How to use DeFi on Bitcoin without “polluting” the blockchain

Bitcoin (BTC) is known for its immutability and hard-coded rules that make the system secure but slow to modernize. However, that does not mean that the Bitcoin blockchain – the underlying network that powers the original cryptocurrency – is closed to innovation and development. Although initial efforts to introduce decentralized finance (DeFi) to Bitcoin, such as cross-chain bridges and wrapped tokens resulted in a massive wave of hacks and exploits in the DeFi space, developers continue to look for new and more reliable ways to tap into . the unmatched liquidity of the BTC pool.

Launched in November 2021, the Bitcoin Taproot upgrade was an important step in adding additional functionality to the base layer of Bitcoin. Among other benefits, including cheaper and more efficient transactions, the Taproot upgrade also introduced rudimentary smart contracts – the backbone of DeFi – to Bitcoin for the first time.

The Taproot upgrade adds rudimentary smart contracts to the Bitcoin network. Source: Chaindebrief

Bitcoin DeFi: The First Attempt

Smart contracts are automated agreements between several parties that are stored on a blockchain. They enable a wide range of DeFi functionality. The introduction of smart contracts to the Bitcoin foundation hinted at the possibility of mainstream DeFi trends like non-fungible tokens (NFTs) appearing on the Bitcoin network, and developers rushed to work on it.

Shortly after, Bitcoiners came up with their version of NFTs with the Ordinals protocol, sparking a heated debate about adding more usability to the Bitcoin foundation as opposed to “overloading” it with non-essential content. Ordinals, also known as Bitcoin NFTs, allow users to enter digital content on the Bitcoin blockchain. Launched in January 2023, Ordinals quickly became a popular way to interact with the base layer, surpassing over 3 million inscriptions.

The total number of ordinals passed 3 million on 1 May. Source: Dune

Following the launch of ordinals, BRC-20 tokens emerged as an experimental token standard based on the Bitcoin Request for Comment (BRC) protocol. These tokens represented exchangeable assets on a 1:1 basis. However, the influx of memecoins such as Pepecoin (PEPE) on the BRC-20 standard led to an congestion problem, resulting in a backlog of 500,000 transactions awaiting settlement. This surge in demand caused transaction fees to skyrocket to $30 per transaction, significantly affecting the efficiency of the entire Bitcoin network.

Bitcoin DeFi: The Second Attempt

To make NFTs more efficient on Bitcoin, a new protocol called Bitcoin Stamps, or “Secure Tradeable Art Maintained Securely”, was launched shortly after the Ordinal. And unlike the ordinals, Bitcoin stamps allow imprinting or embedding of image data into the Bitcoin network by storing image data across multiple unused transaction outputs to increase decentralization and immutability.

Although the second attempt to add NFT usability to the Bitcoin network is considered an improvement over ordinals, Bitcoin stamps are far from providing ideal results. The protocol requires a canvas size of 24 x 24 pixels, which limits the capabilities of pixel-art NFTs.

Meanwhile, the problem of “polluting” the Bitcoin blockchain by storing data directly on the base layer remains unsolved. Also, a controversial topic still hovers over the Bitcoin community: Do we need NFTs on the main Bitcoin chain?

Additionally, just as BRC-20 spawned from ordinals, stamps formed their own tokenization standard called SRC-20. However, while SRC-20 tokens have greater immutability, they take up even more block space than BRC-20 tokens, and if their popularity were to grow, it would further overload the Bitcoin network.

Bitcoin DeFi Using Layer 2

An alternative approach aims to address all the shortcomings of layer-1 (i.e. Bitcoin), DeFi by moving NFTs and tokens to layer 2 thereby reducing Bitcoin traffic, lowering fees and adding more use cases. As the Lightning Network solved many aspects of Bitcoin payments as a layer-2 solution, NFTs and tokens can also be moved to the second layer to keep the Bitcoin foundation clean and efficient. This reduces the need for all transactions to use Bitcoin for settlement.

Mintlayer, a layer-2 solution that builds the tools to enable DeFi on Bitcoin, aims to open up Bitcoin to NFTs along with smart contracts, atomic exchanges and decentralized applications (DApps). Using a layer-2 network directly on Bitcoin enables lower coin and transfer costs while adding smart contract functionality and reducing congestion on the base layer.

Instead of trying to get DeFi onto the Bitcoin network through unreliable gateways like cross-chain bridges and wrapped tokens, Mintlayer enables the direct exchange of native Bitcoin for other tokenized assets minted directly on Mintlayer, eliminating all intermediaries between Bitcoin and DeFi.

To tokenize assets with tailored protocols designed for specific use cases, Mintlayer has introduced three tokenization standards. MLS-01 is designed for securities, stablecoins and equity tokens to work on Bitcoin, while MLS-02 is designed for confidential transactions. The third, MLS-03, is built for NFTs only. Since it was developed specifically with NFTs in mind, there is no need to write a smart contract – unlike ordinals and stamps. MLS-03 also unlocks the limits introduced by layer-1 experiments by exploiting the freedom of layer-2.

“It’s exciting to see innovation on the Bitcoin blockchain,” said Enrico Rubboli, CEO of Mintlayer, adding: “But ultimately NFTs and tokens have to be on layer 2. There are many limitations to NFT- are and tokens in terms of size, smart contract capabilities and immutability that Mintlayer will not be subject to.”

DeFi on Bitcoin allows the sustainable and efficient use of decentralized financial applications on the Bitcoin network. By transferring the complexity of DeFi to Layer 2, Bitcoin users can now benefit from improved scalability, reduced transaction costs and a wider range of financial services, while leveraging the security and robustness of the underlying Bitcoin blockchain.