TL;DR

• The broader context for BTCFi: 1. The narrative around Ethereum and Ethereum-killer chains is weakening, and infrastructure development is nearing saturation, with the industry lacking fresh narratives and only superficial buzzwords remaining. 2. Compared to other public chains, BTC has not yet formed a comprehensive resource monopoly.
• BTC’s main scaling solutions include state channels, sidechains, and rollups, UTXO + client validation, large blocks, and other asset protocols. However, all scaling solutions face technical challenges in achieving “legitimacy” validation.
• Prerequisites for BTCFi development include: cross-chain interoperability, solutions for Layer 2 scaling, smart contract functionality, and infrastructure and development tools that do not require redundant construction.
• Major challenges facing BTCFi include: the limitations of the Bitcoin protocol and liquidity issues, security and trust issues with cross-chain bridges, difficulties in accurately capturing prices with oracles, and finding the correct development path for BTCFi.

1. BTCFi

1.1 What is BTCFi?

The Bitcoin chain was once the least active among public blockchains, with a market capitalization of up to a trillion dollars but remaining in a “dormant” state for a long time. “Fi” refers to Finance. Therefore, the goal of BTCFi is to create a decentralized financial market for Bitcoin within this trillion-dollar market. BTC holders will directly use Bitcoin-related staking, lending, market-making, and other financial derivatives to generate passive income. This is to introduce DeFi into the native Bitcoin ecosystem and unlock more financial value.

1.2 Background

2023 was an important year for Bitcoin’s ecosystem, marking its official rise to prominence. Various tokens, represented by BRC20, sparked significant wealth effects and triggered FOMO (fear of missing out) in the market. Looking at the current state of the industry, apart from the “Inscription” protocol, another reason for the Bitcoin ecosystem’s rise is the weakening narrative and saturation of infrastructure development in Ethereum and Ethereum-killer chains. The industry is lacking fresh narratives, with only superficial buzzwords remaining. Bitcoin’s ecosystem has effectively replicated Ethereum’s development path, but the fundamental challenge is how to scale blocks without disrupting Bitcoin’s native consensus or causing a hard fork.

As of October 1st, Bitcoin’s ecosystem has seen frequent funding rounds, with 14 public rounds totaling over $71.1 million. Currently, BTCFi’s only opportunity is that, for both users and VCs, the Bitcoin ecosystem still holds opportunities, and unlike other public chains, it has not formed a comprehensive resource monopoly. Non-VC-funded assets have also given rise to numerous protocol assets like BRC20, ORC20, ARC20, SRC20, and CAT20. We explore Bitcoin as digital gold and move into the controversial topic of BTCFi. The core discussion revolves around how to ensure asset security and adopt effective scaling methods.

1.3 The First Market Trigger: Index Asset Protocols

Index assets can generally be divided into non-UTXO bound assets (BRC20) and UTXO bound assets (ARC20). The ARC20 fungible token standard is based on Bitcoin’s smallest unit, “Satoshi.” Each token is equivalent to one Satoshi, ensuring the minimum value of the token is one Satoshi. This standard, applied to the Bitcoin blockchain via the Atomicals protocol, enables the use of colored coin technology in the Bitcoin ecosystem. It also allows these tokens to be split and combined like ordinary Bitcoin, paving the way for the potential AVM.

Other Asset Protocols:

• ORC20: A token standard based on the Bitcoin Ordinals protocol extension. The Ordinals protocol allows users to assign unique markers to individual satoshis (the smallest Bitcoin unit). 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: A Bitcoin token standard introduced with a similar approach to ORC20 but with an emphasis on simpler and more efficient token issuance and transfer mechanisms. SRC20 aims to reduce contract complexity, lower transaction fees, and enhance efficiency, making it a protocol for token construction on the Bitcoin blockchain.
• CAT20: A similar token standard used for issuing custom tokens (Custom Asset Tokens). Compared to ORC20 and SRC20, CAT20 focuses more on enabling individuals or enterprises to create custom tokens on the Bitcoin chain. It allows users to define parameters such as token supply, name, and other features, and the tokens can circulate on the Bitcoin network for creating and managing digital assets.

