TL;DR
The larger context of BTCFi is: 1. The narrative of Ethereum and Ethereum-killer chains is gradually weakening, and infrastructure construction has reached saturation, with the industry overall lacking fresh narratives, leaving only superficial jargon; 2. Compared to other public chains, BTC has not formed a comprehensive resource monopoly;
The main expansion solutions for BTC include state channels, sidechains, and Rollups, UTXO + client-side verification, large blocks, and other asset protocols, but all types of expansion solutions must jointly face the technical difficulties of compliance with 'orthodox' verification;
The prerequisites for the development of BTCFi are: cross-chain interoperability, solutions for layer two scaling (Layer2), smart contract functionality, and infrastructure and development tools that do not require one-click repeated construction;
The main challenges faced by BTCFi are: the limitations of the Bitcoin protocol and liquidity issues, security 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 has historically been the least active public chain, with a market value reaching a trillion dollars but remaining in a long-term 'dormant' state.
Fi stands for Finance, thus the purpose of BTCFi is to establish a decentralized financial market for Bitcoin within this trillion-dollar market, allowing BTC holders to directly use Bitcoin-related staking, lending, market-making, and other financial derivative tools to generate yield, effectively bringing DeFi into the native Bitcoin ecosystem to activate more financial property values.
1.2 Background
2023 is a crucial year for the Bitcoin ecosystem to officially reach its peak, with various tokens represented by BRC20 triggering obvious wealth effects and stimulating market FOMO. Looking at the industry's current state, aside from the inscription's broken horse cart, another reason the Bitcoin ecosystem can arise is that the narrative capabilities of Ethereum and Ethereum-killer chains are gradually weakening and infrastructure construction has reached saturation, leaving the industry overall lacking fresh narratives.
The Bitcoin ecosystem has also perfectly replicated the development path of Ethereum, but the fundamental challenge it faces is how to expand blocks without breaking the native consensus of Bitcoin or causing a hard fork.
As of October 1, data statistics show frequent financing situations in the Bitcoin ecosystem, with 14 instances of public financing 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, lacking a comprehensive resource monopoly compared to other public chains.
Non-VC financing asset classes have also given birth to numerous protocol assets such as BRC20, ORC20, ARC20, SRC20, CAT20, etc. From the digital gold BTC to the controversial BTCFi, whether Bitcoin's Fi is a false proposition or not, the core discussion point is how to ensure the security of assets and adopt effective scaling methods.
1.3 The first ignition point in the market: Indexed asset protocols
Indexed assets can generally be divided into non-UTXO bound assets of BRC20 and UTXO bound assets of ARC20; the ARC20 homogeneous token standard is based on Bitcoin's smallest unit 'satoshi', with each token 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, allowing colored coin technology to be realized in the Bitcoin ecosystem, also allowing these tokens to be divided and combined like regular Bitcoins, paving the way for the potential of AVM in the future.
Other asset-related protocols
ORC20: A token standard based on the Ordinals protocol for Bitcoin.
The Ordinals protocol allows users to assign a unique identifier to a single satoshi (the smallest unit of Bitcoin) on the Bitcoin network.
ORC20 aims to create a token standard similar to Ethereum's ERC20 that allows users to issue and trade tokens on the Bitcoin network;
SRC20: Another Bitcoin token standard introduced with a similar idea to ORC20, but unlike it, SRC20 emphasizes a simpler and more efficient token issuance and transfer mechanism.
It attempts to optimize the complexity of token contracts, reduce transaction costs, and improve efficiency, and can be used to build token protocols on the Bitcoin blockchain;
CAT20: A similar token standard primarily used for issuing custom tokens (Custom Asset Token).
Compared to ORC20 and SRC20, CAT20's functionality is more focused 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 within the Bitcoin network, used for creating and managing digital assets.
2. Who will seize the market potential of BTCFi with layer two expansion solutions?
BTCFi's development is inseparable from DeFi, and further expansion of DeFi relies on blockchain scalability.
However, there is currently no unified and clear division of paths for blockchain scalability, and the trade-offs among different paths regarding feasibility, degree of decentralization, and security remain controversial, all facing a common technical difficulty: compliance with Bitcoin's 'orthodoxy' verification.
DeFiLlama: Bitcoin Sidechains / Total Value Locked All Chains
By observing the related data from DeFiLlama on November 5, 2024, we can also find that currently, among sidechain-related projects, CORE, Bitlayer, BSquared, and Rootsock have the highest TVL share, totaling up to 76.56%.
Currently, BTCFi has exhibited similar characteristics to ETHFi, which relies on nested returns.
The token-based Buff benefits of BTCFi come from: analogous to Babylon + LRT rewards + BTC expansion chain rewards + ETH chain LRT bundled rewards (similar to Pendle and Swell);
The token-based Buff benefits of ETHFi come from: POS interest + re-staking rewards + LRT rewards + ETH expansion chain rewards.
Pendle / BTC Bonanza
2.1 State channels
State channels are a scaling solution that allows users to conduct multiple transactions off the mainnet, submitting to the mainnet only when opening or closing the channel.
Currently, Bitcoin has the Lightning Network and Ark, where users deposit BTC into a multi-signature address and conduct daily transactions through state channels, ultimately verifying the transaction results through mainnet consensus to ensure security.
