CeFi vs. DeFi

What are CeFi (centralized finance) and DeFi (decentralized finance)? In the blockchain world, CeFi is the use of cryptocurrencies to conduct financial activity (borrow, lend, stake, etc.) via centralized exchanges, such as Coinbase and Binance. DeFi focuses on decentralizing this practice by implementing smart contracts, dApps, and decentralized autonomous organizations (DAOs). DeFi’s main goal is to eliminate or limit the number of intermediaries, fees, and regulations inherent in CeFi systems. Thus, DeFi gives individuals more control, freedom, and opportunity to effectively capture yield on their assets.

Ever since DeFi began its boom in 2020, the majority of projects have been built on Ethereum and newer L1s, such as Solana and Avalanche. But why not Bitcoin? After all, the Bitcoin network has a longer track record and is well-known for its decentralization. The reason for Bitcoin’s lag in DeFi lies within its design. Although the network is secure and censorship-resistant, its programming language doesn’t support loops or complex flows. This makes it incredibly difficult to devise fully-expressive smart contracts directly on the base layer.

In addition, because the Bitcoin blockchain can handle so few transactions per second, the more people transact on the network, the more expensive it becomes for users to get their transactions included in a block. In 2021, the average Bitcoin transaction cost was over $10, while the fees of rival networks remained as low as fractions of a penny. Its 10-minute block time acts as another drawback since DeFi use cases typically require rapid settlement of multiple transactions. Therefore, Bitcoin’s architecture makes it a great store of value but presents scalability challenges. This is the reason why Ethereum and other networks have dominated the DeFi project space with their smart contract-friendly platforms.

Traditionally, Bitcoiners who want access to DeFi opportunities have done so via wrapped versions of Bitcoin, the most prominent being wBTC and HBTC. This lets Bitcoin holders embrace DeFi through the use of tokens pegged 1:1 to Bitcoin. In fact, there are currently about 262,000 tokenized Bitcoin on Ethereum. While all of these wrapping solutions have different degrees of reliability and security regarding their bridging mechanism, any sort of wrapped Bitcoin version on Ethereum is ultimately dependent on Ethereum’s underlying base layer blockchain. Therefore, they don’t inherit any of Bitcoin’s security. Because of this drawback, sidechains and second-layer protocols have been developed to satisfy Bitcoiners’ hunger for DeFi action while also striving to maintain Bitcoin’s core tenets.

Ordinals and Inscriptions 2023

On January 20, 2023, the Ordinals Protocol was created on Bitcoin. This breakthrough allowed for the embedding of any type of file into the smallest unit of Bitcoin, a Satoshi, thereby tracking its movement across the Bitcoin network. The result was an on-chain tracking of file ownership, effectively birthing a new kind of Non-Fungible Token (NFT) native to the Bitcoin blockchain.

The idea of leveraging Bitcoin's block space for use cases other than traditional financial transactions is not a new one. In 2010, initial ideas of a DNS system founded on Bitcoin materialized into Namecoin in 2013. During this evolutionary phase, "Colored Coins" became the nomenclature for protocols enabling the marking, or "coloring", of unspent transaction outputs (UTXOs) for deployment in off-chain protocols. The initial period allowed virtually unlimited data storage in a transaction, as long as it adhered to the scripting system semantics and miners received appropriate fees. This functionality was capitalized upon in early systems like Counterparty, which made its debut in 2014 and initially minted tokens using a script originally intended for multisig transactions.

The unrestricted storage potential, however, was soon identified as a threat to Bitcoin's long-term scalability. This was primarily because all Bitcoin nodes needed to actively monitor all UTXOs for transaction validation. Outputs containing extraneous data were deemed unspendable and were merely storage burdens for nodes unconcerned with the specific data or protocol. Essentially, they became non-productive elements.

The v0.9.0 release of Bitcoin Core in March 2014 introduced OP_RETURN as a standard to tackle this issue. OP_RETURN allowed senders to mark an output as unspendable, signaling nodes to disregard these outputs, thus not inflating the UTXO set. A subsequent modification capped the size of data in an OP_RETURN output to 40 bytes and later to 80 bytes. OP_RETURN quickly became a popular means to add arbitrary data to the Bitcoin blockchain. Counterparty transitioned to using OP_RETURN, facilitating the creation of the first blockchain-based NFTs. Even today, it's simple for anyone to record data such as a short message in the Bitcoin blockchain using OP_RETURN.

