Decentralized finance (DeFi) has been a hot topic for many crypto investors and enthusiasts.DeFi hopes to realize the vision that several important financial services are cheaper and more efficient when the role of intermediaries is reduced or completely eliminated。

In theory, it also makes online financial services more inclusive because it transcends artificial barriers such as geographic borders or jurisdictions.

DeFi products and protocols do this by allowing the rules (and outcomes) of financial interactions to be coded into permissionless blockchains.image description

DeFi Momentum Is Growing Rapidly

Still, Bitcoin remains the most liquid, best-known, and most decentralized cryptocurrency in the world (over 60% market cap at time of writing). This clearly makes Bitcoin a strong opponent for decentralized financial products. However, this is only an obvious advantage, does not mean that it is easy to achieve.

Bitcoin believers want to preserve the reliability and hardness of Bitcoin at all costs, and are unwilling to fundamentally change its monetary policy for any reason. Despite the existence of sidechain solutions like RSK, it is impossible for smart contract functionality to be added to the Bitcoin protocol to enable DeFi products.

However, this does not mean that Bitcoin DeFi will never be realized.

Many individuals and teams are working hard to use its current design to apply Bitcoin to financial products ranging from centralized to almost completely decentralized.

This article will discuss how Bitcoin DeFi is possible. Explain the different technical approaches and combine the different use cases they address.

1. First of all, what does DeFi mean?

Decentralized finance, or DeFi, is an umbrella term for all financial services that can be performed without a central authority, or where the mechanisms for controlling financial products are distributed among different entities.

DeFi products include decentralized loans, decentralized exchanges, decentralized derivatives or decentralized stable currency issuance.

Many people think that decentralized payment itself is a DeFi product. I happen to agree with this argument. In this regard, BTC is the most used cryptocurrency for payments.

Services like BTCPay Server even allow merchants to receive Bitcoin directly without third-party payments. Therefore, this article mainly discusses how Bitcoin can expand its Defi footprint beyond decentralized payments.

2. Overview of Bitcoin Centralized Financial Products

Before diving into the path of Bitcoin DeFi, let’s start with some of the “centralized” financial services currently using Bitcoin. Once DeFi can be effectively executed on Bitcoin, these services will become the main target of decentralization.

bitcoin loan

One of the most popular financial services created on Bitcoin is loans. We can divide companies in this area into two parts. The first are companies that allow investors to borrow bitcoin and other cryptocurrencies to trade or make markets; the most famous of these is Genesis Capital.

Genesis Capital reportedly processed $1.1 billion in cryptocurrency loans in 2018, with around 75% of those loans denominated in BTC.

The other part is companies that provide BTC collateral loans, such as BlockFi and Unchained Capital. To protect against volatility in collateral values, these firms only issue over-collateralized loans with loan-to-value (LVT) ratios between 20% and 50%.

margin loan

A margin loan is a special case of a mortgage loan used for leveraged trading. In this case, the borrowed funds are not allowed to leave the lending platform. Conversely, if the trade loses at or below the value of the collateral, the margin is liquidated to return the funds to the lender.

stable currency

stable currency

Stablecoins that can be easily transferred with low fees are of particular interest to traders looking to profit from volatility but maintain a stable value when trading is inactive. Tether (USDT) was one of the first stablecoins to address this issue.

It is built entirely on Bitcoin using the OmniLayer protocol. OmniLayer allows the creation and transfer of assets using Bitcoin transaction opcodes.

USDT was created as a stable currency to anchor with the U.S. dollar. It is hoped that USDT tokens will be issued when the corresponding U.S. dollars are deposited into Tether, and USDT tokens will be destroyed when USDT tokens are converted back to U.S. dollars.

Although Tether can be traded in a decentralized manner, it is centralized in the most important respects: reserve and control. Tether Corporation holds and controls USD reserves corresponding to issued USDT tokens in its bank accounts, which often place it in legal custody.

More recently, Tether has started to reduce its dependence on the Bitcoin network by issuing USDT on blockchains like Ethereum and EOS, which reduces transaction activity in the Bitcoin blockchain.

3. Decentralized Finance of Bitcoin

Possible ways Bitcoin can be used for DeFi

Now let’s take a look at how DeFi products can be used in conjunction with Bitcoin, and some use cases and projects in this regard. Possible use cases include decentralized exchanges (DEXs), decentralized lending, decentralized stablecoins, and decentralized derivatives.

The technical methods to realize Bitcoin DeFi include:

1. Using Bitcoin's current features, such as hashed time-locked contracts (HTLC), to advance direct cross-chain atomic swap implementations, decentralized exchanges for other cryptocurrencies can be used.

2. Alliance side chain technology, such as Blockstream's Liquid. These sidechains use a two-way peg to the Bitcoin blockchain and can use the pegged BTC in various financial activities.

