. Additionally, RSK features a two-way peg, allowing Bitcoin to be locked in contracts and used on the RSK platform.

Bitcoin DeFi on Stacks

Stacks is a protocol built on top of the Bitcoin blockchain with the express purpose of facilitating the use of smart contracts, decentralized applications, and programmability within the Bitcoin ecosystem. By allowing the development of new blockchain-based applications and the execution of smart contracts, the security, functionality, and stability of the Bitcoin blockchain can be maintained.

Stacks uses a unique mining mechanism called Proof of Transfer (PoX), by sending bitcoins to a smart contract on the Stacks blockchain, Stacks tokens can be mined. This process allows Bitcoin miners to participate in the verification of Stacks transactions and receive STX rewards as a result.

Stacks also features a native programming language called Clarity, which is designed to be secure, predictable, and easily auditable, making it ideal for building decentralized applications and smart contracts.

Bitcoin DeFi on Mintlayer

Mintlayer is a layer 2 solution for Bitcoin that supports smart contracts and enables DeFi projects on the Bitcoin blockchain. The company was founded in 2019 to provide infrastructure and key tools for projects building the future of Bitcoin. Mintlayer provides a sustainable architecture for DeFi, inherits the security model of Bitcoin, and achieves truly decentralized, trustless and transparent transactions. Mintlayer not only hopes to expand Bitcoin’s functionality, but also pave the way for other developers to create and launch innovative solutions to further enhance its utility.

Advantages and Challenges of Bitcoin DeFi

Advantage

While Ethereum is one of the most used and popular blockchains in DeFi, Bitcoin is becoming a viable option as well. Bitcoin’s dominance in the cryptocurrency market makes it a strong choice for DeFi projects looking to attract a wider audience. There are several advantages to building DeFi on Bitcoin.

good foundation

Bitcoin is the most stable, secure, and decentralized blockchain in the world. Since the first block was released in 2009, the network has continued to prove its durability with limited modifications to its core protocol and near-zero downtime. This makes Bitcoin an ideal foundation for developers to build the next generation of financial products and services.

network effect

Bitcoin is the largest cryptocurrency by market cap, mining infrastructure, and user base. A large user base makes it easier for DeFi projects to reach a wider audience. Although Ethereum has a thriving developer community, its user base is still relatively small compared to Bitcoin. The world is looking to Bitcoin as the digital asset standard for investors.

Broad use cases

Bitcoin’s fixed supply and scarcity make it an attractive asset for DeFi projects. By using Bitcoin as collateral, DeFi platforms can create new financial products that are safer and more reliable than traditional financial products. As demand use cases for Bitcoin increase, creating DeFi applications on Bitcoin will bring innovative and substantial utility to the asset and network.

challenge

Although the above describes many Bitcoin DeFi use cases and the benefits of building DeFi on Bitcoin, there are still some challenges to large-scale application in the future.

One of the biggest challenges is the limited capacity of the Bitcoin blockchain. It is capable of handling around 7 transactions per second, compared to around 25-30 that Ethereum can handle. This limited capacity can result in slow transaction times and high fees during periods of high demand.

In addition, the basic layer of the Bitcoin network lacks smart contract functions, resulting in poor composability of Bitcoin, which requires Layer 2 solutions to support DeFi applications. Although these second-layer blockchains rely on Bitcoin’s security foundation, they still pose similar security risks to other dApps.

Finally, regulatory uncertainty and lack of clarity on the legal status of Bitcoin DeFi could also pose challenges to the development and adoption of these applications.

summary

Launched in 2008 as the first cryptocurrency, Bitcoin was widely trusted by the public as it designed a secure, decentralized and censorship-resistant network. Today, it remains the most important blockchain and its current market capitalization exceeds $500 billion, clearly establishing its position as the leading digital store of value, which is a huge achievement.

As more and more people realize that safe cryptocurrency investment is more important than potential high returns, it has become more and more attractive to DeFi developers and investors. Bitcoin does not have to be a monetary asset with minimal utility all the time, as the most trusted blockchain, more potential can be unlocked by building Bitcoin DeFi. Bitcoin may develop into the cornerstone of the future financial system, and its technology, applications and infrastructure will usher in a new era of DeFi.