Inscriptions: A New Age of Digital Artifacts

Inscriptions offer a novel way of recording arbitrary data—or "digital artifacts" as the ordinals documentation refers to them—on the Bitcoin blockchain. An inscription represents a Bitcoin-native digital artifact, also known as an NFT, and it doesn't necessitate a sidechain or separate token. These inscribed satoshis can be transferred using Bitcoin transactions, sent to Bitcoin addresses, and held in Bitcoin UTXOs.

Conversely, Inscriptions are an innovative form of NFT. They embed the raw file data directly into the Bitcoin blockchain, rather than referencing an external source. They can be text, video, images, etc., although, text-based Inscriptions are the large majority (image below). This peculiarity of incorporating the raw data within the blockchain rather than pointing to an external file sets Inscriptions apart, imparting them a unique status in the realm of digital assets.

In contrast to the early Colored Coin protocols and OP_RETURN, which inserted data into outputs, inscriptions incorporate their data into the transaction's witness data. The segregated witness ("segwit") upgrade activated in 2017 and Taproot in 2021 facilitated a system like inscriptions by easing some of the size restrictions imposed on witness data. These upgrades also offered a discount for data housed in a separate data structure reserved for the witness, effectively increasing the block size to a potential 4MB.

The inscription protocol utilizes an "envelope" to store data—essentially a Bitcoin script crafted in a way that prevents execution. A digital artifact is thus established by encoding the artifact's data—say, a jpeg's bytes—within such an envelope. The inscription occurs on the first satoshi of the first output of the transaction where the envelope is unveiled, which only happens upon spending.

BTC inscriptions 2023 — Source: Galaxy Digital Research

Ordinal Theory: A New Perspective

Proposed by developer Casey Rodarmor in 2022 (though the concept dates back to 2012), "ordinal theory" offers a novel way of "coloring" bitcoins without additional data. Instead, it establishes a system at the social layer—one that anyone can opt to follow, dating back to the first bitcoin block ever mined. Ordinal numbers linearly order a set of numbers in mathematics. "Ordinal theory" seeks to do the same for every single satoshi (the smallest unit of Bitcoin currency) ever minted.

Since the Bitcoin protocol doesn't explicitly track satoshi movements, ordinal theory introduces a theoretical system to do so. This becomes essential for tracking and moving inscriptions made on those satoshis. Similar to earlier Colored Coin protocols, if you can track a specific coin or set of coins and associate an asset with those coins, you can trade both the coin and the associated asset. If an asset, such as an image, is connected to a particular satoshi, only the owner of that satoshi can "own" the asset. By following ordinal theory, sending that satoshi in a transaction essentially transfers ownership of the associated asset, and anyone interested in verifying the ownership can independently audit this transfer.

Further enhancing this concept, an incognito user named "domo" identified a mechanism to generate fungible tokens using the Ordinals Protocol. The process entails inscribing JavaScript Object Notation (JSON) onto Bitcoin (Satoshis) using the Ordinals Protocol. This procedure, known as "Deploying" a BRC-20, requires specifying a ticker, a cap on the number of tokens, and a mint limit. Remarkably, users can mint these tokens at no cost – indeed, all BRC-20 tokens were minted freely without any pre-mining.

The transferability of BRC-20 tokens is conditioned upon a token project reaching its maximum mint limit. Transfers are also facilitated through inscription, where a user can encode a transfer JSON equivalent to the quantity of tokens they intend to dispatch.

The Dawn of BRC-20 Tokens

The cryptocurrency landscape has been invigorated by the advent of the BRC-20 token standard, a Bitcoin-based protocol inspired by Ethereum's renowned ERC-20. Memecoins, such as Pepe (PEPE) and Memetic (MEME), have been instrumental in the BRC-20 surge, a development that has led to the minting of thousands of unique tokens.

Understanding the BRC-20 Standard

BRC-20, although similar in many respects to the ERC-20 protocol, diverges in several critical areas. Notably, BRC-20 tokens are minted and transacted through the Ordinals protocol, which does not rely on Ethereum's smart contract system. This distinction necessitates the use of a Bitcoin wallet for the minting and exchange of BRC-20 tokens.

The BRC-20 standard's influence is evidenced by the market capitalization explosion of BRC-20 tokens, which recently reached $120 million. The BRC-20 protocol leverages Ordinal inscriptions of JSON data to create a collection that operates much like fungible NFTs. While the BRC-20 has demonstrated its potential to mimic ERC-20's fungibility, its practical applications are presently quite limited.

In comparison to ERC-20 tokens, which can be employed as collateral across Ethereum's myriad decentralized applications, BRC-20 tokens are largely confined to minting and transfer functions. However, asset sales can still be performed on-chain using escrow or emblem vault functions due to the lack of native Bitcoin decentralized exchange solutions.

