20.12.2024
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Bitcoin-based decentralized finance (DeFi) has become a vital part of the Bitcoin ecosystem due to the increasing rise of scaling solutions, such as Layer 2s, which have unlocked more use cases and opportunities for Bitcoin users.
In this guide, we will discuss Bitcoin-based DeFi, why it makes sense to build decentralized financial services on Bitcoin, and how layers have opened more opportunities for the Bitcoin ecosystem.
Decentralized finance (DeFi) is a movement that provides internet-native financial services, such as trading, borrowing, and lending, by leveraging public blockchain networks.
By using blockchain technology, smart contracts, and digital assets, DeFi platforms can offer services in a more decentralized manner, reduce or eliminate the need for intermediaries, and, in turn, make these services cheaper and more accessible.
Bitcoin DeFi is now an emerging sector in the digital asset market after being Bitcoin’s missing ingredient for a long time.
The base layer—the Bitcoin blockchain—was not suitable for supporting the complex solutions needed for decentralized finance. Therefore, smart contract-enabled Bitcoin Layer 2 solutions had to be implemented first.
In 2023, the Ordinals protocol emerged, giving birth to fungible token protocols on Bitcoin, such as BRC-20 and Runes. This development has contributed to the advancement of DeFi on the oldest blockchain. The appearance of various new protocols has expanded the utility of the largest cryptoasset network beyond storing value and handling payments.
The hallmark of Bitcoin DeFi has been enabling smart contracts built on top of this blockchain and transforming BTC into a productive asset for its hodlers.
However, Bitcoin-native DeFi is just making its first steps while developers continue to build applications that might also generate extra demand for BTC.
Building DeFi on Bitcoin enhances the utility and reliability of these projects that can leverage the network’s infrastructure, decentralization, and security, which are considered to be stronger than on other blockchains.
Let's explore the key reasons why developing DeFi for Bitcoin is worthwhile.
Bitcoin has no centralized authority to oversee its daily operations and the development of the entire network. While the same might be claimed by other blockchains too, Bitcoin is by far the most decentralized cryptocurrency network.
The reason for this is that the blockchain relies on a proof-of-work (PoW) consensus mechanism involving thousands of independent nodes and miners to validate transactions, compile them into blocks, and add them to the blockchain. Within the blockchain community, the consensus is that PoW ensures better decentralization than other algorithms, such as proof-of-stake.
Meanwhile, anyone can suggest a Bitcoin update, which is then carefully considered in public by a vast community of developers and anyone else willing to join the debate, as there is no central authority governing this process.
PoW, which secures Bitcoin and makes it immutable, requires miners to commit their computing power to mine the blockchain. In return, they earn rewards and collect fees for processed transactions.
Currently, the total computational power of Bitcoin, or hashrate, fluctuates around 600 exahashes per second, meaning that quintillions of guesses are being submitted to the blockchain every second in an attempt to find a block and collect BTC. No other blockchains that use PoW come even close to this.
In theory, a bad actor would need to take over at least 51% of the hashrate to make changes to the blockchain, which would be largely limited to the ability to alter their own transactions and could be quickly averted. However, in practice, this is nearly impossible due to the extremely high attack cost and the complexity involved. This level of security cannot be claimed for other blockchains, many of which have actually suffered multiple attacks.
While many cryptoassets are accessible for trading 24/7, BTC is the most liquid. This means it is easier to find a buyer or seller of BTC than any other cryptoasset. This is especially important for large transactions, as the more liquid an asset is, the less a transaction might affect its price.
This property of Bitcoin is valued by large investors who seek the highest liquidity and, in turn, help make Bitcoin even more liquid, further increasing the attractiveness of BTC.
Since its first block was released on January 3, 2009, Bitcoin has only twice experienced downtime events, with the last one occurring on March 12, 2013, lasting around six hours. In other words, Bitcoin has been 100% operational for more than 11 years. This level of stability is ideal for developers who need to build reliable DeFi applications.
In comparison, in May 2023, Ethereum experienced two performance hiccups when blocks on the second-largest blockchain by market capitalization stopped being finalized.
Bitcoin, as the first cryptocurrency, is also by far the best known in this sector and has the strongest brand not only within the cryptoasset industry but also in the mainstream world.
