The Future of DeFi for Bitcoin

Can decentralized bridges be the solution to safely using Bitcoin in DeFi?

Bitcoin, the first cryptocurrency, was introduced to the world in 2008. 14 years later, it remains the most important blockchain; the bedrock that all other blockchains are built on.  For most people, Bitcoin was and will continue to be their first exposure to blockchain technology.

Other blockchains are either too complex, cater only to traders, or are scaling toward a niche industry that not all users are interested in. On the contrary, Bitcoin has held the same mission since the day its white paper was released: this is a currency for the people.

If Bitcoin’s mission is to be accessible, why is there no secure, decentralized way to use Bitcoin on any chain? Bitcoin DeFi is booming, only it’s not really DeFi.

What Is DeFi?

At the core of DeFi lies a problem that existed long before the blockchain did: how do we ensure that the exchange of goods is always fair? This is even more difficult on the internet, where counterparties are often anonymous.

In the late 90s, computer science proved what was already state-of-the-art in trade for centuries: we need a trusted 3rd party to ensure the exchange is fair. That’s a big problem for another core value of the Bitcoin framework: decentralization.

DeFi attempts to change that by using blockchains – decentralized multi-stakeholder networks where decisions require consensus among the majority – as these “trusted” third parties.

The logic of the exchange is encoded into programs executed by all nodes and consensus participants, and if the majority of the network is honest, the fairness of the exchange will be ensured.

Today, we see this concept in decentralized exchanges, borrowing and lending, stablecoins, derivative markets, and more.

DeFi Directly on Bitcoin

While possible in theory, DeFi on Bitcoin requires three things to work. The first is a method of representing assets other than BTC, otherwise, there is nothing to trade BTC against.

Colored Coins was a method of storing metadata directly on Bitcoin’s blockchain to represent real-world assets and is often considered one of the first steps toward NFTs.

However, the major projects that used Colored Coins have instead adopted more user-friendly tools on chains like Ethereum.

Taro and RGB can bring this feature back, but as of today, these mechanisms are early stage and rather complex and difficult to use and build on.

In addition, there does not seem an easy way to have decentralized stablecoins or synthetics on the Bitcoin blockchain with currently available features, so Taro and others would have to rely on centralized exchanges like Bitfinex and Circle.

The second requirement for Bitcoin to be used in DeFi is a way to exchange assets using the Bitcoin network to enforce fairness. Hashed Timelock Contracts, or HTLC, are a type of smart contract with a timed escrow so both parties exchanging currency are protected.

HTLCs are currently being used on swaps and some of the newest constructions on the Lightning Network. However, matching traders directly on Bitcoin is not an easy task when compared to order books and automated market makers (AMMs) used on other networks.

The third requirement to bring Bitcoin to DeFi is having automated and trustless ways to react to price changes and events on other chains.

Discreet Log Contracts (DLCs) have the potential to bring exchange rates and real-world events onto Bitcoin, albeit it is not clear if the user experience will be as good as that of oracle giants like Chainlink. Verifying events happening on other chains cryptographically seems like an impossible task.

This leads to the conclusion that, while DeFi on Bitcoin is being actively developed, it will take time for it to launch at scale and mature. This is why Bitcoiners interested in DeFi usually try their luck on other chains.

Bitcoin DeFi on Other Chains

There are around 473,000 BTC currently used on other chains, worth a total of about $9 billion.

Ethereum and its L2 networks, which include Polygon, Optimism, and Arbitrum, hold the majority of off-chain Bitcoin (290k BTC), followed by Binance Smart Chain with (112k BTC) and Solana (17k BTC).

What are people doing with their BTC on DeFi? After analyzing the data on Ethereum, the answer is clear. The majority of Bitcoin used in cross-chain DeFi is being used in lending markets.

The most popular use case: borrowing USD stablecoins against BTC, which is essentially a bet on the success of Bitcoin while still being able to use a portion of the capital for other financial activities or day-to-day transactions.

Users who are more comfortable with investing experiment with automatic portfolio diversification, e.g., on pools pairing BTC with Ethereum and USDT. Professional traders explore arbitrage trading across centralized and decentralized exchanges.

