How Bitcoin Builds DeFi – Bankless
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Dear Bankless Nation,
Bitcoin has a market cap of ~$400 billion.
Like the OG grandaddy crypt, it’s pretty good.
Bitcoin’s bare-bones design created a secure, decentralized and censorship-resistant network widely trusted by the masses.
Unfortunately, this design also comes at a trade-off – the network has no smart contract capabilities at the base layer.
That means that aside from serving as an inflation hedge, much of the value of Bitcoin is currently idle capital. This is in contrast to smart contract networks where capital can be transferred and used in creative ways.
But just like trolls, onions and any other blockchain, Bitcoin has layers.
It is where DeFi and smart contracts are built.
Lightning Network, Stacks, RSK and Liquid are just some of the early examples of this.
Muneeb Ali from Stacks & Trust Machines gives us a great overview of the Bitcoin DeFi landscape today.
– Bankless team
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Guest writer: Muneeb AliFounder of Stacks
Bitcoin has established itself as the store of value in the crypto industry.
However, Bitcoin is mainly held passively in wallets and cold storage. It is not considered a productive asset.
Currently, all active use of Bitcoin for trading or lending occurs mainly through centralized companies such as Coinbase or BlockFi.
There is a huge opportunity to finally enable decentralized use cases for Bitcoin that can turn it into a productive asset by actively distributing BTC in smart contracts.
During the last bull market we saw the rise of web3 – DeFi, NFTs and other applications. Most of these experiments are currently taking place on Ethereum and newer L1s such as Solana and Avalanche.
With that, the developer and app ecosystem on the Bitcoin side remains relatively small compared to Ethereum. This is because the Bitcoin foundation is simple and does not support complex applications. Bitcoin follows simple design architecture to keep the base layer secure, immutable and durable.
Despite its simplicity, Bitcoin remains the largest asset class in the industry. Even in today’s bear market, there is $400 billion in capital just sitting there waiting to be unlocked by developers in new use cases and applications.
In this article, we discuss the future of Bitcoin, how this ecosystem will be built, and highlight some projects that bring new use cases to the Bitcoin ecosystem.
All of this happens through Bitcoin layers, which will unlock a new wave of innovation that could massively expand the Bitcoin economy.
DeFi is coming to Bitcoin Today.
This is how.
Bitcoin was designed to scale in layers.
Satoshi Nakamoto wrote about this opportunity in 2010:
Bitcoin L1 is for settlement, not payments.
For example, payments can happen on faster, cheaper layers like Lightning and then settle back down to L1.
Similarly, other Bitcoin teams such as RSK or Stacks are introducing smart contracts (complete execution environments) without changing the basis.
There is a clear separation between the roles of Bitcoin and the teams.
Experimentation takes place on higher layers. The base layer optimizes for decentralization and durability; it focuses on being a value store.
Bitcoin becomes more productive at the higher layers without sacrificing decentralization and other valuable properties (as censorship resistance) on L1.
Four main Bitcoin layers exist today: Lightning, Stacks, RSK and Liquid.
Each team is at different stages of maturity and traction. This research report from the blockpublished in June 2022, provides an overview of the current state of Bitcoin teams.
Lightning is a layer to scale payments on Bitcoin.
Lightning is focused on faster and cheaper payments in a trust-minimized way. Payments are made off-chain through specific channels; ultimately, the channel makes the final settlement on the Bitcoin main chain.
Lightning does not have an execution environment or a global ledger; it has a peer-to-peer design focused on payments. Today, the Lightning Network’s channel capacity has recently passed $100 million, with 17,000+ active nodes and millions of payments processed.
Stacks is a Bitcoin smart contract layer.
It has a complete execution environment and any application that can be built on chains like Ethereum or Solana can be built on the Stacks layer.
Transactions on stacks are automatically settled on Bitcoin every Bitcoin block.
