Author: YBB Capital Researcher Ac-Core
TL;DR
The broader context of BTCFi is: 1. The narratives of Ethereum and Ethereum-killer chains are gradually weakening, and infrastructure construction has reached saturation, with the industry overall lacking fresh narratives, leaving only hollow terms; 2. Compared to other public chains, BTC has not formed a comprehensive resource monopoly;
The main scaling solutions for BTC include state channels, sidechains and Rollups, UTXO + client validation, large blocks, and other asset protocols. However, all scaling solutions must face the technical challenges of meeting 'orthodoxy' verification;
The prerequisites for the development of BTCFi are: cross-chain interoperability, solving Layer 2 scaling solutions, smart contract functionality, and infrastructure and development tools that do not require one-click repetitive construction;
The main challenges facing BTCFi are: the limitations of the Bitcoin protocol and liquidity issues, the security and trust issues of cross-chain bridges, the difficulty of oracles in accurately capturing prices, and finding a development path unique to BTCFi.
1. BTCFi
1.1 What is BTCFi
The Bitcoin chain was once the least active public chain, with a market value reaching trillions of dollars but long in a 'sleeping' state. Fi stands for Finance, thus the purpose of BTCFi is to establish a decentralized financial market belonging to Bitcoin in this trillion-dollar market, allowing BTC holders to directly use Bitcoin-related staking, lending, market-making, and other financial derivative tools to generate yield, thus bringing DeFi into the native Bitcoin ecology to activate more financial value.
1.2 Background
2023 is an important year for Bitcoin ecology to officially reach its peak, with various tokens represented by BRC20 triggering significant wealth effects, igniting the FOMO sentiment in the market. Looking at the current industry situation, aside from the inscriptions that are a broken cart, another reason why the Bitcoin ecology can rise is that the narrative capabilities of Ethereum and Ethereum-killer chains are gradually weakening, and infrastructure construction has become saturated, leaving the industry overall lacking fresh narratives, only having hollow terms. The Bitcoin ecology also perfectly replicates the development path of Ethereum, but the essential challenge it faces is how to expand the blockchain without destroying Bitcoin's native consensus or performing hard forks.
As of October 1, data statistics show frequent financing situations in the Bitcoin ecosystem, with 14 publicly disclosed financings totaling over $71.1 million. The only opportunity for BTCFi currently is that, for both users and VCs, the Bitcoin ecosystem is still full of opportunities and does not form a comprehensive resource monopoly compared to other public chains. Non-VC financing asset classes have also given birth to many protocol assets such as BRC20, ORC20, ARC20, SRC20, CAT20. We explore from the digital gold BTC to the controversial BTCFi, questioning whether Bitcoin's Fi is a false proposition, with the core discussion point being how to ensure asset security and adopt effective expansion methods.
1.3 The first market ignition point: Indexed asset protocols
Indexed assets can be roughly divided into non-UTXO bound assets of BRC20 and UTXO bound assets of ARC20. The ARC20 fungible token standard is based on Bitcoin's smallest unit 'satoshi,' where each token is equivalent to 1 satoshi, ensuring the minimum value of the token is 1 satoshi. This standard is applied to the Bitcoin blockchain through the Atomicals protocol, enabling colored coin technology to be implemented within the Bitcoin ecology, and also allowing these tokens to be divided and combined like regular Bitcoins, paving the way for the future potential of AVM.
Other asset protocols
ORC20: A token standard based on the Ordinals protocol expansion of Bitcoin. The Ordinals protocol allows users to assign unique markers to individual satoshis (the smallest unit of Bitcoin) on the Bitcoin network. The goal of ORC20 is to create a token standard similar to Ethereum's ERC20, allowing users to issue and trade tokens on the Bitcoin network;
SRC20: Another Bitcoin token standard introduced based on the idea of ORC20, but unlike it, SRC20 emphasizes a simpler and more efficient token issuance and transfer mechanism. It aims to reduce transaction costs and improve efficiency by optimizing the complexity of token contracts and can be used to build token protocols on the Bitcoin blockchain;
CAT20: A similar token standard primarily used for issuing customized tokens (Custom Asset Token). Compared to ORC20 and SRC20, CAT20's functionality focuses more on creating customized tokens for individuals or businesses on the Bitcoin chain. It allows users to define the total supply, name, and other parameters of the token, and circulates in the Bitcoin network to create and manage digital assets.
