Beginner's Guide to DeFi on Bitcoin: Should You Build on the Bitcoin Network?

Over the years, DeFi (Decentralized Finance) has become one of the cryptocurrency industry's most exciting and rapidly growing niches. While DeFi platforms are most commonly associated with the Ethereum network, Bitcoin is quickly emerging as a viable option for DeFi projects.

This beginner's guide will explore the workings of DeFi on Bitcoin, including its advantages, limitations, and how it works.

What Is DeFi?

Decentralized finance or DeFi is a term used to describe a new wave of financial applications built on decentralized blockchain networks. DeFi's objective is to create a more open, transparent, and accessible financial system where anyone can participate without intermediaries.

In traditional finance, financial transactions rely heavily on intermediaries. These may include banks, brokerages, payment processors, etc. They act as trusted third parties that hold and transfer money and assets between parties, but they also charge fees and can introduce counterparty risk.

DeFi aims to eliminate intermediaries by leveraging the power of blockchain technology. By using smart contracts, DeFi applications can automate financial transactions, removing the need for all forms of intermediaries.

DeFi is currently dominated by Ethereum, but newer blockchains like Solana, Avalanche, Cardano, and Polkadot have become competitors. Initially designed for peer-to-peer online transactions, Bitcoin has expanded its capabilities to allow for the launch of native DeFi applications on its network.

What Is Bitcoin on DeFi?

Bitcoin on DeFi refers to the development of decentralized applications (dApps) on the Bitcoin blockchain, made possible by the Taproot upgrade. Unlike Ethereum, Bitcoin's scripting language is not Turing complete, so it relies on wrapped tokens, Layer 2 blockchains, and sidechains to enable DeFi.

Using layer 2 blockchain technologies, users may create a DeFi ecosystem based on the Bitcoin blockchain, making Bitcoin accessible to a larger range of use cases. Sidechains enable smart contracts on the Bitcoin network, connecting it to other blockchains such as Ethereum, Lightning Network, and BNB Smart Chain.

Bitcoin DeFi can improve the long-term viability of the Bitcoin network by promoting financial innovation and expanding its use cases beyond a store of value.

Why DeFi on Bitcoin?

While Ethereum is one of the most utilized and popular blockchains for DeFi, Bitcoin is also emerging as a viable option. Bitcoin's dominance in the cryptocurrency market makes it an attractive choice for DeFi projects looking to reach a broader audience.

There are several advantages to building DeFi on Bitcoin. First, the Bitcoin network's security and immutability make it ideal for DeFi applications. The Bitcoin blockchain is reputable for being resistant to hacks and attacks.

Furthermore, its decentralized nature makes it impossible to manipulate or censor transactions.

Secondly, Bitcoin's large user base makes it easier for DeFi projects to reach a broader audience. While Ethereum has a thriving developer community, its user base is still relatively small compared to Bitcoin's.

Finally, 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 more secure and reliable than traditional ones.

How Does DeFi on Bitcoin Work?

DeFi on Bitcoin works by using smart contracts to automate financial transactions. Smart contracts are autonomous, self-executing programs that run on the blockchain. They enable the creation of trustless dApps that can facilitate financial transactions without intermediaries.

One promising use case for DeFi on Bitcoin is the creation of synthetic assets. Synthetic assets, e.g., Wrapped Bitcoin (wBTC), are financial instruments that simulate the value of an underlying asset, such as gold, stocks, or other cryptocurrencies.

To create a synthetic asset on Bitcoin, a DeFi platform would lock up a certain amount of Bitcoin as collateral. This collateral would then be used to mint a new token representing the underlying asset's value.

For example, if a DeFi platform wanted to create a synthetic gold token, it would lock up a certain amount of Bitcoin as collateral, and then mint a new token representing the value of gold.

The synthetic token could then be traded on a decentralized exchange (DEX) or used as collateral for other loans or financial products. When the synthetic token is redeemed, the collateral is returned to the owner minus any fees or interest accrued during the loan period.

Another use case for DeFi on Bitcoin is the creation of decentralized exchanges (DEXs). DEXs are peer-to-peer exchanges that allow users to trade cryptos without intermediaries.

Using smart contracts, DEXs can automate trades and provide users with a safer, more secure, and more reliable trading experience.

Challenges to the Adoption of DeFi on Bitcoin

Despite the benefits of DeFi on Bitcoin, several challenges need to be addressed. One of the biggest challenges for this is the limited capacity of the Bitcoin blockchain. This limited capacity can result in slow transaction times and high fees during periods of high demand.

In addition, the lack of smart contract functionality on the base layer of the Bitcoin network has resulted in the need for Layer 2 solutions, such as the Lightning Network, to support DeFi applications.

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

3 Protocols Enabling DeFi On Bitcoin

Mintlayer

Mintlayer, as previously mentioned, is a Layer 2 solution for Bitcoin that enables DeFi projects on the Bitcoin blockchain. The company was founded in 2019 and aims to provide the infrastructure and critical tools for projects to build the future of Bitcoin.

Mintlayer aims to provide a sustainable architecture for DeFi that inherits its security model from Bitcoin, allowing for truly decentralized, trustless, and transparent transactions. Mintlayer intends to enable Bitcoin users to leverage their assets to do more without centralization.

Mintlayer has raised $17.2 million from investors, including X21 Digital, Phoenix VC, and Moonrock Capital, in its seed and Series A funding rounds.

Rootstock

Rootstock (RSK)is a smart contract platform running 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 use Solidity, the programming language used to develop Ethereum smart contracts, to create dApps on RSK.

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

Stacks

Stacks is a protocol built on the Bitcoin blockchain with the express purpose of facilitating the use of smart contracts, decentralized apps, and programmability inside the Bitcoin ecosystem.

By permitting the development of new blockchain-based applications and the execution of smart contracts, the Bitcoin blockchain's security, functionality, and stability may be maintained.

Stacks uses a unique mining mechanism called Proof of Transfer (PoX), which enables Stacks tokens to be mined by sending Bitcoin to a smart contract on the Stacks blockchain. This process allows Bitcoin miners to participate in the validation of Stacks transactions and earn STX rewards for doing so.

Stacks also features a native programming language called Clarity, which is designed to be secure, predictable, and easy to audit, making it well-suited for building decentralized applications and smart contracts.

Conclusion

DeFi on Bitcoin is still in its infancy, but there are projects that are working toward creating a sustainable architecture for decentralized finance on the Bitcoin blockchain.

Bitcoin has traditionally been seen as a store of value rather than a platform for DeFi. However, there is a growing interest in expanding its capabilities.