BTCFi: An innovative journey to unlock Bitcoin’s trillion-dollar market value

Author: YBB Capital Researcher Ac-Core

TL;DR

The general background of BTCFi is: 1. The narrative of Ethereum and Ethereum killer chains is gradually weakening and the infrastructure construction has become saturated. The industry as a whole lacks fresh narratives, and only superficial words are 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;

The prerequisites for the development of BTCFi are: cross-chain interoperability, solving the second-layer expansion solution (Layer2), smart contract functions, and no need for one-click repeated construction of infrastructure and development tools;

1. 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 financial derivatives such as staking, lending, and market making to combine interest-bearing and obtain income, that is, to introduce DeFi into the native Bitcoin ecosystem to activate more financial attribute value.

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 Fomo sentiment of the market. Looking at the current situation 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 route of Ethereum, but the essential problem it faces is how to expand the block without destroying the native consensus of Bitcoin or hard forking.

As of October 1, the data statistics show that the Bitcoin ecosystem has frequently raised funds, with 14 public financings totaling more than 71.1 million US dollars. The only opportunity for BTCFi at present is that the Bitcoin ecosystem is still full of opportunities for both users and VCs, and it 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 have 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 of the market: index asset protocol

Index 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", and 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 available in the Bitcoin ecosystem, and also allowing these tokens to be split and combined like ordinary Bitcoin, paving the way for the potential AVM in the future.

Other asset protocols

ORC20:A token standard based on the Ordinals protocol extension of Bitcoin. The Ordinals protocol allows users to give a unique mark to a single satoshi (the smallest unit of Bitcoin) on the Bitcoin network. The goal of ORC20 is 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: is 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 the token, and circulate it in the Bitcoin network for the creation and management of digital assets.

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

The development of BTCFi is inseparable from DeFi, and the further expansion of DeFi depends on the expansion of the 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 all face a common technical difficulty: the need to verify the "orthodoxy" of Bitcoin.

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

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

BTCFi's currency-based Buff income comes from: 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 from the market side, achieving fast transactions, Turing completeness and interoperability, 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 (Proof) 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 degree of 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.

2.3 UTXO+Client Verification

In terms of originality 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 spending. 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 Bitcoin's security, but there is still much room for improvement in data transparency, ease of operation, and perfection of development tools.

2.4 Changing the large block of 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 at 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 to increase from 1MB to 2MB within six months on the same day. The Bitcoin Cash plan was first proposed by Bitmain, a Chinese Bitcoin mining machine company, and the related hard fork tokens include BSV.

3. The 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 dormant for a long time like Ethereum, and the only storage method is a secure hardware wallet or a trusted centralized exchange. How can BTCFi circulate such a huge market value step by step through on-chain financialization?

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 capabilities in its architecture. BTCFi’s first priority is to develop trusted cross-chain bridges so that Bitcoin can participate in DeFi applications in other blockchains with smart contract capabilities. These bridges enable Bitcoin to be “mapped” to other chains, achieving more functionality while retaining its value;

2. Layer 2 Scaling Solutions

Compared to Ethereum’s Layer 2, Bitcoin’s Layer 2 is more difficult to balance between the triangular 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-creating 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. Developers are exploring the provision of smart contract support for Bitcoin through second-layer solutions (such as RSK, AVM, Bitvm) or side chains. This will enable Bitcoin to directly support DeFi functions such as lending, liquidity provision, and derivatives;

4. Powerful developer tools and infrastructure

Developers need complete 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 this type of bridge itself has 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 the cross-chain bridge and prevent the risks brought by centralization or technical failures is still an important challenge facing BTCFi;

4. It is difficult for the oracle to accurately capture the price

Due to the architectural limitations of the Bitcoin blockchain, the oracle service 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 the second layer or side chain solutions. In terms of the dependence on the cross-chain bridge and the problem of price synchronization, in the future BTCFi may mainly rely on the cross-chain bridge to map Bitcoin to other chains to achieve cross-chain price synchronization. Overall, it faces greater technical and security challenges than Ethereum in terms of oracle accuracy;

5. Can it find 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.