Bitcoin DeFi Ecosystem Explained

What is Bitcoin DeFi?

The Bitcoin Taproot upgrade unlocked the potential to create DApps on the Bitcoin blockchain, improving the blockchain’s long-term viability by accelerating the DeFi movement on the Bitcoin network.

Decentralized finance (DeFi) has experienced tremendous success since 2020, with almost all of this growth fueled by Ethereum. Ethereum paved the way for new financial services and instruments, including decentralized exchanges (DEX), automated lending platforms and non-fungible tokens (NFT).

On the contrary, it was not possible to develop smart contract-driven decentralized applications (DApps) on the Bitcoin blockchain until the Taproot upgrade, opening the door to DeFi for the world’s first cryptocurrency. In this context, Bitcoin DeFi refers to developing innovative decentralized applications on Bitcoin’s network, which was not possible before due to the problem of transaction scalability.

Due to the requirement that each digital signature be verified against a public key prior to the implementation of the Taproot upgrade, Bitcoin transactions were relatively slow. Thanks to Taproot, the network can now group multiple digital signatures and validate them all at the same time. As a result, less space is needed on each block, which allows the Bitcoin blockchain to support the development of DeFi applications.

How does Bitcoin DeFi work?

Wrapped tokens like Wrapped Bitcoin, layer-1 blockchains like Stacks and sidechains like Rootstock enable DeFi on Bitcoin.

The scripting language used by Bitcoin, called Script, is not Turing complete, meaning it is deficient in several logical operations, such as loops. As a result, the Bitcoin network supports limited programmability despite the Taproot upgrade, meaning that Bitcoin DeFi platforms rely on layer-2 scaling solutions and sidechains to host their smart contracts.

DeFi on Bitcoin is made possible through wrapped tokens such as Wrapped Bitcoin (wBTC), layer-1 blockchains such as Stacks and sidechains such as Rootstock. For example, wBTC, an Ethereum token introduced in January 2019, is backed one-to-one by Bitcoin (BTC), meaning that one wBTC is always equal to 1 BTC. Users can engage with several of Ethereum’s DApps using the wBTC token.

An independent layer-1 blockchain called Stacks makes hundreds of billions of dollars of capital in BTC available and offers Bitcoin holders new ways to spend and earn from the cryptocurrency. It uses a proof-of-transfer consensus mechanism, which secures the blockchain using Bitcoin’s proof-of-work blockchain.

DeFi products such as Stackswap DEX leverage the Stacks blockchain to allow users to trade and create NFTs, borrow algorithmic stablecoins, and launch and exchange tokens on the Bitcoin network. Additionally, since Stacks and Bitcoin are connected, NFTs created on Stacks will settle and are secured by the Bitcoin blockchain.

Turing-complete smart contracts are enabled on the Bitcoin blockchain by Rootstock, which runs parallel to the blockchain. When BTC is sent to Rootstock, it is transformed into RBTC, a smart contract enabled Bitcoin. Based on two-way communication, this protocol acts as a bridge to connect both chains. For example, Sovryn, one of the first permissionless financial apps, uses RSK’s technology to connect to the Lightning Network, Ethereum, Bitcoin and the BNB Smart Chain.

Which DeFi projects are part of the Bitcoin ecosystem?

Besides wBTC, Stacks and Rootstock, BadgerDAO, RenVM and Liquid Network promote various use cases of Bitcoin DeFi.

BadgerDAO

A decentralized autonomous organization (DAO) called BadgerDAO enables BTC to be used as security across various DApps. BadgerDAO uses the Ethereum-based token BADGER for protocol management and incentive distribution.

Users can earn income from their synthetic BTC assets using Sett Vaults, the first product offered by Badger. Users can unlock their tokenized Bitcoin in SETTs, which are pools of tokens, and let smart contracts manage their holdings to produce a return in the form of bTokens.

The second product from Badger, called Digg, is software that controls the elastic supply cryptocurrency called the DIGG token, linked to the price of BTC in US dollars. Like all other tokens, DIGG can be invested in SETTs to provide a return for the holders and used in DeFi protocols.

RenVM

The decentralized Ethereum protocol Ren creates tokens that monitor the value of non-Ethereum assets like Bitcoin and offer liquidity to projects on multiple blockchains. That said, Bitcoin holders can use Ren (required to pay nodes) to access Ethereum’s range of DeFi products without selling their BTC or moving their assets across blockchains.

The Ren virtual machine stores the original funds, accepts tokens from one blockchain and generates new tokens on another through the RenBridge to exchange assets between blockchains. For example, a user can submit BTC to RenVM, which will issue renBTC, a new token on Ethereum that will reflect the original Bitcoin, meaning that when the user wants to get the Bitcoin back, the transaction can be reversed.

Liquid network

The Liquid Network is a layer-2 Bitcoin solution and a settlement network between exchanges that enables the issuance of digital assets such as security tokens, stablecoins and other financial instruments privately and quickly on top of the Bitcoin blockchain.

LBTC, a wrapped version of Bitcoin, serves as the native token on the Liquid sidechain. Users send BTC to a Lightning Network address (a process called peg-in) on the Bitcoin network to use the Liquid Network. A similar amount of LBTC is minted on the Liquid Network and delivered to the user’s address after the transaction has received 102 confirmations.

In addition, peg-out can be initiated to withdraw BTC by sending LBTC for burning to an unrecoverable address, which, upon receiving two separate confirmations, allows a Lightning Network member to send the original BTC to a user’s Bitcoin network address.

What is the future of Bitcoin DeFi?

The effectiveness of Bitcoin DeFi platforms and protocols will be determined by their long-term stability and security, level of innovation, as well as incentives provided to investors.

With Bitcoin scaling solutions like Rootstock, Stack, Liquid Network and more, it’s clear that DeFi is pouring into the Bitcoin network. However, DeFi on Bitcoin is less accessible than on the Ethereum blockchain and other smart contract platforms.

That said, if developers want to choose the Bitcoin blockchain to develop DApps or mint NFTs, they have to rely on layer-1 or layer-2 solutions, unlike the Ethereum blockchain. For example, one can use Ethereum testnets, such as Ropsten, to build DApps. In contrast, Bitcoin DeFi platforms require bridges like RenBrdige to connect to the Bitcoin network to develop decentralized applications.

Also, NFTs on Bitcoin are still in their infancy; But given that Bitcoin laid the groundwork for cryptocurrencies, it seems only a matter of time before developers flock to the Bitcoin network to develop new financial instruments and platforms.

Therefore, DeFi on Bitcoin must host innovative decentralized finance applications that are not available on other blockchains, have a significant user base and offer a demonstrable advantage over existing DeFi solutions.