In the last couple of years, decentralized finance and Bitcoin have exploded into mainstream awareness. From 2020 to 2021, the DeFi market grew by a staggering 210-times, while Bitcoin saw its value rise by more than 700%. Everyone was talking about crypto, discussing the exciting new ways to invest that go beyond simply “hodling” and hoping the value will moon.
DeFi has emerged as the enabler of these new ways of investing, introducing concepts such as staking, providing liquidity, and yield farming to the world of crypto investing. Yet these innovations have largely remained separate from Bitcoin itself.
Instead, the vast majority of the world’s DeFi applications and protocols sit not on Bitcoin, but on Ethereum or other blockchains that claim to be faster. Bitcoin meanwhile has remained what it was always intended to be – a straightforward digital currency and a store of value.
Times are changing though. For all of the ups and downs it has experienced over the past year, studies show that Bitcoin is enjoying increasingly widespread adoption and growth. And with it, there is increased demand for Bitcoin to merge with the world of DeFi.
Bitcoin is, after all, the world’s most popular cryptocurrency with by far and away the largest market capitalization. Yet most of these assets are sitting idle. By bringing BTC to DeFi, the opportunities for Bitcoin holders could be transformational.
How Does Bitcoin DeFi Work?
The most common way in which Bitcoin is used within the DeFi ecosystem is through so-called “wrapped” tokens. An example is the aptly named Wrapped Bitcoin token (WBTC), which is an ERC-20 token (meaning it runs on the Ethereum blockchain) that’s backed 1:1 with real Bitcoin tokens. WBTC launched in 2019 and gives Bitcoin holders a way to participate in Ethereum-based DeFi without swapping their BTC assets for another cryptocurrency first. They simply swap their BTC for an equivalent amount of WBTC, which can be staked or deployed, or used as collateral in a range of DeFi applications.
WBTC provides easy access to DeFi for Bitcoin holders but the token hasn’t proven to be especially popular. What puts investors off with WBTC is that it relies on a centralized custodian. When purchasing WBTC, users are required to send their BTC to a company called BitGo – which immobilizes that BTC and then mints WBTC on the Ethereum blockchain. Once the user is done with staking their WBTC, they can then trade these tokens back for real BTC. The WBTC is then “burnt” and removed from circulation, and the immobilized BTC is returned to the user.
Using wrapped Bitcoin, it becomes possible to access various crypto margin lending and staking services. This means BTC holders can earn a yield on their assets without selling them. There are a number of decentralized exchanges, or DEXs, that make it possible to trade Bitcoin freely through the use of an API, including Atomex and JellySwap.
It’s a little more complex though, and not nearly as simple as depositing BTC into a centralized lending app such as Nexo or BlockFi. In order to earn a yield on BTC tokens, users must first tokenize their BTC or buy those assets on a DEX such as Uniswap (for ETH wrapped Bitcoin) or PancakeSwap (for BNB wrapped Bitcoin).
Another way to participate in DeFi with wrapped Bitcoin is through trading and lending pools on protocols such as Aave or Compound Finance. Alternatively, users can deposit wrapped Bitcoin into decentralized liquidity pools and earn mining returns on Curve Finance or Harvest Finance.
Aave also provides users with the possibility of obtaining BTC loans through its crypto lending services. It offers BTC loans at competitive rates, providing benefits such as enabling an investor to add liquidity to their bank account without worrying about tax repercussions. It’s also possible to obtain Bitcoin loans without any collateral. Flash loans for example – though such transactions are incredibly complex and require an in-depth knowledge of crypto.
Native Bitcoin DeFi
The idea of using wrapped Bitcoin and entrusting a custodian does not sit well with many Bitcoin supporters, as it goes against the whole ethos of decentralization. No one wants to place their trust in a centralized entity, and with that in mind, the emergence of stacks is highly promising as it brings smart contract capabilities to Bitcoin, enabling it to stand on its own two feet in the world of DeFi.
Bitcoin’s creator Satoshi Nakamoto intentionally wrote a limited scripting language for Bitcoin, because he or she envisaged Bitcoin as a straightforward payment mechanism only. Because of this, it’s not possible to create smart contracts that can execute on the Bitcoin blockchain.
Stacks changes this using a unique Proof of Transfer consensus mechanism that brings programmability to Bitcoin. Like Bitcoin, Stacks is an independent Layer-1 blockchain. Where it gets clever though is that it connects to Bitcoin using the PoX protocol. In order to mine STX tokens, miners must send BTC to the Bitcoin blockchain. In this way, they can record the history of multiple transactions on the Bitcoin network.
Stacks says there are good reasons to do this. Namely, by integrating with Bitcoin in this way it is able to benefit from its unbreachable security. Transactions on the Bitcoin blockchain are irreversible once they have been settled, and the network has never been hacked. Nor will it ever likely be hacked, as the financial cost of doing so is estimated to be many times more than any potential gain that could be made.
