作者：YBB Capital Researcher Ac-Core
TL;DR
The general background of BTCFi is: 1. The narrative of Ethereum and Ethereum Killer Chain is gradually weakening and the infrastructure construction has reached saturation. The industry as a whole lacks new narratives, and only superficial words are left. 2. Compared with other public chains, BTC has not formed a comprehensive resource monopoly;
BTC’s main expansion plans include state channels, side chains and Rollups, UTXO+client verification, large blocks and other asset protocols, but all expansion plans need to face the technical difficulties of complying with “orthodoxy” verification.
The prerequisites for the development of BTCFi are: cross-chain interoperability, solving the second-layer expansion solution (Layer2), smart contract functions, and infrastructure and development tools that do not require one-click duplication;
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 for oracles to accurately capture prices, and finding a development path that belongs to BTCFi.
1. BTCFi
1.1 What is BTCFi
The Bitcoin chain was once the least active public chain, with a market value of up to one trillion US dollars but has been in a "dormant" state for a long time. Fi stands for Finance, so 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 financial derivatives tools such as staking, lending, and market making to combine interest-bearing and obtain income, that is, to introduce DeFi into the native Bitcoin ecosystem to activate more financial attribute value.
1.2 Background
2023 is an important year for the Bitcoin ecosystem to officially reach its peak. Various tokens represented by BRC20 have triggered a significant wealth effect and stimulated the Fomo sentiment of the market. Looking at the current state of the industry, apart from the broken carriage of inscriptions, another reason why the Bitcoin ecosystem can rise is that the narrative ability of Ethereum and Ethereum Killer Chain is gradually weakening and the infrastructure construction has become saturated. The industry as a whole lacks fresh narratives and only has superficial word creation. The Bitcoin ecosystem has also perfectly replicated the development path of Ethereum, but the essential problem it faces is how to expand blocks without destroying Bitcoin's native consensus or hard forks.
According to statistics as of October 1, the Bitcoin ecosystem has seen frequent financing, with 14 public financings totaling more than $71.1 million. The only opportunity for BTCFi at present is that the Bitcoin ecosystem is still full of opportunities for both users and VCs, and has not formed a comprehensive resource monopoly compared to other public chains. Non-VC financing assets have also seen the birth of many protocol assets such as BRC20, ORC20, ARC20, SRC20, and CAT20. We have explored the controversial BTCFI from digital gold BTC to whether Bitcoin's Fi is a false proposition. The core discussion point is how to ensure the security of assets and adopt effective expansion methods.
1.3 The first tipping point of the market: index asset protocol
Indexed assets can be roughly divided into non-UTXO-bound assets of BRC20 and UTXO-bound assets of ARC20. The ARC20 homogeneous token standard is based on the smallest unit of Bitcoin, "Satoshi". Each token is equivalent to 1 Satoshi, ensuring that the minimum value of the token is 1 Satoshi. This standard is applied to the Bitcoin blockchain through the Atomicals protocol, making the colored coin technology feasible in the Bitcoin ecosystem. It also allows these tokens to be split and combined like ordinary Bitcoin, paving the way for the potential AVM in the future.
Other asset agreements
ORC20: A token standard based on the Ordinals protocol extension of Bitcoin. The Ordinals protocol allows users to give a unique mark to a single satoshi (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 similar to ORC20, but different from it, SRC20 emphasizes a simpler and more efficient token issuance and transfer mechanism. It attempts to optimize the complexity of token contracts, reduce transaction fees and improve efficiency, and can be used to build token protocols on the Bitcoin blockchain;
CAT20: is a similar token standard, mainly used to issue custom tokens (Custom Asset Token). Compared with ORC20 and SRC20, CAT20 focuses more on creating custom 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 circulate it in the Bitcoin network for the creation and management of digital assets.