3. Use Bitcoin in other protocols such as Ethereum or Cosmos to interact with DeFi products.

4. Use a protocol layer like OmniLayer or Lightning Network on top of Bitcoin.

These technologies vary in the functions they provide and the range of DeFi applications they can support. Also, most of these technologies are work in progress. Let’s explore these technologies and their corresponding use cases below.

4. Cross-chain swap of decentralized exchanges

The simple premise of a DEX is to execute transactions between Bitcoin and fiat currencies, or between Bitcoin and other cryptocurrencies, while holding your tokens until the transaction is completed. In other words, the transaction does not require depositing your valuable bitcoins in a centralized exchange wallet, nor is it subject to the exchange's security risks.

While such trades can be executed using platforms such as LocalBitcoins or OpenBazaar, these platforms are only suitable for one-off, slow trades, not fast or frequent trades that enable price discovery.

For the latter, centralized order books and the ability to quickly settle trades are required. In fact, building a truly decentralized exchange is one of the hardest challenges facing DeFi.

As long as you use a centralized server to hold orders, then you are not decentralized. However, our focus here is primarily on holding tokens until the transaction is settled.

In this regard, we believe that a handful of companies are developing the technologies needed to make this happen. The ones we feel have the lead are Arwen and Summa.

Arwen uses the concepts of trustless on-chain custody and cross-chain atomic swaps to realize uncustodial processing of centralized exchange orders. In this sense, it is possible to efficiently process centralized order books while maintaining custody of assets until the trade is executed.

Currently, the product only supports cryptocurrencies that use the same codebase as bitcoin, such as litecoin and bitcoin cash. They are working on enabling cross-chain atomic swaps between Bitcoin and Ethereum, as well as ERC-20 tokens. Arwen is currently available on the Kucoin exchange.

Summa invented stateless SPV technology to enable trustless financial services for Bitcoin and other blockchains. Stateless SPV allows for the use of Ethereum smart contracts to verify Bitcoin transactions, potentially executing a wider range of financial transactions using Bitcoin.

Using the technique, Summa's team held an auction, using bitcoin to bid for tokens issued by ethereum. The team is busy developing cross-chain swaps between Bitcoin and Ethereum as well as ERC-20 tokens.

5. Bitcoin DeFi using the alliance side chain

Bitcoin sidechain is a concept proposed by Blockstream in 2014, which introduces new functions to Bitcoin without changing the basic layer of the protocol. Since then, the concept has been greatly developed.

The simple concept of a sidechain is to create a separate chain with a small number of validators (called a federation) and use a token in that chain that is pegged to BTC via a two-way peg.

The benefits of this include faster transaction confirmation or enabling some potentially controversial features like confidential transactions, tokenization of other assets or smart contracts. The main disadvantage of sidechains is the need to trust a small coalition of validators to operate the sidechain and keep it running.

There is also a risk of losing money using a sidechain if for some reason the sidechain validators decide to abandon the sidechain. In such a case, the anchor asset will be in trouble and cannot be exchanged back to BTC.

RSK is a well-known sidechain that aims to provide smart contract functionality to Bitcoin. It supports Solidity smart contracts, making it easy to migrate Ethereum DeFi protocols to RSK. In addition to RSK, Blockstream launched their Liquid sidechain product at 2018 Business Applications.

However, Blockstream's initial focus is around the tokenization of assets and faster transactions, but the concept may later be expanded to support DeFi applications.

6. Decentralized derivatives using the Bitcoin layer

The third way to implement Bitcoin DeFi products is to utilize an intermediate layer built on top of Bitcoin, such as the Lightning Network or OnmiLayer.

Since the Lightning Network is relatively new to Bitcoin development, developing complex DeFi products using the Lightning Network is now a research topic. The most worth mentioning in this regard is the Discreet Log Contracts that will be discussed in detail later.

Another option is to use OmniLayer. One of the more intriguing projects in this regard is Tradelayer, which attempts to implement a decentralized derivatives market on Bitcoin.

The purpose of this project is to extend the OmniLayer protocol through multi-signature channels to use Bitcoin or other tokens issued on Bitcoin as collateral for peer-to-peer derivative transactions.

A possible scenario is to allow traders to pledge funds to multi-signature addresses, and jointly sign transactions and transaction updates to settle derivative transactions.

In this sense, users can use leverage locally and get fast execution by signing transactions together. Using the same approach, another possible use case might be to use bitcoin as collateral to issue stablecoins, just as ether is used to issue DAI on MakerDao.

7. Bitcoin DeFi with the help of external forces

WBTC on Ethereum

A completely different approach to using Bitcoin in DeFi is to leverage a network like Ethereum or Cosmos. Since most DeFi projects are now running on Ethereum, it seems logical to try to find a way to use BTC on Ethereum.

The simplest idea is to issue a BTC-backed ERC20 token (WBTC), which can be traded on any Ethereum DEX or used in various Ethereum DeFi projects.

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WBTC supply keeps increasing

While WBTC may drive the use of BTC in DeFi, this has some significant downsides. The first and most important is counterparty risk. The BTC used to mortgage WBTC is maintained by a centralized institution or organization that may be hacked.

