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DeFi on Bitcoin

Crypto

Over the past few years, DeFi has transformed from a niche concept to one of the most innovative sectors in modern finance. While Ethereum has been typically the platform of choice for the majority of DeFi protocols, there is now an emerging trend to bring DeFi onto Bitcoin. Once considered impractical, there are now several active developments that may potentially shift Bitcoin’s store of value appeal to a multi-purpose and yield-bearing asset.

  • DeFi on Bitcoin is becoming a fast-growing ecosystem, integrating features like smart contracts, Layer 2 scalability solutions and shared-security
  • DeFi can potentially mobilise long-term Bitcoin holders in return for yield-bearing opportunities
  • DeFi on Bitcoin can improve its interoperability with other protocols that were otherwise limited or inaccessible to users

It’s been nearly four years since the DeFi summer of 2020, a period that saw the rise of market leaders like Uniswap, Maker and Aave, along with hundreds of alternative financial models that helped the DeFi sector grow into a multi-billion-dollar industry.

But few would’ve thought that DeFi, an ecosystem so heavily dependent on Ethereum’s infrastructure, would see similar advancements being brought to Bitcoin. In our previous note, we explored how innovations like the Ordinals protocol, the BRC-20 token standard and upgrades like Taproot and OP_CAT are now bringing smart contract-like features and asset issuance to Bitcoin’s ecosystem. For this piece, we want to explore how some of these developments can potentially benefit its tokenholders.

Can DeFi on Bitcoin mobilise idle assets?

Bitcoin’s strong reputation as a store of value and macro hedge is not without good reason. Over the years, its performance and resilience has earned the trust of many crypto companies and investors, a trust that is now extending to traditional finance (TradFi) institutions as well. However, the majority of Bitcoin holders, also known as HODLers, are essentially investors betting on Bitcoin’s long-term future value.

The HODLer’s goal is simple: buy Bitcoin, store it safely and accumulate long-term wealth through capital gains. This mindset is the reason why a lot of Bitcoin lies idle in wallets (cold storage) and exchanges, and rarely ventures outside of its own network. The idleness, however, also has to do with Bitcoin’s inherent design. While the network does support its role as a decentralised form of money, an investment vehicle and even a reserve asset, its very infrastructure has, for the most part, limited its utility to these functions alone – until now.

This is where DeFi on Bitcoin gets a little more interesting. Imagine transforming Bitcoin from a passive store of value into an active, yield-bearing asset. The HODLer could put his or her Bitcoin to work by participating in various DeFi-related activities and earn a yield in return.

For instance, one method is wrapping Bitcoin into tokens like wBTC, which represents Bitcoin on Ethereum and can be used in various Ethereum-based DeFi protocols. Another method involves Bitcoin holders locking their assets into Bitcoin-native protocols and using these deposits as collateral. In return, tokenholders receive a yield-bearing token or derivative, which can then be used to earn yield through various DeFi use cases.

DeFi protocols improving Bitcoin’s utility

Today, there are over 30 plus protocols working on Bitcoin’s DeFi ecosystem, offering use cases from lending and borrowing to liquid staking, shared security, decentralised exchanges and scalability solutions. Here’s a few projects to consider, some of which are quickly gathering assets:

  • BabylonChain:  A Bitcoin staking protocol that allows Bitcoin holders to natively stake their Bitcoin to validate proof-of-stake (PoS) blockchains and earn yields as a return. It provides the same slashable economic security guarantees as Ethereum’s EigenLayer.
  • pSTAKE Finance: A new Bitcoin yield and liquid staking protocol built on top of the BabylonChain. It operates as a security-sharing protocol where users can deposit their Bitcoin to lend economic security to other PoS blockchains.
  • Photon Labs: A Layer 2 solution that provides users with a liquid yield-bearing token PBTC backed by Bitcoin and its derivatives. Holders deposit their Bitcoin into the Photon protocol and receive the PBTC, which can then be used for various DeFi use cases like staking and market-neutral trading.
  • BounceBit: A Bitcoin restaking protocol that adopts a CeDeFi approach where the Bitcoin is stored with a regulated CeFi custodian. Bitcoin holders can mint a wrapped version of Bitcoin (wBTC) on the BounceBit chain and delegate it to node operators. In return, they receive a liquid staking derivative that can be restaked to other shared security protocols.
  • Stacks: A Layer 2 Bitcoin solution that incentivises Bitcoin miners by rewarding them with STX tokens. A miner’s chance of being selected to validate a block on Stacks is relative to the amount of Bitcoin they have committed to the network. On the other side, STX token holders (aka Stackers) can earn Bitcoin rewards by locking their tokens in the Stacks protocol.
  • Bifrost BTCFi: A decentralised CDP that uses only Bitcoin as collateral. Users can borrow, lend, and generate yield from their assets while maintaining their Bitcoin holdings. When users deposit their Bitcoin, the protocol mints the yield-bearing stablecoin BtcUSD, which can then be used for various DeFi activities.
  • Solv Protocol: A decentralised asset management protocol that recently launched its first yield-bearing token SolvBTC. It leverages an Ethereum token standard to bridge Bitcoin’s liquidity to various DeFi protocols and offers liquid staking tokens to Bitcoin holders in exchange for providing the liquidity.
  • Merlin Chain A Layer 2 protocol that allows investors to stake wrapped Bitcoin (M-BTC) to earn rewards while participating in activities like lending, borrowing and liquidity provision.