2.2 Sidechains and Rollups
From the perspective of developing the Bitcoin ecosystem from the market side, achieving fast transactions, Turing completeness, and interoperability, sidechains and Rollups are better suited for the development of Bitcoin's ecosystem.
Bitcoin's sidechains and Rollups have strong independence. Rollups aim to move complex operations to Layer 2, with the mainnet only responsible for verifying proofs submitted periodically from Layer 2, thereby improving throughput. This mechanism ensures that Layer 2's ledger is secure and consistent with the mainnet.
For sidechains, the mainnet cannot directly verify whether cross-chain behavior on the sidechain is legitimate; cross-chain bridges lock mainnet assets and map them on the sidechain, often increasing other verification methods to enhance the decentralization of the chain to ensure asset security, while currently, both sidechains and Rollups still have good market performance in releasing liquidity.
2.3 UTXO+ Client-side verification
In terms of native and security, the UTXO solution is more prominent and better aligns with the definition of 'orthodoxy.'
UTXO + client-side 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 natively adopts the UTXO (Unspent Transaction Output) model rather than the account model, the core idea of client-side verification is to shift transaction validation from the blockchain's consensus layer to off-chain, with the related clients responsible for verification.
Specifically, users need to verify the validity of transfer statements on their client-side 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 itself.
The RGB protocol is a concrete implementation of this concept, initially proposed by Peter Todd in 2016 with the ideas of 'one-time seals' and 'client-side verification.' RGB uses Bitcoin's UTXO as a 'seal' to bind the state changes of off-chain assets to 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 offers significant efficiency and privacy advantages, it still has some flaws. Users' clients only store transaction data relevant to themselves, leading to data island problems that hinder the development of DeFi and other applications.
UTXO + client-side verification achieves efficient and privacy-friendly off-chain transaction verification by inheriting the security of Bitcoin, but there is still significant room for improvement in terms of data transparency, operational convenience, and the completeness of development tools.
2.4 Changing the original consensus of large blocks
Changing the existing consensus also means changing the current Bitcoin; there are rigid issues such as consensus and ecological development in realizing the vision of BTCFi, which are only discussed here.
BCH (Bitcoin Cash) is a hard fork of Bitcoin due to scalability issues, initiated at Block 478558 (August 1, 2017). Bitcoin Cash has a block size of 8M, while Bitcoin's block size was determined on the same day to increase from 1MB to 2MB within six months.
The plan for Bitcoin Cash was first proposed by China's Bitcoin mining machine company Bitmain, with related hard fork tokens like BSV.
3. The Fi in BTCFi needs to better release liquidity
pixabay.com
As mentioned at the beginning, Bitcoin's trillion-dollar market value cannot remain in a long-term dormant state like Ethereum's, where borrowing assets for interest is possible; the only storage options are secure hardware wallets or trusted centralized exchanges. How can BTCFi gradually circulate such a large market value through on-chain financialization?
3.1 Prerequisites for development
1. Cross-chain interoperability
The Bitcoin blockchain differs from other smart contract platforms like Ethereum, as its architecture 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 functionality.
These bridges can enable Bitcoin to 'map' to other chains, achieving more functions while retaining its value;
2. Layer two scaling solutions (Layer2)
Compared to Ethereum's layer two, Bitcoin's layer two faces greater difficulty in balancing between the triangle problem, often sacrificing some degree of decentralization.
However, for the market, more centralized development often generates new wealth effects more easily. How project teams can provide the market with greater wealth effects to compensate for insufficient decentralization may be the primary consideration.
3. 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;
4. Strong developer tools and infrastructure
Developers need comprehensive tools and infrastructure to create and deploy BTCFi applications, but the Bitcoin ecosystem seems not to require one-click, chain-like repetitive construction.
3.2 Major challenges faced
1. Limitations of the Bitcoin protocol
Bitcoin's design is meant to serve as a secure and reliable means of value storage, lacking 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 technological innovations;
2. Liquidity issues
Even when Bitcoin is brought into Ethereum and other smart contract-supporting blockchains through cross-chain bridges, its liquidity in DeFi is still far lower than tokens like Ethereum; the current lack of liquidity may limit the popularity of BTCFi.
3. Security trust issues of cross-chain bridges
Cross-chain bridge technology is key to the development of BTCFi, but these bridges inherently carry security risks.
In recent years, cross-chain bridge attacks have been frequent, leading to significant financial losses.
How to ensure the security of cross-chain bridges and prevent risks from centralization or technical failures remains a significant challenge for BTCFi;
4. Oracle's difficulty in accurately capturing prices
The architectural limitations of the Bitcoin blockchain mean that oracle services cannot be 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, possibly requiring reliance on Layer 2 or sidechain solutions.
In the reliance on cross-chain bridges and the price synchronization dilemma, BTCFi may mainly rely on cross-chain bridges to map Bitcoin to other chains in the future to achieve cross-chain price synchronization.
Overall, it faces greater technical and security challenges in obtaining the accuracy of the oracle than Ethereum;
5. Can it forge its own development path instead of merely mimicking Ethereum?
The core goal of Bitcoin's design from the beginning was 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 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 is also more applicable to Bitcoin.
Reference article: (Comparison of four mainstream Bitcoin expansion solutions: Who will truly unlock the trillion market potential of BTCFi?)
This article is a collaborative reprint from: Deep Tide
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