Large institutional investors and traditional finance giants typically consider dealing with bitcoin before any other cryptoasset due to its decentralization, security, and reliability. Moreover, when it comes to regulation, BTC has the clearest status as a commodity, while the status of many other cryptoassets remains uncertain.
Because of its first-mover advantage and real-world adoption as a monetary asset, Bitcoin enjoys a large network effect. Network effects occur in monetary and communication networks, where the total value of being on one common network is higher than the total value of being on separate networks. When everyone who wants to transact uses the same money and the same payment system, for example, transactional friction is much lower.
Because of Bitcoin’s network effect, users and financial protocols will tend to find their way to Bitcoin as the center of gravity. This gives confidence to innovators, developers, and users that Bitcoin is the place to be as the ecosystem continues to evolve.
Building DeFi for Bitcoin largely happens on Layer 2 networks. Let’s explore why.
Building directly on the Bitcoin blockchain is challenging due to its limited programmability. However, with the emergence of protocols such as the non-fungible token protocol Ordinals and the subsequent creation of fungible BRC-20 and Runes tokens, this might change.
While Ordinals, BRC-20s, and Runes are just tokens issued on Bitcoin and are not DeFi per se, their development might open doors for more DeFi-like solutions on the mainchain.
Layer 2 networks were introduced as a way of scaling Bitcoin and introducing programmability to the blockchain without modifying it. This means these L2s can help Bitcoin scale while upholding Bitcoin’s security and decentralization.
With L2s providing sufficient programmability, developers can build a wide range of DeFi applications that support trading, lending, borrowing, staking, liquidity provision, and more.
Currently, there are multiple live Bitcoin L2 solutions. The most popular of these is the Lightning Network, which facilitates fast and cheap BTC transactions. Others are smart contract-enabled layers such as Rootstock, Stacks, and Build on Bitcoin. Some of these L2s also use their own native assets, which might be completely separate tokens or pegged to BTC.
Read on to find some of Bitcoin’s most exciting use cases in decentralized finance.
Token issuance involves creating and distributing digital assets. By scaling the base layer and introducing programmability to Bitcoin, new protocols like BRC-20, Runes, and L2 solutions have made it possible to issue tokens on Bitcoin. This includes stablecoins, which can now be issued on Bitcoin’s second layers, such as the Lightning Network. Due to their relative price stability, stablecoins like DLLR are ideal for trading in decentralized finance.
Bitcoin DeFi has made it possible for investors and traders to access a range of tradeable assets secured by the Bitcoin blockchain, including BTC itself. L2s also help create decentralized exchanges and facilitate atomic swaps between blockchains.
With the help of L2s, DeFi protocols are also bringing lending and borrowing services to Bitcoin. For example, a lending protocol allows you to lock your BTC into a lending pool, enabling you to earn interest on your loans while still capitalizing on BTC appreciation. This way, your assets no longer remain idle but generate extra income despite market volatility.
Meanwhile, these DeFi solutions also allow you to borrow necessary funds using your BTC as collateral. However, remember that both lending and borrowing come with their own risks.
With the emergence of Bitcoin layers, liquidity provision is now also a reality on Bitcoin. By providing liquidity to decentralized automated market maker (AMM) pools in exchange for trading fees, BTC holders can earn rewards.
Sovryn, which operates on Rootstock and Build on Bitcoin, is a feature-rich DeFi platform for Bitcoin that you can use for decentralized swapping, lending, borrowing, margin trading, and more. Moreover, it is also a protocol for a non-custodial, BTC-backed stablecoin, the Sovryn Dollar (DLLR).
On Sovryn, you can get 0% interest loans on BTC that issue a USD-pegged stablecoin, quickly exchange BTC and RBTC, the native token of the Rootstock sidechain, bridge your assets between Rootstock and Ethereum, enjoy instant trading on Sovryn AMM, earn fees by lending tokens, stake SOV, the native token of Sovryn, and more.
Furthermore, Sovryn is the foundational architect of BitcoinOS, a platform for scalable, interoperable smart contracts on Bitcoin that aims to bring even more DeFi use cases to the Bitcoin ecosystem.
Connect your wallet to the Sovyrn dapp here to start your Bitcoin DeFi journey!
