Over the last decade, Bitcoin has clearly established its identity as the leading digital store of value. While this is a tremendous accomplishment, it does not have to stop there. A new era of development within the Bitcoin ecosystem is transforming how retail investors and financial institutions interact with and ultimately think of Bitcoin.
Bitcoin does not have to remain an unproductive asset with minimal utility. Moreover, the Bitcoin network does not need to be limited to the capabilities of its base layer. As the most trusted blockchain, there is much more potential to be unlocked by building on top of Bitcoin. Looking forward, Bitcoin can evolve into the bedrock of the future financial system - with technologies, applications, and infrastructure that commence a new era of decentralized finance.
Let’s explore decentralized finance, how it relates to Bitcoin, and the many use cases DeFi brings to the network.
What is DeFi?
DeFi (Decentralized Finance) is a term used to describe blockchain technologies, applications, and infrastructure that enable financial activity without the need for traditional financial systems.
DeFi does not require a central entity or intermediary to facilitate transactions. Instead, financial applications are run autonomously by encoded protocols on the blockchain.
By eliminating the “middlemen,” DeFi has several advantages over CeFi (centralized finance).
Programmability. With the implementation of smart contracts, transactions can execute autonomously and instantly. This also allows developers to create new financial services and digital assets.
Transparency. The history of all transactions is forever publicly visible and verified by other network users. Additionally, many DeFi projects make their code open-source, so anyone is free to view, analyze, and audit.
Accessibility. Users have full custody and control over their funds, and there is no need for reliance on a bank. This significantly reduces the barriers for many unbanked people across the world.
Borderless - DeFi is accessible regardless of geographic location and local jurisdiction. Similarly, you can transact freely with any other user. International and domestic transactions are treated the exact same on the blockchain.
Why DeFi on Bitcoin?
There are many benefits to having DeFi projects on Bitcoin compared to other layer-1 blockchains.
Sound fundamentals
Bitcoin is the world's most stable, secure, and decentralized blockchain. Since its first block in 2009, the network has continually proven its durability with limited modifications to its core protocol and near-zero downtime. This makes Bitcoin the ideal foundation for developers building the next generation of financial products and services.
Network effects
Bitcoin (BTC) is the largest cryptocurrency in market cap, mining infrastructure, and user base. The world is converging on BTC as the digital asset standard for retail and institutional investors.
Utility
As Bitcoin grows, demand for more use cases will also increase. As it stands, a significant percentage of circulating BTC is held in cold storage and therefore needs to be more productive. Creating DeFi applications on Bitcoin will add innovative and substantial utility to the asset and the network.
How is Bitcoin DeFi Possible?
The Bitcoin base layer is remarkably simple, which allows it to be the most secure, decentralized, and censorship-resistant blockchain. However, this simplicity means that it lacks in functionality compared to other layer 1s. More specifically, Bitcoin’s base does not have full smart contract programming - a fundamental component for building decentralized applications.
Smart contracts allow parties to exchange value without the need of a third party to ensure that each transaction is legitimate, transparent, and trustless. When smart contracts are executed, they are published on the blockchain, where a record of completed transactions is available for anyone to review.
This does not mean that Bitcoin can never have DeFi. Bitcoin’s sound fundamentals actually position it to be the most trustworthy final settlement layer for smart contracts.
In recent years, innovative research and developments have uncovered ways to build technologies, applications, and infrastructure on top of the Bitcoin blockchain. This is achieved by solutions known as “layers”.
Layers are protocols that increase the functionality and scalability of the Bitcoin blockchain. There are four layers that are most prominent to Bitcoin DeFi. Each layer is unique in the way it connects to Bitcoin’s base and the added utility it brings to the network.
Bitcoin DeFi on Lightning Network
Lightning Network is a layer 2 scaling solution for fast, secure, and cheap peer-to-peer payments.
Lightning creates “channels” between two parties, in which many transactions can be sent back and forth off-chain. This system dramatically reduces the strain on Bitcoin’s base and is key to the scalability of BTC payments.
Bitcoin DeFi on Stacks
Stacks is a smart contract platform for Bitcoin. Through Stacks’ “Proof-of-Transfer” mechanism, Stacks transactions settle on Bitcoin automatically at every block. Smart contracts on Stacks can read and react to Bitcoin transactions, which intrinsically tie the two blockchains together.
Stacks has a number of DeFi projects with different use cases, including asset management, lending, decentralized exchanges, atomic swaps, and stablecoins.
Bitcoin DeFi on RSK
RSK (Rootstock) is an EVM-compatible Bitcoin sidechain, seamlessly integrating Ethereum-based applications with Bitcoin. RSK uses a process called “merged mining,” which simultaneously mines RSK and Bitcoin blocks. For onboarding to RSK, funds are transferred via the Powpeg - a two-way bridge that converts BTC to RSK’s native asset, smartBTC (RBTC).
RSK’s DeFi ecosystem is home to wallets, asset swaps, lending protocols, trading platforms, stablecoins, bridges, and more.
Bitcoin DeFi on Liquid Network
Liquid Network is a Bitcoin layer for confidential transaction and asset issuance. Liquid aims to remove reliance on traditional financial systems, third parties, and custodians in favor of trustless, self-custody solutions.
