How does Bitcoin DeFi work?

How does Bitcoin DeFi work?

How does Bitcoin DeFi work?

Decentralized finance (DeFi) is revolutionary. A new financial system that anyone can use, unhindered by borders and antiquated banks that are closed on the weekends. Investors are curious about Bitcoin DeFi, and how they can use the world’s most popular cryptocurrency in this rapidly expanding ecosystem.  

In this article we’ll look at how Bitcoin DeFi works, which protocols have the most liquidity, and what you can do with your Bitcoin on blockchains like Ethereum and Stacks.


    How DeFi for Bitcoin works

    Bitcoin was designed to be as simple and robust as possible. Complex systems are prone to failure (crypto bridges, for example), and Bitcoin was designed to be an unhackable store of value that will last a lifetime. To that end, Bitcoin doesn’t have native support for smart contracts, and so there is no Bitcoin native DeFi on the base layer.

    All things Bitcoin DeFi either happen on a second layer, like the Lightning Network, or on another blockchain. Currently the Lightning Network has about $100 million in network capacity, making it a comparatively small player in the Bitcoin DeFi space. Ironically, most of the largest Bitcoin DeFi projects are actually on Ethereum.

    To use Bitcoin on another blockchain you need to bridge the coins. There are decentralized services that connect Bitcoin to Ethereum, like renBTC. However, these protocols have been unable to gain a lot of traction. That’s partly because of fees and also partly because of smart contract risk. Decentralized protocols tend to be more complex, which introduces more room for exploits.

    Even though it’s a centralized service, Wrapped Bitcoin (WBTC) is by far the most popular version of tokenized Bitcoin on Ethereum. Here’s how the protocol works.

    • An investor deposits BTC with the WBTC DAO
    • The deposited BTC is locked up and the DAO issues WBTC in direct proportion to how much BTC was deposited
    • WBTC is an ERC20 token and the investor receives the token in their Ethereum wallet
    • At any point, the investor can return WBTC to the DAO and get their BTC back

    WBTC’s market cap on Ethereum is currently $5.4 billion, making it the 18th largest cryptocurrency in the world. A lot of investors want to use Bitcoin DeFi! Here are just a few of the use cases for WBTC on Ethereum:

    • Deposit WBTC in MakerDAO and take out a collateralized debt position (CDP) against the value of the coins. The current borrowing fee is a very reasonable 0.75% for users that collateralize their loan at 175%. Another vault only requires a 145% collateralization rate, however, the annual borrowing fee is 2.25%. More information is available here
    • Deposit WBTC into a borrowing platform like Compound or Aave to earn a yield. You can check the deposit rates for WBTC using DeFirate.com
    • Trade on Uniswap. WBTC trades against dozens of tokens on Uniswap

    DeFi on Bitcoin
    Bitcoin borrowing rates on MakerDAO- IMG Source

    While WBTC has been around since 2019, and is the most trusted Bitcoin DeFi option, the standard is somewhat centralized. For example, BitGo custodies the Bitcoin deposits from users. The company also runs a KYC/AML check on all investors before they can mint new WBTC.

    There’s big demand for a more decentralized DeFi Bitcoin solution, and one protocol believes they’ve found the answer.


    Stacks DeFi

    Investors who don’t like the DeFi Bitcoin options available on Ethereum might want to check out the Stacks blockchain. Stacks is unique in that it uses a “Proof of Transfer” security mechanism to achieve consensus. Basically, Stacks uses the minting of Bitcoin to secure its own blockchain (more technical details are available here). The implication is that if you trust Bitcoin, you can trust Stacks.  

    The Proof of Transfer consensus mechanism on Stacks - IMG Source

    Stacks uses its close integration with Bitcoin to support an ecosystem of decentralized Bitcoin DeFi applications. According to Stack’s website, its dapps “are decentralized since they don't depend on any centralized platform, server, or database to function. Rather, they use the Stacks blockchain to authenticate users and facilitate read and write requests for them without any single point of failure or trust.”

    A list of all the decentralized applications running on top of Stacks is available on their website. One of the more notable examples is Bitcoin domain names, a Stacks based DeFi Bitcoin application that lets users register a .BTC domain. This is a DeFi for Bitcoin protocol competing with Ethereum’s ENS domain name service.

    Bitcoin domain names - IMG Source

    Then there is Arkadiko, a decentralized borrowing platform known for its self-repaying loans. Also popular is Gamma, a NFT minting protocol and marketplace for Stacks users.

    While the stacks DeFi for Bitcoin ecosystem isn’t as large as Ethereum’s, it remains one of the best solutions for BTC investors who don’t want to use WBTC.

    The Gamma NFT protocol on Stacks - IMG Source

    DeFi on Bitcoin applications

    Due to Bitcoin’s architecture it’s difficult for the blockchain to have a native DeFi ecosystem. Although the Taproot upgrade on Bitcoin did introduce the possibility for certain types of smart contracts, they’re less complex than what’s possible on a blockchain like Ethereum or Polkadot.

    Ethereum’s Bitcoin DeFi ecosystem has the most liquidity, but Stacks is also a viable option for investors who want to use their BTC for more than just sending transactions.


    How to buy Bitcoin


    You can buy Bitcoin (BTC) and other cryptocurrencies in Exodus, in any way you prefer:

    This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.

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