Original title: "BTCFi: An innovative journey to unleash Bitcoin's trillion-dollar market value"

Original author: Ac-Core, YBB Capital Research

TL;DR

●     The general background of BTCFi is: 1. The narrative of Ethereum and Ethereum killer chains is gradually weakening and infrastructure construction has become saturated. The industry as a whole lacks fresh narratives, and only superficial word creation is 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 various expansion plans need to face the technical difficulties of "orthodoxy" verification;

●     BTCFi The prerequisites for development 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 faced by BTCFi are: the limitations and liquidity issues of the Bitcoin protocol, the security and trust issues of the cross-chain bridge, and the difficulty of the oracle to accurately capture prices, and to find a development path that belongs to BTCFi.

I. 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 means Finance. Therefore, 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 staking, lending, market making and other financial derivatives tools to combine interest and obtain income, that is, to introduce DeFi into the native Bitcoin ecosystem to activate more financial attribute values.

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 market's Fomo sentiment. 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 frequently raised funds, 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. Many protocol assets such as BRC20, ORC20, ARC20, SRC20, and CAT20 have also been born on the non-VC financing asset side. We explored from digital gold BTC to the controversial BTCFI, whether Bitcoin's Fi is a false proposition, and the core discussion point is how to ensure the security of assets and adopt effective expansion methods.

1.3 The first detonation point in the market: Indexed asset protocols

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 possible in the Bitcoin ecosystem. It also allows these tokens to be split and combined like ordinary Bitcoins, and also paves the way for the potential AVM in the future.

Other asset protocols

ORC20: A token standard based on the extension of Bitcoin's Ordinals protocol. The Ordinals protocol allows users to give unique tags to single Satoshis (the smallest unit of Bitcoin) on the Bitcoin network. ORC20 aims to create a token standard similar to Ethereum ERC20, allowing users to issue and trade tokens on the Bitcoin network;

SRC20: Another Bitcoin token standard launched with a similar idea 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: A similar token standard, mainly used to issue custom tokens (Custom Asset Token). Compared with ORC20 and SRC20, CAT20's function 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 tokens, and circulate them in the Bitcoin network for the creation and management of digital assets.

Second, the second-layer expansion plan, who will take advantage of the market potential of BTCFi

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 at present. The trade-offs between feasibility, decentralization and security of different paths are still controversial, and they all face a common technical difficulty: the verification of Bitcoin's "orthodoxy".

Image source: DeFiLlama: Bitcoin Sidechains / Total Value Locked All Chains

By observing the above-mentioned data from DeFiLlama on November 5, 2024, we can also find that among the current sidechain-related projects, the four projects of CORE, Bitlayer, BSquared, and Rootsock have the highest TVL, totaling up to 76.56%. Compared with BTCFi, which also relies on nesting doll income, and "ETHFi", the current BTCFi has the following similar characteristics:

●     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 scheme that allows users to conduct multiple transactions outside the main network and submit 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 Sidechain and Rollup

From the perspective of developing the Bitcoin ecosystem, achieving fast transactions, Turing completeness and interoperability from the market side, sidechain and Rollup are more suitable for the development of Bitcoin's ecosystem. Bitcoin's sidechain and Rollup have strong independence. Rollups are designed to move complex operations to Layer2, and the main network is only responsible for verifying the proofs submitted regularly by Layer2, thereby increasing throughput. This mechanism ensures that the ledger security of Layer2 is consistent with the main network. 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.

2.3UTXO+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 specific implementation of this concept, which was first proposed by Peter Todd in 2016 as the "one-time seal" and "client verification" concepts. 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 payments. In this way, RGB retains the strong security of the Bitcoin network.

Although this solution brings significant efficiency and privacy advantages, it still has some flaws. The user's client only stores transaction data related to itself, resulting in data silos and hindering the development of applications such as DeFi. UTXO + client verification achieves efficient and privacy-friendly off-chain transaction verification by inheriting the security of Bitcoin, but there is still much room for improvement in data transparency, ease of operation, and completeness of development tools.

2.4 Large blocks that change the original consensus

Changing the original consensus also means changing today's Bitcoin. There are hard problems such as consensus and ecological development in realizing the BTCFi vision, which are only explained here.

BCH (Bitcoin Cash) is a hard fork of Bitcoin in 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 on the same day to increase from 1MB to 2MB within six months. The Bitcoin Cash plan was first proposed by Bitmain, a Chinese Bitcoin mining machine company, and the related hard fork tokens include 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 be borrowed and earned interest like Ethereum, and it is in a long-term dormant state. The only storage method can choose a secure hardware wallet or a trusted centralized exchange. How can BTCFi circulate such a huge market value through on-chain financialization step by step?

3.1 Prerequisites for development

1. Cross-chain interoperability

Unlike other smart contract platforms such as Ethereum, the Bitcoin blockchain does not have native smart contract functions in its architecture. BTCFi’s first task is to develop a trusted cross-chain bridge so that Bitcoin can participate in DeFi applications in other blockchains with smart contract functions. These bridges enable Bitcoin to be "mapped" to other chains, achieving more functions while retaining its value;

2. Second-layer expansion solution (Layer2)

Compared with Ethereum's second layer, Bitcoin's second layer is more difficult to balance between the triangle problems, and will more or less abandon the direction of decentralization. But for the market, more centralized development is often more likely to produce new wealth-making effects. How the project team should give the market more wealth effects to make up for the lack of decentralization may be the primary consideration;

3. Smart contract function

In order to support DeFi applications, Bitcoin needs some form of smart contract function. There is no native smart contract in the current Bitcoin network, and developers are exploring second-layer solutions (such as RSK, AVM, Bitvm) or side chains to provide smart contract support for Bitcoin. This will enable Bitcoin to directly support DeFi functions such as lending, liquidity provision, derivatives, etc.;

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 construction of one-click chain issuance.

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 needs to overcome 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 capture prices accurately

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 the oracle system in the BTCFi ecosystem, and it may need to rely on a second-layer or sidechain solution. In terms of the dependence on cross-chain bridges and the problem of price synchronization, BTCFi may rely mainly 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 than Ethereum in terms of oracle accuracy;

5. Can it take its own development path instead of blindly imitating Ethereum

The core goal of Bitcoin's initial design was security over functionality, and even more so in the design of BTCFi, market acceptance 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 article: "Comparison of the four major Bitcoin expansion solutions: Who will truly release the trillion-dollar market potential of BTCFi?"

This article comes from a contribution and does not represent the views of BlockBeats.

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