2. Layer 2 Scaling Solutions: Who Will Capture BTCFi’s Market Potential?

BTCFi’s development is inseparable from DeFi, and the further expansion of DeFi relies on blockchain scalability. However, there is no unified and clear categorization of blockchain scalability paths, and different approaches still face debates over feasibility, decentralization, and security, all of which share a common technical challenge: meeting the “legitimacy” validation of Bitcoin.

Source: DeFiLlama — Bitcoin Sidechains / Total Value Locked Across All Chains

By observing the data from DeFiLlama on November 5, 2024, we can see that among the current sidechain-related projects, CORE, Bitlayer, BSquared, and Rootsock have the highest TVL (Total Value Locked), accounting for a combined 76.56%. Compared to the current BTCFi, which is similarly reliant on nested yield farming and “ETHFi,” we observe the following similarities:

• The BTCFi native token-based Buff yields come from: Babylon-like rewards + LRT rewards + BTC scaling chain rewards + ETH chain LRT bundle rewards (similar to Pendle and Swell).
• The ETHFi native token-based Buff yields come from: POS interest + re-staking rewards + LRT rewards + ETH scaling chain rewards.

Source: Pendle / BTC Bonanza

2.1 State Channels

State channels are a scaling solution that allows users to conduct multiple transactions off-chain, only submitting to the mainnet when opening or closing the channel. In Bitcoin, we currently have the Lightning Network and Ark. Users deposit BTC into a multi-signature address and conduct day-to-day transactions through the state channel. The final transaction results are then verified through the mainnet consensus to ensure security.

2.2 Sidechains and Rollups

From a market perspective, to develop the Bitcoin ecosystem and enable fast transactions, Turing completeness, and interoperability, sidechains and rollups are better suited for Bitcoin’s ecosystem development. Bitcoin’s sidechains and rollups have strong independence. Rollups aim to move complex operations to Layer 2, with the mainnet only responsible for validating proofs (Proofs) regularly submitted by Layer 2, thereby improving throughput. This mechanism ensures that the Layer 2 ledger remains consistent with the mainnet.

For sidechains, the mainnet cannot directly verify the legality of cross-chain actions on the sidechain. Cross-chain bridges lock assets on the mainnet and map those assets onto the sidechain. These solutions typically introduce additional verification mechanisms to increase the decentralization of the chain and ensure asset security. Meanwhile, both sidechains and rollups have shown strong market performance in terms of releasing liquidity.

2.3 UTXO + Client Validation

From a native and security perspective, UTXO-based solutions stand out as they align more closely with the definition of “legitimacy.” UTXO + client validation is an off-chain solution based on Bitcoin’s features, designed to improve transaction efficiency and privacy while maintaining Bitcoin’s security. Bitcoin natively uses the UTXO (Unspent Transaction Output) model rather than the account model. The core idea of client validation is to shift transaction validation from the blockchain’s consensus layer to off-chain, where client-related transactions are validated by the clients themselves.

Specifically, users need to verify the validity of transfer claims on their own clients, ensuring transaction security and efficiency. This off-chain validation reduces the burden on the blockchain, and by having each client store only data related to themselves, it guarantees user privacy.

The RGB protocol is a concrete implementation of this concept, first proposed by Peter Todd in 2016, introducing the concepts of “single-use seals” and “client validation.” RGB uses Bitcoin’s UTXO as “seal tags” and binds off-chain asset state changes with Bitcoin’s UTXOs to ensure secure off-chain state changes without double-spending. This approach preserves the strong security of the Bitcoin network.

Despite the significant advantages in efficiency and privacy, this solution still has some drawbacks. Users’ clients only store transaction data relevant to themselves, leading to the issue of data silos, which hinders the development of DeFi and other applications. UTXO + client validation inherits Bitcoin’s security to enable efficient, privacy-friendly off-chain transaction validation, but it still has significant room for improvement in data transparency, operational convenience, and the development of tools.

2.4 Large Blocks Changing the Original Consensus

Changing the original consensus also means altering Bitcoin itself. There are hard challenges in achieving BTCFi’s vision, including consensus and ecosystem development. Here, we’ll only provide a general overview.