The Birth of BRC-20 Tokens

The BRC-20 standard allows any individual to mint tokens for free (excluding transaction fees) in amounts specified by the token contract during deployment. The protocol precludes the pre-mining of asset issuances.

Over the course of Q2 2023, the total market cap of BRC-20 tokens has skyrocketed, rising to ~$620M on May 9th. This meteoric growth has been accompanied by a massive increase in individual BRC-20 tokens. In an unprecedented development, BRC-20 token transactions have exceeded the original volume of Bitcoin transactions on the blockchain. From April 29 to May 2, BRC-20 transactions accounted for over half of the Bitcoin blockchain's activity, surpassing standard BTC transactions.

The Implications of High Transaction Fees

The surge in BRC-20 transactions has also led to a rise in transaction fees and congested mempool due to the increased token activity. Since its inception in late April, the network has yielded an additional ~120 BTC in transaction fees for miners.

BTC mempool clogged may 2023 — Source: mempool.joenicke.de

Bitcoin's Taproot upgrade, ironically, is the reason for this increase in fees. This upgrade inadvertently created a new design space that allowed users to inscribe arbitrary content on the blockchain. Although the creation of BRC-20, which utilizes an unconventional distribution method, has been the immediate trigger for this surge, the Ordinals (Image NFTs) have largely dominated the discourse.

The "proof of burned fee" mechanic, where users must forfeit transaction fees to generate new tokens, has driven transaction fees to prohibitive levels in the short term, pushing out other forms of conventional usage.

The Future of BRC-20

The current fervor for minting BRC-20 tokens will likely subside relatively soon. The situation appears to be a passing event, akin to the Otherside mint on Ethereum, rather than a long-lasting phenomenon. Nevertheless, it is undeniable that Ordinals and Inscriptions have unveiled a significant latent demand for Bitcoin blockspace, launching us into a higher fee regime, even if this immediate spike will dissipate in due course.

Certain critics have expressed concern about the high fees obstructing the introduction of newcomers to Bitcoin. However, this viewpoint represents a misunderstanding of the network's nature. Base layer settlements are a finite resource and cannot be expected to remain inexpensive indefinitely. The settlement assurances sought should align with the transaction's nature. For instance, you don't need a bank wire level of assurance to buy a coffee, and you don't need a base layer transaction to settle a $5 test payment to a friend.

Embracing the High Fee Environment

Those Bitcoiners who are frustrated by the high fees should instead focus on the slow development of Layer 2 solutions in the Bitcoin space. The rise in fees should not come as a surprise: data shows that fees have exceeded $50 per transaction at certain points in both 2021 and 2017. Fees will always mirror the market's demand for Bitcoin blockspace, and if your desired usage mode is priced out, that simply means that base layer Bitcoin isn't the right network for you.

The increased fee pressure should be viewed positively by those small blockers who have remained intellectually consistent from 2017 to today. It acts as a catalyst for the further adoption of established L2 networks like Lightning, and where Lightning falls short, alternative L2 systems. As is true with all commodities, high prices are the solution to high prices. As a venture capitalist, I am heartened by the entrepreneurs I have been meeting recently who have started designing novel L2s that explore alternative design spaces. In particular, I am optimistic about the potential addition of rollups, which have demonstrated a clear product-market fit on Ethereum, to Bitcoin.

Lightning the Solution?

Lightning is best suited for high-frequency, low-value payments – which certainly doesn't satisfy all types of Bitcoin transactional demand. There are many ways to move dollars around – we have wires, ACH, credit and debit networks, Fednow, physical cash, remittances, money orders, and more. Each has its own set of trade-offs and offers different transactional speeds and settlement assurances, as does Lightning. Let's take a look.

What Is the Lightning Network (LN)?

Contrary to popular belief, Bitcoin is a settlement network—not a payment network. The blockchain acts as an immutable ledger, but the sending and receiving of micropayments are unrealistic due to fees. To overcome this scalability blockade, Joseph Poon and Thaddeus Dryja wrote their 2015 white paper, “The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments,” as they aimed to create a second-layer solution without compromising the security of the base layer. In simple terms, the Lightning Network’s goal is to allow for quick and low-cost peer-to-peer microtransactions occurring on a payment channel that’s not a part of Bitcoin’s base layer until settlement. The most commonly used analogy is the idea of a bar tab. When one goes to a bar with a credit card, they open a tab if they intend to have multiple drinks. This customer and the drinking establishment open a payment channel through the credit card. The patron (responsibly) buys drinks throughout the night and closes the payment channel by paying the final check. The only transactions that the bank sees are for the total amount of drinks, not each individual drink. Lightning works similarly.