Contracts on the Stacks layer can read and react to Bitcoin transactions, and work is underway to easily move BTC in and out of the Stacks layer in a trustless manner. Developers have recently published 5000+ contracts on Stacks, and contracts (e.g stacking) has $150M+ capital locked and earning BTC rewards.
RSK is a Bitcoin team merged with Bitcoin (simultaneously mining RSK blocks along with Bitcoin blocks) and brings EVM compatible smart contracts.
RSK uses an association of hardware wallets to plug in and out of BTC to RSK.
Liquid is a unified layer of Bitcoin pin-in and out functionality managed by the federation. Liquid currently has asset issuance functionality, but not a full execution environment (unlike Stacks and RSK) yet.
Other than the Bitcoin layers discussed above, some scripts in the Bitcoin main chain, such as DLCs (Discreet Log Contracts) and Taproot, can enable limited programmability directly on the Bitcoin foundation (eg: Atomic Finance).
Taproot and DLCs can also improve the functionality of the Bitcoin layers by improving the interaction between the base layer and the different Bitcoin layers.
Taproot or DLCs should not be confused with full execution environments like EVM; they have a different scope but are complementary to Bitcoin layers like Stacks and RSK, which have full execution environments (EVM for RSK and Clarity VM for Stacks).
Bitcoin focuses on durability and decentralization. Users can take Bitcoin software from as far back as 2013 and run it unchanged for use with the current chain.
Furthermore, regular users with laptops and home internet connections can run full nodes with Bitcoin unlike many new L1s where it is not possible given the high hardware or bandwidth requirements for full nodes.
Bitcoin has a grassroots movement, and the culture rejects all points of centralization in the ecosystem – at least at the base layer. The Bitcoin community takes a cautious and risk-averse approach to network upgrades, and changes to the codebase happen slowly and cautiously.
Bitcoin has the largest crypto capital base, largest brand name and community. Bitcoin has been around the longest, and given the Lindy effect, it is most likely to survive for decades to come.
It has reached a level of decentralization and security budget that is very difficult for any actor to shut down the network or launch significant attacks against it. Bitcoin codebase carries the biggest live bug bounty on the planet; anyone in the world can discover an exploit to steal money and yet in 10+ years we have not seen exploits or hacks on the live network.
In my opinion, successful experiments and valuable applications in crypto will eventually move towards using BTC capital and benefiting from the security of Bitcoin settlements.
There is some evidence that it is already happening, for example following the popularity of .eth names, recently 100,000 .btc names were registered on Bitcoin through the Stacks layer, with secondary market trading on Bitcoin NFT exchanges that Gamma.
Further, Zest protocol brings on-chain Bitcoin lending against corporate balances to the Bitcoin ecosystem, similar to how Maple Finance brought this functionality to Ethereum.
Often, developers are interested and excited about the idea of building on Bitcoin.
However, they quickly realize that the developer tools and infrastructure need more work and that speed and performance issues are very real and need to mature further.
There are complicated technical challenges like a Bitcoin plug out of layers that need to be solved before we can move towards successful apps from crypto being implemented at scale and gaining mainstream user adoption.
Ethereum arguably has the largest developer community in crypto, and newer L1s like Solana and Avalanche attract more developers than Bitcoin.
However, we have also seen how developers and capital can quickly move from one chain to another. The developer and user experience on various Bitcoin layers continues to mature, and recently there has been significant capital injection into companies built on Bitcoin — Trust Machines raised a $150 million roundand LightSpark raised a big round in 2022 respectively.
Bitcoin is not a rock; it is a programmable store of value and will become even more valuable through the introduction of Bitcoin layers.
While there is a long road ahead, DeFi is being built on Bitcoin Today.
You can try it yourself. Check out our essential guide to Bitcoin DeFi below.
Muneeb Ali is a co-founder of Stacks, a Bitcoin smart contract team. He is the CEO of Trust Machines, a startup that builds Bitcoin applications. He received his PhD in distributed systems from Princeton. A more detailed bio is here.
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