However, this is not quite “true” DeFi. While the applications on Ethereum can be considered DeFi because they do not rely on any centralized middlemen, our current methods of using Bitcoin on and off other chains are not true DeFi…yet.

A vast majority of all Bitcoin on other chains is controlled by a few trusted actors and is mainly supplied by institutional market makers. In the few places where retail can participate, KYC is often required.

This defies Bitcoin’s purpose: to provide a decentralized, secure, and accessible financial system for everyone in the world.

Bitcoin on Other Chains - How Does It Work?

As of right now, Bitcoin only exists on the Bitcoin blockchain. To use it on other chains, BTC needs to be “wrapped”, meaning a 1:1 representation of BTC on another network is created, often as a native token.

But there is a catch: wrapping is risky. Because the Bitcoin blockchain cannot react to external events, the process of locking BTC while the wrapped BTC is being used and unlocking BTC when the wrapped BTC is redeemed is challenging.

Someone needs to do the locking and unlocking. The problem: people using wrapped BTC are placing trust in the person holding their native Bitcoin in a world where trustlessness is necessary for security.

Here’s how the process works: holders first deposit their BTC with an issuer on the Bitcoin blockchain. The issuer then confirms receipt to the target blockchain, minting a “wrapped BTC” token at a 1:1 rate, native to the target chain.

To redeem that token, users must return their wrapped BTC to the issuer on the target network, who in turn sends BTC to their Bitcoin wallet at a 1:1 rate.

Finally, the wrapped BTC is deleted (“burned”) by the issuer, who can be an individual, a group of people (multi-sig), or a smart contract (enforced by consensus).

For that reason, nearly all wrapped BTC relies on centralized solutions controlled by trusted intermediaries or exchanges. Holders using those solutions must give up the single most important characteristic that makes Bitcoin a valuable asset: its decentralization.

How to Build a Decentralized Bridge?

The first step in building a decentralized bridge is allowing anyone to become an operator responsible for securing the BTC while the wrapped BTC exists.

Operators need to make sure that once the wrapped BTC is traded, only the new owner should be able to use it to claim BTC, for example.

At first, this decentralized approach may seem like a bad choice since Bitcoin holders would find themselves relying on unknown actors instead of a centralized, potentially well-known entity trust.

But this concern can be addressed by a combination of incentives and punishments: operators must lock collateral in other assets on the target chain and, should they misbehave by stealing or losing the Bitcoin or sending it to the wrong person, the collateral is liquidated and used to reimburse the victims.

At the same time, operators must also ensure that the collateral is worth more than the Bitcoin locked, and must rebalance the system after liquidations – in a similar way to how stablecoins like DAI operate.

To make the system complete, there needs to be a way to verify Bitcoin transactions. This can be done by Bitcoin light clients, the same mechanism that powers mobile wallets, deployed as smart contracts on the target chain.

The resulting system is a mix of a bridge and a decentralized stablecoin.

Launching Bitcoin Into DeFi

Bitcoin’s importance is larger than ever, particularly in countries where systematic financial censorship runs rampant.

Even assets like DAI, well known for its high level of decentralization, can eventually be regulated for being largely backed by assets like wBTC and USDC, which are both centralized. This only increases the demand for an alternative to fiat currencies that people don’t trust.

However, the ability to make payments alone won’t be enough for everyone. Increased adoption demands the entrance of Bitcoin into DeFi.

Bitcoin will continue to be the gateway to crypto for most new adopters and has become an essential financial tool for people without access to censorship-resistant currency.

Why shouldn’t they be able to use their Bitcoin with DeFi integrations to earn passive income for further financial empowerment? A decentralized system that enables interoperability on Bitcoin opens up a world of possibilities to reimagine the future of blockchain, finance, and humanity.

There is a huge gap when it comes to decentralized cross-chain solutions. The ones that exist are either centralized or insecure, and we shouldn’t have to choose one or the other.

What we need now are ways to enable the trustless transfer between chains, ensuring that holders can access DeFi safely and without losing the main benefits of Bitcoin.