2. Second-layer expansion plan, who will take advantage of BTCFi’s market potential?
The development of BTCFi is inseparable from DeFi, and the further expansion of DeFi depends on the expansion of blockchain. However, there is no unified and clear division of the paths for blockchain expansion. The trade-offs between feasibility, decentralization and security of different paths are still controversial, and all of them face a common technical difficulty: the need to comply with the verification of Bitcoin's "orthodoxy".
图源：DeFiLlama ：Bitcoin Sidechains / Total Value Locked All Chains
By observing the relevant data of DeFiLlama on November 5, 2024, we can also find that among the current sidechain-related projects, CORE, Bitlayer, BSquared, and Rootsock have the highest TVL, totaling 76.56%. At this stage, BTCFi, which relies on the same nesting doll income, and "ETHFi", have similar characteristics as follows:
BTCFi's currency-based Buff income comes from: analogy to Babylon + LRT rewards + BTC extension chain rewards + ETH chain LRT package income (such as Pendle and Swell);
ETHFi’s currency-based Buff income comes from: POS interest + re-staking rewards + LRT rewards + ETH extension chain rewards.
Image source: Pendle / BTC Bonanza
2.1 State Channel
The state channel is an extension solution that allows users to conduct multiple transactions outside the main network and submit them to the main network only when the channel is opened or closed. In Bitcoin, there are currently lightning networks and Ark. After users deposit BTC in a multi-signature address, they conduct daily transactions through the state channel, and finally verify the transaction results through the main network consensus to ensure security.
2.2 Sidechains and Rollups
From the perspective of developing the Bitcoin ecosystem, achieving fast transactions, Turing completeness and interoperability from the market side, sidechains and Rollups are more suitable for the development of Bitcoin's ecosystem. Bitcoin's sidechains and Rollups are highly independent. Rollups are designed to move complex operations to Layer2, and the main network is only responsible for verifying proofs submitted regularly by Layer2, thereby increasing throughput. This mechanism ensures that the ledger security of Layer2 is consistent with the main network. As for the sidechain, the main network cannot directly verify whether the cross-chain behavior on the sidechain is legal. The cross-chain bridge will lock the main network assets and map the assets on the sidechain. Both often increase the decentralization of the chain by adding other verification methods to ensure asset security. At the same time, in terms of releasing liquidity, the current sidechain and Rollups solutions still have a good market performance.
2.3 UTXO+Client Verification
In terms of nativeness and security, the UTXO solution is more prominent and more in line with the definition of "orthodoxy". UTXO + client verification is an off-chain solution based on the characteristics of Bitcoin, which aims to improve transaction efficiency and privacy while inheriting the security of Bitcoin. Because Bitcoin natively adopts the UTXO (unspent transaction output) model instead of the account model, the core idea of client verification is to transfer transaction verification from the consensus layer of the blockchain to the off-chain, and the transaction-related clients are responsible for verification. Specifically, users need to verify the validity of the transfer statement on their own clients to ensure that the transaction is secure and efficient. This off-chain verification reduces the burden on the blockchain and ensures user privacy by storing only data related to each client.
The RGB protocol is a concrete implementation of this concept, which was first proposed by Peter Todd in 2016 as the concept of "one-time seal" and "client verification". RGB uses Bitcoin's UTXO as a "seal" to bind the state changes of off-chain assets to Bitcoin's UTXO, thereby ensuring secure off-chain state changes without double spending. In this way, RGB retains the strong security of the Bitcoin network.
Although this scheme brings significant efficiency and privacy advantages, it still has some drawbacks. The user's client only stores transaction data related to itself, resulting in data island problems and hindering the development of applications such as DeFi. UTXO + client-side verification achieves efficient and privacy-friendly off-chain transaction verification by inheriting the security of Bitcoin, but there is still considerable room for improvement in terms of data transparency, operational convenience, and development tool perfection.
2.4 Large blocks that change the original consensus
Changing the original consensus also means changing today’s Bitcoin. In realizing the BTCFi vision, there are hard issues such as consensus and ecological development, which are only explained here.