Bitcoin Cash (BCH) is a hard fork of Bitcoin that took place at Block 478558 (August 1, 2017) to address Bitcoin’s scalability issues. The block size of Bitcoin Cash is 8MB, while Bitcoin’s block size was determined to increase from 1MB to 2MB over the next six months. Bitcoin Cash was proposed by Bitmain, a Chinese Bitcoin mining hardware company, and other hard forked tokens, such as Bitcoin SV (BSV), also emerged.

3. BTCFi’s Fi Needs Better Liquidity Release

Source: pixabay.com

As mentioned at the beginning, Bitcoin’s trillion-dollar market cap cannot remain in a dormant state like Ethereum, where borrowing and earning interest are possible. The only way to store Bitcoin is through secure hardware wallets or trusted centralized exchanges. How can BTCFi gradually circulate such a massive market cap through on-chain financial methods?

3.1 Prerequisites for Development

1.Cross-chain Interoperability

Unlike Ethereum and other smart contract platforms, the Bitcoin blockchain does not natively support smart contract functionality. BTCFi’s primary task is to develop trusted cross-chain bridges so that Bitcoin can participate in DeFi applications on other blockchains that support smart contracts. These bridges would allow Bitcoin to be “mapped” onto other chains while preserving its value, enabling it to have more functionalities.

1. Layer 2 Scaling Solutions (Layer 2)

Bitcoin’s Layer 2 scaling faces more challenges in balancing the “triangle problem” compared to Ethereum’s Layer 2 solutions. Bitcoin’s Layer 2 solutions tend to sacrifice decentralization to some extent. However, from the market’s perspective, more centralized development often creates new wealth effects, and the project team’s task is to find ways to provide wealth effects to compensate for the lack of decentralization. This may be one of the primary issues to consider.

1. Smart Contract Functionality

To support DeFi applications, Bitcoin requires some form of smart contract capability. The current Bitcoin network lacks native smart contracts, and developers are exploring second-layer solutions (such as RSK, AVM, BitVM) or sidechains to provide Bitcoin with smart contract support. This would enable Bitcoin to directly support DeFi functions such as lending, liquidity provision, and derivatives.

1. Robust Developer Tools and Infrastructure

Developers need comprehensive tools and infrastructure to create and deploy BTCFi applications. However, the Bitcoin ecosystem does not necessarily require repetitive “one-click” infrastructure development, as seen with other blockchains.

3.2 Main Challenges Faced

1.Limitations of the Bitcoin Protocol

Bitcoin was designed as a secure and reliable store of value and lacks the flexibility of Ethereum or other blockchains that are specifically designed for DeFi. Due to the absence of built-in smart contract functionality, developing BTCFi applications must overcome the inherent limitations of the protocol, which may involve complex technological innovations.

1. Liquidity Issues

Even if Bitcoin is brought onto Ethereum or other smart contract-enabled blockchains via cross-chain bridges, its liquidity in DeFi remains far lower than Ethereum-based tokens. The current lack of liquidity may limit the widespread adoption of BTCFi.

1. Security and Trust Issues with Cross-Chain Bridges

Cross-chain bridge technology is key to the development of BTCFi, but these bridges are inherently risky. In recent years, cross-chain bridges have been targeted by attacks, leading to significant financial losses. Ensuring the security of cross-chain bridges and preventing risks from centralization or technical failures remains a significant challenge for BTCFi.

1. Difficulty in Accurate Price Feeds from Oracles

The Bitcoin blockchain’s architecture restricts the deployment of oracle services in the same way as projects like Chainlink on Ethereum. This limitation makes deploying oracle systems within the BTCFi ecosystem more complex, and may require relying on second-layer or sidechain solutions. In terms of cross-chain bridges and price synchronization challenges, BTCFi will likely rely on cross-chain bridges to map Bitcoin onto other chains for cross-chain price syncing. As a result, BTCFi faces greater technical and security challenges regarding oracle accuracy compared to Ethereum.

1. Finding Its Own Development Path, Not Just Mimicking Ethereum

The core goal of Bitcoin’s design has always been security over functionality. This priority will continue in BTCFi, where security will always take precedence over functionality. Bitcoin’s adoption globally is mainly concentrated in value storage and payments, so BTCFi will likely focus on financial products related to payments and value storage. The concept of PayFi is not only applicable to Solana but is even more suited to Bitcoin.

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