2. Layer 2 scaling solutions, who will claim BTCFi's market potential
The development of BTCFi cannot be separated from DeFi, and the further expansion of DeFi relies on blockchain scalability. However, there is currently no unified and clear division of the paths for blockchain scalability, and the trade-offs in feasibility, decentralization, and security among different paths are still controversial, all facing a common technical challenge: the need to meet the verification of Bitcoin's 'orthodoxy.'
Image Source: DeFiLlama: Bitcoin Sidechains / Total Value Locked All Chains
By observing the relevant data from DeFiLlama as of November 5, 2024, we can also see that among current sidechain-related projects, the four projects CORE, Bitlayer, BSquared, and Rootsock have the highest TVL share, totaling up to 76.56%. Currently, compared to similar returns from 'ETHFi', BTCFi has shown the following similar characteristics:
The coin-based Buff income of BTCFi comes from: analogous to Babylon + LRT rewards + BTC expansion chain rewards + ETH chain LRT bundled income (like Pendle and Swell);
The coin-based Buff income of ETHFi comes from: POS interest + re-staking rewards + LRT rewards + ETH expansion chain rewards.
Image Source: Pendle / BTC Bonanza
2.1 State Channels
State channels are a scaling solution that allows users to conduct multiple transactions off the mainnet, only submitting to the mainnet when the channel is opened or closed. Currently, in Bitcoin, there are the Lightning Network and Ark, where users deposit BTC in a multi-signature address and conduct daily transactions through the state channel, ultimately verifying transaction results through mainnet consensus to ensure security.
2.2 Sidechains and Rollups
From the perspective of market-side development of the Bitcoin ecology, achieving rapid transactions, Turing completeness, and interoperability, sidechains and Rollups are more suitable for the ecological development of Bitcoin. Bitcoin's sidechains and Rollups have strong independence; Rollups aim to move complex operations to Layer 2, with the mainnet only responsible for verifying the proofs submitted periodically by Layer 2, thereby increasing throughput. This mechanism ensures the security of Layer 2's ledger and its consistency with the mainnet. However, for sidechains, the mainnet cannot directly verify whether cross-chain behavior on the sidechain is legal; cross-chain bridges will lock mainnet assets and map assets on the sidechain, often increasing the degree of decentralization of the chain to ensure asset security while currently having good market performance in releasing liquidity.
2.3 UTXO + client verification
From the perspectives of native nature and security, the UTXO solution is more prominent and aligns better with the definition of 'orthodoxy.' UTXO + client verification is an off-chain solution based on Bitcoin's characteristics, aiming to improve transaction efficiency and privacy while inheriting Bitcoin's security. Since Bitcoin inherently uses the UTXO (Unspent Transaction Output) model rather than the account model, the core idea of client verification is to shift transaction verification from the consensus layer of the blockchain to off-chain, with the client related to the transaction responsible for verification. Specifically, users need to verify the validity of the transfer statement on their own clients to ensure transaction security and efficiency. This off-chain verification reduces the burden on the blockchain and ensures user privacy by having each client store only data relevant to themselves.
The RGB protocol is a concrete implementation of this concept, first proposed by Peter Todd in 2016 with the concepts of 'one-time seals' and 'client verification.' RGB uses Bitcoin's UTXO as 'seals' to bind off-chain asset state changes with Bitcoin's UTXO, ensuring secure off-chain state changes without double spending. In this way, RGB retains the strong security of the Bitcoin network.
Although this solution brings significant efficiency and privacy advantages, it still has some flaws. Users' clients only store transaction data relevant to themselves, leading to data island issues that hinder the development of applications such as DeFi. UTXO + client validation achieves efficient and privacy-friendly off-chain transaction verification by inheriting Bitcoin's security, but there is still significant room for improvement in terms of data transparency, operational convenience, and the completeness of development tools.
2.4 Large blocks that change the existing consensus
Changing the existing consensus also means changing today's Bitcoin; there are hard issues such as consensus and ecological development in realizing the vision of BTCFi, which will only be elaborated here.