Second, the introduction of an intermediary to keep assets (BTC) to some extent eliminates the outstanding advantages of DeFi. Finally, to use BTC/WBTC in DeFi, users have to pay fees in ETH, something that many Bitcoin enthusiasts are reluctant to do.

Cosmos Zones

Cross-chain projects, such as Cosmos, have opened up new opportunities for assets like Bitcoin to appear in the DeFi arena. For example, the Cosmos protocol defines Peg Zones, where assets (issued on Cosmos) can be pegged to other blockchain assets like Bitcoin.

In these areas, it will be possible to add smart contract functionality to anchored assets and benefit from faster certainty (referring to the irreversibility of transactions).

This approach has been embraced by some hard-core bitcoin supporters like Eric Meltzer for a reason: In this approach, bitcoin still retains its role as the native currency for paying fees and using the peg zone.

People who hold bitcoins can mortgage their anchored bitcoins in this area to process transactions in the area and claim the area's handling fees.

At this level, Bitcoin will benefit from this new technology without relying on a different asset. This is in stark contrast to WBTC, which requires the use of ETH to pay fees or interact with DeFi protocols.

It is worth mentioning that using the Cosmos zone to implement Bitcoin's DeFi is still under development. It is unclear how the two-way peg between Bitcoin and Cosmos will work. Cosmos’ implementation of Interchain Communication (IBC) has not yet been finalized.

If a two-way peg requires an escrow service, like WBTC, or some validator to enforce the peg, like a federated sidechain, then a Bitcoin zone on Cosmos is no different than any other solution.

In addition to projects building such systems for Bitcoin, we are seeing a surge in interest in using Cosmos to bring DeFi to other assets, such as Kava Labs. If these practices are deemed successful, the barriers to using Bitcoin in DeFi will be significantly lowered.

Success in this is being able to attract enough liquidity to the peg zone and maintain a reasonable level of decentralization by attracting enough validators.

8. Research on expanding the capabilities of Bitcoin DeFi

Merkle-style Abstract Syntax Tree (MAST)

Bitcoin in its current form has limited capabilities for implementing smart contracts through scripting languages. Script is not a Turing-complete language, which means it cannot be used to describe generalized programs. However, it can still be used to implement some smart contract functions.

This is done with Pay to Script Hash (P2SH) and SegWit addresses, where transactions (transactions) cannot be processed unless certain conditions (defined by script programs) are met. The problem with this approach is that complex transactions with multiple conditions are too large, making them expensive to use.

For these reasons, there has been a proposal to implement a Merkle-style Abstract Syntax Tree (MAST) in Bitcoin. MAST is just an extension of the functionality of P2SH, which will make it cheap and feasible to process Bitcoin transactions with complex conditions.

While the obvious benefit of MAST is improving Bitcoin’s scalability by saving block space, a less obvious benefit is that it enables some Bitcoin DeFi use cases.

For example, if we assume that a decentralized price source oracle can be realized, then MAST can realize decentralized lending using BTC as collateral or decentralized stablecoin issuance.

The diagram below shows a possible decision tree for a decentralized lending scenario using MAST. Various conditions of loan settlement can be coded as redemption and hashed into the MAST address.

The MAST address can guarantee the fair execution of the loan and guarantee that the lender will get the loan collateral if the borrower does not repay the loan on time or the value of the collateral is lower than the loan value plus interest.

Another research idea to expand the functionality of Bitcoin DeFi is Discreet Log Contracts (DLCs) proposed by Tadge Dryja of the MIT Digital Currency Initiative (DCI).

A simple explanation of DLC is that it is a way for two parties to create a futures contract, which is simply a bet on the future price of an asset.

DLC requires both parties to choose an oracle (or oracles) that publicly broadcasts the price of an asset before creating a contract. When the contract is liquidated, either party can use the public and signed message from the oracle machine to liquidate the contract and obtain profits.

DLC uses Schnorr signatures to hide the contract details of the oracle. This guarantees that the oracle cannot change the output of the contract. Since the DLC uses similar technology to the Lightning Network, it is still possible to integrate the DLC with the Lightning Network.

9. Conclusion

Since early 2018, DeFi protocols have been attracting a lot of attention. Although Ethereum is considered an advantageous protocol in the development of DeFi, developers and investors have been paying attention to the huge potential of Bitcoin, the most liquid cryptocurrency, in DeFi.

This overwhelming interest has led many development teams to look for the best way to achieve this goal. While this will create more competition between Bitcoin and Ethereum and possibly all new smart contract platforms, this competition is what is needed to drive development and realize the vision of an open decentralized financial system.

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Disclaimer: This article is the author's independent opinion, and does not represent the position of the Blockchain Institute (public account), nor does it constitute any investment opinion or suggestion.

Disclaimer: This article is the author's independent opinion, and does not represent the position of the Blockchain Institute (public account), nor does it constitute any investment opinion or suggestion.