Decentralized Finance in Bitcoin

Possible technological approaches to use Bitcoin for DeFi

Now let’s look into how DeFi products can be used with Bitcoin and list a few use cases and projects in that area. The possible use cases include decentralized exchanges (DEXs), decentralized lending, decentralized stablecoins, and decentralized derivatives. The technological approaches to implement Bitcoin DeFi include

Using Bitcoin current capabilities such as Hash Time Locked Contracts (HTLCs) to facilitate direct cross-chain atomic swaps to build decentralized exchanges with other cryptocurrencies. Federated sidechains to Bitcoin such as Blockstream’s Liquid. These sidechains use two-way pegs to the Bitcoin blockchain and allow the use of pegged BTC in various financial activities. Using Bitcoin within other protocols such as Ethereum or Cosmos to interact with DeFi products. Using layers on top of Bitcoin like OmniLayer or Lightning Network.

These technologies differ in capabilities and the range of DeFi applications they can support. In addition, most of these technologies are work in progress. In the following, we explore these technologies and the use cases they target.

Cross-chain Swaps For Decentralized Exchanges

The simple premise of DEXs is to execute trades between Bitcoin and fiat or between Bitcoin and other cryptocurrencies while keeping custody of your coins until the trade is completed. In other words, trading without the need to deposit your valuable bitcoins into a centralized exchange wallet and be subjected to the exchange security risks.

While such trades can be performed using platforms like LocalBitcoins or OpenBazaar, these platforms are only suitable for once-in-a-while slow trading and are not suitable for fast or frequent trading that allows efficient price discovery. For the latter, a centralized order book along with the ability to quickly settle trades is needed. Practically speaking, building a truly decentralized exchange is one of the hardest challenges in DeFi. As long as you have centralized servers keeping or even displaying the order book, you still have centralized components. However, our focus here is mainly around keeping custody of coins until trades are settled. In this domain, we believe a small number of companies are developing the technology needed to achieve that. The ones that we feel at the leading the pack are Arwen and Summa.

Arwen uses the concepts of trustless on-chain escrows and cross-chain atomic swaps to allow non-custodial access to centralized exchanges order books. In that sense, it is possible to trade efficiently on a centralized order book while maintaining custody of the asset 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 implementing cross-chain atomic swaps between Bitcoins and Ethereum and ERC-20 tokens. Arwen can currently be used (in beta) on Kucoin exchange.

Summa has invented the Stateless SPV technology to allow for trustless financial services for Bitcoin and other blockchains. Stateless SPV allows for validating Bitcoin transactions using an Ethereum smart contract making it possible to perform a wide range of financial transactions using Bitcoin. Using that technology, Summa’s team performed an auction using bitcoin bidding for Ethereum-issued tokens. The team is working on generalized cross-chain exchanges between Bitcoin and Ethereum and ERC-20 tokens.

Bitcoin DeFi Using Federated Sidechains

Bitcoin sidechain is a concept that was proposed by Blockstream in 2014 to introduce new features to Bitcoin without changing the protocol base layer. Since then the concept has developed significantly. The simple idea of sidechains is to create a separate chain with a small number of validators (called a federation) and use a token in that chain that is a pegged to BTC through a two-way peg. The benefits can include faster transaction confirmation or implementing features that may be controversial such as confidential transaction, tokenization of other assets or smart contracts. The main drawback of sidechains is the need to trust a small federation to operate the sidechain and keep it running. There is also a risk of losing money by using sidechains if, for any reason, sidechain validators decided to abandon the chain. In those situations, pegged assets would get stuck and cannot be redeemed back to BTC.

A notable sidechain working to bring smart contract functionality to Bitcoin is RSK. It supports Solidity smart contracts making it easy to migrate Ethereum DeFi protocols to RSK. In addition to RSK, Blockstream has commercially launched its Liquid sidechain product in 2018. However, Blockstream’s initial focus is around the tokenization of assets and faster transaction but the concept could be expanded later to support DeFi applications.