With Liquid Network, users can send and receive BTC with additional privacy measures. Users can also create their builds on Bitcoin DeFi by introducing security tokens, trustless swaps, private P2P payments, and more.
Bitcoin DeFi Use Cases
Bitcoin DeFi enables an entirely new range of use cases that are supported by unmatched immutability, transparency, and trustlessness.
Let’s take a look at some of the functions of decentralized finance on the Bitcoin network.
Asset management
With self custody, users are in charge of their own digital assets. This means that all the account’s passwords, private keys, and seed phrases are only accessible by the owner. Funds can be simply and conveniently managed through a Bitcoin wallet. There are two main types of wallets, “hot” and “cold”.
Hot wallets are directly connected to the internet, and make it easy to buy, sell, and transfer funds. Hot wallets are also used for interacting with Bitcoin DeFi applications.
Cold wallets are physical pieces of hardware that can store digital assets offline. In general, cold wallets are viewed as much safer and less prone to malicious attacks.
There are many types of Bitcoin wallets such as mobile or desktop, software or hardware. Bitcoin wallets can also be classified by those off-chain, integrated with the base layer, or connected to a layer.
Asset issuance
Anyone can issue their own token with Bitcoin layers. There are various applications for introducing new assets, including stablecoins, tokenized bitcoins, security tokens, digital collectibles, rewards, and vouchers.
Atomic swaps
Atomic swaps allow two parties to trade cryptocurrencies from two different blockchains. Sending funds cross-chain allows for users to gain exposure to new ecosystems with unique platforms and applications.
Borrowing and lending
Decentralized platforms have ways to borrow and lend Bitcoin in a direct, peer-to-peer manner.
For borrowers, crypto loans can be acquired without the need of an intermediary. In most cases, these loans are used for trading or arbitrage purposes. Borrowing and lending applications are dependent on smart contracts for facilitating transactions, and thus require the capabilities of Bitcoin layers like Stacks, RSK, and Liquid.
For lending, users can receive passive income in the form of yield on their deposited crypto assets. DeFi lending is a popular method to earn interest on your BTC, rather than having it sit idle in a wallet. Interest rates can vary depending on the DeFi platform, the loan term, and the loan amount.
Derivatives
Derivatives allow a buyer and a seller to enter an agreement to sell an underlying asset. The most popular derivatives are futures, options, and perpetual contracts.
Decentralized exchanges (DEXs)
Decentralized exchanges are peer-to-peer marketplaces where traders can swap digital assets without the need of a central entity. Since a decentralized exchange requires complex smart contracts to operate autonomously, a Bitcoin DEX must be created on a layer, such as Stacks.
Decentralized Autonomous Organizations (DAOs)
DAOs are community-led groups that operate without a central authority and yield their governance to their members. DAOs are most often deployed in DeFi applications, in which members can vote on protocol updates and the management of the DAO’s funds. Currently, DAOs exist on Stacks and RSK.
Marketplaces
Marketplaces allow users to directly exchange digital and physical goods in a borderless and trustless manner. On Bitcoin’s layers, there are markets for buying and selling NFTs such as digital art, music, and gaming collectibles.
Payments
Peer-to-peer DeFi payments are faster, cheaper, and more secure than traditional payment rails. Blockchain also gets rid of any limitations with sending cross-border payments. With just a device and an internet connection, anyone in the world can send and receive money near-instantaneously. Bitcoin payments are most prominent on the Lightning Network.
Prediction markets
DeFi users can make predictions or “bets'' on a variety of blockchain-based and real-world future outcomes. On Bitcoin, many prediction markets transactions occur with Discreet Log Contracts (DLCs). DLCs are a type of smart contract that utilizes oracles to bring outside world data on-chain in a trustless manner.
Stablecoins
Stablecoins are digital currencies that have their value pegged to that of another currency, commodity, or financial instrument. The most common application of stablecoins is fiat, more specifically the US Dollar. Stablecoins allow users to hold digital assets on-chain that are far-less volatile, and a viable means of payment.
Bitcoin layers have a number of stablecoins, including USDT, DAI, and USDA.
Trading
Bitcoin trading is an overarching term for a range of activities, including futures, margin trading, and swaps. With CeFi trading, users must trust a business to manage funds and execute transactions on their behalf. DeFi trading removes reliance on third parties and utilizes smart contracts in their place. In general, DeFi infrastructure offers lower fees, faster transaction settlement times, and higher fund security with self-custody.
Learn More About Bitcoin DeFi
DeFi yields a new standard for trust and economic opportunity. Individuals can be in charge and have true financial freedom without depending on a centralized entity.
Decentralized finance on Bitcoin is an exciting development for the world’s most trusted blockchain. With immense amounts of capital and unrivaled security, Bitcoin shows much promise as a growing platform for decentralized applications.
Thanks to Bitcoin layers, users can do much more with their funds, all while remaining within the network’s ecosystem. Whether you want to send Bitcoin payments, lend BTC, or join a Bitcoin-based DAO, the possibilities for interacting with Bitcoin DeFi are here today.