BCH (Bitcoin Cash) is a hard fork of Bitcoin at Block 478558 (August 1, 2017) due to Bitcoin scalability issues. The block size of Bitcoin Cash is 8M, while the block size of Bitcoin was decided to increase from 1MB to 2MB within six months on the same day. The Bitcoin Cash plan was first proposed by Bitmain, a Chinese Bitcoin mining machine company. The related hard fork token also includes BSV.
3. Fi in BTCFi needs to release liquidity better
Image source: pixabay.com
As mentioned at the beginning, Bitcoin's trillion-dollar market value cannot remain dormant for a long time like Ethereum, where it can only be stored in secure hardware wallets or trusted centralized exchanges. How can BTCFi circulate such a huge market value step by step through on-chain financialization?
3.1 Prerequisites for development
1. Cross-chain interoperability
Unlike other smart contract platforms such as Ethereum, the Bitcoin blockchain is not natively architected for smart contract functionality. BTCFi’s first priority is to develop trusted cross-chain bridges so that Bitcoin can participate in DeFi applications on other blockchains with smart contract functionality. These bridges enable Bitcoin to be “mapped” to other chains, enabling more functionality while preserving its value;
2. Layer 2 Scaling Solution
Compared with Ethereum's second layer, Bitcoin's second layer is more difficult to balance between the three problems, and both will give up more or less in the direction of decentralization. But for the market, more centralized development is often more likely to produce new wealth-creating effects. How the project team should give the market more wealth effects to make up for the lack of decentralization may be the first consideration;
3. Smart contract function
In order to support DeFi applications, Bitcoin needs some form of smart contract functionality. There are no native smart contracts in the current 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 DeFi functions such as lending, liquidity provision, and derivatives;
4. Powerful developer tools and infrastructure
Developers need comprehensive tools and infrastructure to create and deploy BTCFi applications, but the Bitcoin ecosystem does not seem to require repetitive one-click chain-issuing construction.
3.2 Main Challenges
1. Limitations of the Bitcoin Protocol
Bitcoin is designed to be a secure and reliable means of storing value, and does not have the flexibility of Ethereum or other blockchains designed specifically for DeFi. Due to the lack of built-in smart contract functions, the development of BTCFi applications requires overcoming the limitations of the protocol itself, which may involve complex technical innovations;
2. Liquidity issues
Even if Bitcoin is introduced to Ethereum and other blockchains that support smart contracts through cross-chain bridges, the liquidity of Bitcoin in DeFi is still much lower than that of tokens such as Ethereum. The current lack of liquidity may limit the popularity of BTCFi;
3. Security and trust issues of cross-chain bridges
Cross-chain bridge technology is the key to the development of BTCFi, but such bridges themselves have security risks. In recent years, cross-chain bridge attacks have occurred frequently, resulting in a large amount of capital losses. How to ensure the security of cross-chain bridges and prevent risks caused by centralization or technical failures is still an important challenge facing BTCFi;
4. Oracles are difficult to accurately capture prices
Due to the architectural limitations of the Bitcoin blockchain, oracle services cannot be deployed on the Bitcoin blockchain as easily as projects such as Chainlink on Ethereum. This limitation makes it more complicated to deploy oracle systems in the BTCFi ecosystem, and may require reliance on second-layer or sidechain solutions. In terms of cross-chain bridge dependence and price synchronization problems, in the future BTCFi may rely mainly on cross-chain bridges to map Bitcoin to other chains to achieve cross-chain price synchronization. Overall, the accuracy of the oracle faces greater technical and security challenges than Ethereum;
5. Can it forge its own development path instead of blindly imitating Ethereum?
The core goal of Bitcoin's initial design was to prioritize security over functionality, and even more so in the design of BTCFi, market acceptance and security will always take precedence over functionality. Bitcoin's global adoption is mainly focused on value storage and payment, so BTCFi may focus on financial products related to payment and value storage. The concept of PayFi is not only applicable to Solana but also to Bitcoin.
Reference articles:
(Comparison of the four major Bitcoin expansion solutions: Who will truly unleash the trillion-dollar market potential of BTCFi?)