Source: DeFiLlama, Bitcoin liquid staking solutions

Bitcoin as a valuable infrastructure for DeFi

Bitcoin’s trust and strong security makes it an ideal choice for DeFi. Its network has never been hacked, and the sheer cost and complexity to even overthrow or execute a 51 percent attack makes such an attempt highly unlikely. This is why Bitcoin-based solutions like Stacks (through Proof-of-Transfer) and Rootstock (through merged mining) leverage Bitcoin’s security without needing to build their own separate mechanisms – and they can also extend this benefit to solutions built on top of Stacks and Rootstock.

This is also why staking protocols like the BabylonChain protocol are capitalising on Bitcoin’s security. By using Bitcoin as collateral, these protocols extend Bitcoin’s security guarantees to other Layer 2 solutions. Just like Ethereum’s EigenLayer protocol, this involves a slashing mechanism that penalises malicious behaviour, and Bitcoin tokenholders who commit their assets as staking collateral can earn the additional yield by accepting these conditions.

So, why is sharing security important exactly? With the exception of Ethereum, the majority of PoS blockchains struggle to attract substantial capital for staking. Their consensus mechanism relies on the value of the staked assets, so a lower amount of assets will naturally cast doubt on their security and leave them vulnerable to hacks and exploits. Now that Bitcoin’s security can be leveraged through a few innovative staking protocols, it would seem logical for these struggling chains to consider Bitcoin as a viable option.

However, increased staking could introduce new risks like centralisation and protocol vulnerabilities to those who are used to the safety of cold storage and HODLing. The big question is whether the potential additional yield is really worth the added risk of using these intermediaries. Right now, we are still in the early stages, so it is important to monitor how the security and trust around these protocols develop.

Plenty of room for growth

That being said, compared to Ethereum’s 1000 plus DeFi protocols, Binance Smart Chain’s 700 plus and Arbitrum’s 600 plus projects, Bitcoin’s DeFi ecosystem is still relatively small with around 30 active projects. While it may be substantially smaller than the rest, the increasing developer activity and many upcoming launches suggest there is plenty of room for growth.

As for the Bitcoin HODLer, it might take time to trust an early-stage ecosystem that promises new yield-bearing opportunities. But there are certainly compelling signs that make Bitcoin’s growing DeFi ecosystem difficult to ignore, so we will be monitoring these developments closely.

ENDS

Disclaimer: The information in this publication pertaining to Sygnum Bank AG (“Sygnum”) is for general information purposes only, as per date of publication, and should not be considered exhaustive. This publication does not consider the financial situation of any natural or legal person, nor does it provide any tax, legal or investment advice. This publication does not constitute any advice or recommendation, an offer or invitation by or on behalf of Sygnum to purchase or sell any assets. No elements of precontractual or contractual relationship are intended. While the information is believed to be from accurate and reliable sources, Sygnum makes no representation or warranties, expressed or implied, as to the accuracy of the information. Sygnum expressly disclaims any and all liability that may be based on such information, omissions, or errors thereof. Any statements contained in this publication attributed to a third party represent Sygnum‘s interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. Sygnum reserves the right to amend or replace the information, in part or entirely, at any time, and without any obligation to notify the recipient of such amendment / replacement or to provide the recipient with access to the information. Simultaneously, there is no obligation of Sygnum to inform recipients of information, if before provided information later becomes outdated, inaccurate or obsolete, unless otherwise provided by applicable law. The information provided is not intended for use by or distributed to any individual or legal entity in any jurisdiction or country where such distribution, publication or use would be contrary to the law or regulatory provisions or in which Sygnum does not hold the necessary registration, approval authorisation or license. Except as otherwise provided by Sygnum, it is not allowed to modify, copy, distribute or reproduce, display, license, or otherwise use any content for commercial purposes.

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The information in this publication pertaining to Sygnum Bank AG (“Sygnum”) is for general information purposes only, as per date of publication, and should not be considered exhaustive. This publication does not consider the financial situation of any natural or legal person, nor does it provide any tax, legal or investment advice. This publication does not constitute any advice or recommendation, an offer or invitation by or on behalf of Sygnum to purchase or sell any assets. No elements of precontractual or contractual relationship are intended. While the information is believed to be from accurate and reliable sources, Sygnum makes no representation or warranties, expressed or implied, as to the accuracy of the information. Sygnum expressly disclaims any and all liability that may be based on such information, omissions, or errors thereof. Any statements contained in this publication attributed to a third party represent Sygnum‘s interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. Sygnum reserves the right to amend or replace the information, in part or entirely, at any time, and without any obligation to notify the recipient of such amendment / replacement or to provide the recipient with access to the information. Simultaneously, there is no obligation of Sygnum to inform recipients of information, if before provided information later becomes outdated, inaccurate or obsolete, unless otherwise provided by applicable law. The information provided is not intended for use by or distributed to any individual or legal entity in any jurisdiction or country where such distribution, publication or use would be contrary to the law or regulatory provisions or in which Sygnum does not hold the necessary registration, approval authorization or license. Except as otherwise provided by Sygnum, it is not allowed to modify, copy, distribute or reproduce, display, license, or otherwise use any content for commercial purposes.

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