Decentralized Derivatives Using Bitcoin Layers

A third approach to implement Bitcoin DeFi products is to utilize intermediate layers built on top of Bitcoin such as Lightning Network or OnmiLayer. As LN is a relatively new Bitcoin development, building complex DeFi products using LN is a topic of research. The most notable effort there is Discreet Log Contracts which are discussed in some detail at the end of this article.

The other option is using OmniLayer. One of the interesting projects in this regard is Tradelayer, which is trying to implement decentralized derivative markets on Bitcoin. The project aims to extend the OmniLayer protocol with multisig channels to allow for using Bitcoin, or other tokens issued on Bitcoin, as collateral for peer-to-peer derivative trades. A possible scenario is to have traders pledging capital to multisig addresses and co-sign transactions and trade updates to settle the derivative trade. In this sense, users can take leverage natively and get fast-execution by co-signing trade transactions. Using the same methodology, another possible use case could be the issuance of stable coins using Bitcoin as collateral the same way Ether is used to collateralize DAI issuance on MakerDao.

Bitcoin DeFi With External Help

Wrapped BTC on Ethereum

A completely different approach to allow using Bitcoin in DeFi is to leverage other networks like Ethereum or Cosmos. As most DeFi projects now work on Ethereum, it seemed logical to try to find ways to use BTC on Ethereum. The simplest idea is to issue a BTC-backed ERC20 token (WBTC) that can be traded on any Ethereum DEX or used in various Ethereum DeFi projects. The BTC used to mint WBTC are secured in mutisig wallets maintained by the project custody providers. As of early July 2019, only ~540 WBTC were minted is a tiny fraction of the BTC circulating supply.

Growth of the Wrapped BTC (WBTC) supply over time

While WBTC may facilitate using BTC in DeFi, it suffers a few important drawbacks. The first and most important is counterparty risk. The BTC used to collateralize WBTC is maintained by centralized parties that might be hacked. Secondly, introducing intermediate entities to custody the assets (BTC) to some extent kills the point of the DeFi movement. Finally, to use BTC/WBTC in DeFi, users have to pay fees in ETH, which is something many Bitcoin fans are not willing to do.

Cosmos Zones

Interoperability blockchain projects, such as Cosmos, opened new opportunities to bring DeFi to assets like Bitcoin. For example, Cosmos protocol defines Peg Zones where assets (issued on Cosmos) can be pegged to other blockchain assets like Bitcoin. In these zones, it is possible to add smart contract functionality to the pegged asset and benefit from faster finality. This approach has garnered the support of some hardcore Bitcoin supporters like Eric Meltzer for one specific reason: in this approach, Bitcoin will remain the native currency to pay fees and use the peg zone. Bitcoiners can stake their pegged bitcoins in the zone to process the zone transactions and claim the zone fees. In that sense, Bitcoin will benefit from the new tech without depending on a different asset. This comes in stark contrast to WBTC, which requires using ETH to pay for fees or interact with DeFi protocols.

It is worth mentioning that using Cosmos zones for Bitcoin DeFi is still work under development and there is a number of stealth projects that are building it. It is not clear yet how the two-way peg between Bitcoin and Cosmos would work. The implementation of the Cosmos Inter-Blockchain Communication (IBC) is not yet finalized. If the two-way peg requires custodial services, like WBTC, or a few validators to execute the peg, like federated sidechains, the Bitcoin zone on Cosmos will not offer much differentiation to other solutions.

In addition to the projects that are building such systems for Bitcoin, we are seeing a lot of interest in using Cosmos for bringing DeFi to other assets such as Kava Labs. If these efforts deemed successful, barriers for Bitcoin use in DeFi would significantly diminish. Success in this regard is to be able to attract sufficient liquidity to the peg zone and to maintain a reasonable level of decentralization by attracting a large enough number of validators.