This high level of settlement assurance provides strong benefits for DeFi apps. Stacks-based DeFi apps have novel security properties that surpass those on any other blockchain. At the same time, it guarantees that all forks are public, with nodes able to identify the canonical Stacks fork and locate blocks they have not yet downloaded. Most importantly, it means Stacks has the same level of security as Bitcoin itself does. Even though Stacks is an independent blockchain, hacking it would be as difficult as taking out Bitcoin itself.
Another reason to want to integrate with Bitcoin is its network effects. Bitcoin enjoys a special status as the world’s premier cryptocurrency, and its demand and use cases are growing by the day. There are billions of dollars worth of capital locked into its network, most of which is sitting idle, serving as a store of value and little else. Stacks, rather than compete with Bitcoin like every other blockchain is attempting to do, is trying to build new use cases for BTC holders, enabling them to lend BTC, obtain loans in BTC, buy and sell NFTs, and more besides.
Already, there is a range of exciting new DeFi applications on Stacks that use native BTC. For instance, STX holders can “stack” their tokens (similar to staking) and receive rewards in BTC (this comes from the BTC that miners must pay to mine STX). There are also dozens of other types of apps, such as DEXs that use native BTC, wallets, digital identity apps, city coins, NFT marketplaces, social media services, survey apps, and more.
But Why Does Bitcoin Need DeFi?
The Bitcoin community has been a lot slower to embrace DeFi than most others in the crypto industry, and it has good reason to be wary. The DeFi movement has seen multiple cases of fraud and its history is littered with false promises, and there are a lot of critics who say the entire industry is based on speculation alone.
There may be some truth to those arguments but that doesn’t mean DeFi will always be this way. On the contrary, if Bitcoin can become more relevant to the DeFi space, it could well bring much greater legitimacy and would surely result in additional and much-needed liquidity.
That’s good for DeFi, but what about Bitcoin? How does it benefit? The answer is it stands to gain much wider adoption through DeFi.
In a recent op-ed, ALEX co-founder and Chief Executive Dr. Chiente Hsu argues that if Bitcoin is ever going to achieve mass adoption, it must evolve beyond its current role as a store of value and a vehicle for transactions.
“As Bitcoin DeFi grows, it will allow sovereign collectives to determine their own bitcoin yield curve, increase the capital efficiency of bitcoin as an asset, and accelerate mass adoption and the development of the bitcoin economy,” Hsu writes.
The thrust of the argument for Bitcoin DeFi is that the modern world is not built on money, but rather, on finance. The world’s debt far exceeds the amount of money that’s actually in circulation due to the way our banking systems and economies work. Finance is what powers everything from banking to marketplaces, financial instruments, credit, and leverage. For example, while there is estimated to be around $1.5 trillion of physical USD in circulation, the US national debt stands at over $30 trillion (and counting).
Hsu explains that this is the case because it’s not money, but rather time, that is the most valuable resource on the planet. Debt, or more specifically yields and interest rates, are a medium of exchange for the time value of money. The way the system works is that there are millions of people who need money today, and they’re willing to pay a premium for that cash. At the same time, those with lots of resources only need money in the future, so they’re willing to risk lending it out for a premium.
Bitcoiners love to talk about how Bitcoin lets people become their own bank. This is because anyone who holds Bitcoin is responsible for the safekeeping of their own assets. However, if people are really to become their own banks they need to do more than just act as a money vault. Banks borrow funds from depositors at low-interest rates, then use those funds to invest at higher rates, profiting from the difference. So, if Bitcoiners are to be their own banks, they should not only be responsible for the safety of their money, but also for its productivity.
If Bitcoin is to become a productive asset, it needs DeFi as a vehicle to enable that productivity.
A Marriage Made In Crypto Heaven
Should the Bitcoin community decide to adopt DeFi en masse, it will almost certainly lead to higher total value locked, both in Bitcoin and the wider DeFi ecosystem. As Bitcoin gains more liquidity, this will generate greater interest and speed up its adoption, leading to further use cases that accelerate its evolution as a mainstream asset.
Bitcoiners might be wary of DeFi, but Bitcoiners also want Bitcoin to succeed. And it stands to reason that making Bitcoin more useful will increase its chances of success.
Marrying Bitcoin with DeFi will enhance its prospects by making it easier to swap tokens, creating more options for staking to generate interest and yield. In this way, Bitcoin can become a more useful, versatile, and profitable asset. At present, doing these things with Bitcoin in its native form is very difficult, if not impossible. DeFi promises to change this dynamic, making it simple for any Bitcoin holder to put their funds to work.
What’s needed now is greater awareness of the possibilities that DeFi and Bitcoin can bring if they work in tandem. As more people come to realize how they can use DeFi to leverage their Bitcoin holdings, the space will attract growing amounts of liquidity. That will help Bitcoin’s value to appreciate, attract more users, and create a virtuous circle that will lead to hitherto unprecedented levels of adoption and value.