BCH (Bitcoin Cash) is a hard fork of Bitcoin due to Bitcoin's scalability issues at Block 478558 (August 1, 2017). The block size of Bitcoin Cash is 8M, while Bitcoin's block size was decided on the same day to increase from 1MB to 2MB within six months. The plan for Bitcoin Cash was first proposed by Chinese Bitcoin mining company Bitmain, and related hard fork tokens include BSV.
3. The Fi in BTCFi needs to better release liquidity
Image Source: pixabay.com
As stated at the beginning, Bitcoin's trillion-dollar market value cannot borrow coins to earn interest like Ethereum, remaining in a long-term dormant state, with storage methods limited to secure hardware wallets or trusted centralized exchanges. How can BTCFi gradually circulate such a massive market value through on-chain financial means?
3.1 Prerequisites for Development
Cross-chain interoperability: The Bitcoin blockchain, unlike Ethereum and other smart contract platforms, does not possess native smart contract functionality. The primary task of BTCFi is to develop trusted cross-chain bridges so that Bitcoin can participate in DeFi applications on other blockchains with smart contract capabilities. These bridges will enable Bitcoin to 'map' to other chains, retaining its value while achieving more functionality;
Layer 2 scaling solutions: Bitcoin's Layer 2 finds it more challenging to balance between the triangle problem compared to Ethereum's Layer 2, often sacrificing decentralization to some extent. However, for the market, a relatively centralized development often leads to new wealth effects, and how project teams can provide the market with more wealth effects to compensate for the lack of decentralization may be the primary consideration;
Smart contract functionality: To support DeFi applications, Bitcoin needs some form of smart contract functionality. Currently, there are no native smart contracts in the Bitcoin network, and developers are exploring ways to provide smart contract support for Bitcoin through second-layer solutions (such as RSK, AVM, Bitvm) or sidechains. This will enable Bitcoin to directly support lending, liquidity provision, derivatives, and other DeFi functions;
Robust developer tools and infrastructure: Developers need comprehensive tools and infrastructure to create and deploy BTCFi applications, but the Bitcoin ecology seems not to require repetitive construction of one-click chain issuance.
3.2 Main Challenges Faced
The limitations of the Bitcoin protocol: Bitcoin's design is to serve as a secure and reliable means of value storage and does not possess the flexibility of Ethereum or other blockchains specifically designed for DeFi. Due to the lack of built-in smart contract functionality, developing BTCFi applications must overcome the limitations of the protocol itself, which may involve complex technical innovations;
Liquidity Issues: Even with cross-chain bridges bringing Bitcoin to Ethereum and other smart contract-supporting blockchains, Bitcoin's liquidity in DeFi is still far lower than tokens like Ethereum. Current liquidity shortages may limit the popularity of BTCFi;
Security and trust issues of cross-chain bridges: Cross-chain bridge technology is key to the development of BTCFi, but these bridges themselves have security risks. In recent years, cross-chain bridge attacks have been frequent, leading to significant capital losses. Ensuring the security of cross-chain bridges and preventing risks from centralization or technical failures remains an important challenge facing BTCFi;
Oracles struggle to capture prices accurately: The architectural limitations of the Bitcoin blockchain prevent oracle services from being easily deployed on the Bitcoin blockchain like projects such as Chainlink on Ethereum. This limitation makes deploying oracle systems in the BTCFi ecosystem more complex and may require reliance on second-layer or sidechain solutions. In the reliance on cross-chain bridges and the price synchronization dilemma, BTCFi may mainly depend on cross-chain bridges to map Bitcoin to other chains for cross-chain price synchronization in the future. Overall, it faces greater technical and security challenges regarding the accuracy of oracles compared to Ethereum;
Can it find its own development path rather than merely imitating Ethereum? The core goal of Bitcoin's design from the beginning is security over functionality. Even more so in the design of BTCFi, market acceptance and security will always take precedence over functionality. The adoption of Bitcoin globally is mainly concentrated on value storage and payments, so BTCFi may focus on financial products related to payments and value storage. The concept of PayFi is not only applicable to Solana but also more suitable for Bitcoin.
Reference Article:
(Comparison of the four mainstream Bitcoin scaling solutions: Who will truly unleash the trillion-dollar market potential of BTCFi?)