The LN lets users open multi-signature payment channels with each other in which they can send fractions of BTC back and forth without paying transaction fees each time. A Lightning channel is bidirectional, meaning both parties can send/receive payments. If one party wants to exit the channel or settle their transactions at any point, they can close the channel and settle back on the base layer. This means users can fit numerous transactions into one large fee-driven settlement. As an L2 to Bitcoin, the Lightning Network is not its own blockchain or token. It maintains its reliance on Bitcoin for its security. The Bitcoin mainchain acts as the final arbiter to any disputes on this secondary layer.

Moreover, an individual doesn’t need to have an open channel with the exact person with which they’re trying to transact. They only need to have a clear path from node-to-node-to-node that eventually links to said person. Routing is what enables transactions between two unconnected nodes to occur through pre-existing linked channels. Routing between otherwise unconnected nodes is enabled by Hashed Time Locked Contracts (HTLCs). An HTLC is a special type of smart contract transaction and is used to allow one party to guarantee payment to another through a shared node connection. Separate individual nodes have the ability to allocate their Bitcoin liquidity to help route payments between two parties that are otherwise not directly connected.

The first Lightning Network implementation was launched in March 2018 and wasn’t possible until the implementation of another Bitcoin enhancement, SegWit. In August 2017, SegWit introduced a new paradigm for block size calculation in the Bitcoin protocol, transitioning from a simplistic 1MB limit to a more nuanced system of Weight Units (WUs). Under this system, each block is constrained to a maximum of 4 million WUs, a change that allows for more efficient use of block space.

The SegWit-modified Bitcoin transaction incorporates a bifurcated structure:

The transactional segment encompasses sender and receiver information, along with input and output specifics. In the WU system, every vByte of this transactional data equates to four WUs, effectively quadrupling its 'weight' relative to the second segment.
The 'witness' segment, on the other hand, houses cryptographic signatures and scripts. In this case, each vByte of witness data carries a single WU - a quarter of the 'weight' of transaction data. This differential weighting system was devised to optimize block space utilization while maintaining robust security measures.

Although Poon and Dryja were not the first to discuss and promote off-chain scalability solutions, their white paper inspired multiple development teams (such as Lightning Labs, Blockstream, and ACINQ) to work on the Lightning Network with the goal of making it the most robust payment layer built on top of Bitcoin.

Use cases and the status of Lightning today

The LN has grown drastically since its inception. Currently, the Lightning channel capacity has crossed $110 million and continues to hit all-time highs as measured by BTC locked in public Lightning channels. Roughly 30% of channels are private, meaning the true value of the network is likely to be understated by current metrics.

With 17,000+ active nodes and over 5,000 BTC deposited into the network, the network’s trajectory is promising. Using the LN becomes easier as the network grows, and since the start of 2021, the number of LN channels has increased from about 12,000 to 90,000. What’s even more encouraging is the number of companies and services building upon the LN.

Bitcoiners have a copious amount of options when it comes to interacting on the Lightning Network. Companies like Casa, Lightning Labs, and Umbrel allow users to run their own Lightning node. Users can also choose from a full range of Lightning wallet solutions, such as Muun, Bluewallet, and Strike. Widely considered to be the most popular LN service, Strike is a mobile app that lets users transact on the Lightning Network with a USD bank account. With Strike, you could pay in bitcoin without being exposed to volatility/tax liabilities or in fiat without taking exposure to BTC. This results in faster settlement times and lower fees. Strike has shown strong signs of growth over the years given its partnerships with big names, such as Shopify, NCR, BitPay, and Robinhood.

The latest improvement to the Lightning technology stack is the proposed Taro upgrade, made possible by the Taproot soft fork. Introduced by Lightning Labs in April 2022, Taro aims to allow Lightning users to send stablecoins and other assets over the LN at virtually zero cost. By leveraging the fiat-to-bitcoin-to-fiat payment railway, those in developing nations with high inflationary pressures or inefficient banking resources could use Taro to facilitate global payments with no tax implications.

So, how does Taro work? Taro doesn’t have its own blockchain as it’s a protocol that’s tied down to Bitcoin’s base layer. Taro assets can be considered Bitcoin UTXOs that exist within a Bitcoin Taproot UTXO. However, a lot of the data that make up a Taro asset is off-chain; only the hash of this data is committed to the Bitcoin base layer. Bitcoin essentially acts as a publication system enabling an embedded consensus for the Taro protocol. Taproot removed some limitations that were put in place by SegWit, like the limit on the maximum per-transaction witness data footprint.

The off-chain data that makes up a Taro asset consists of the Taro signature, the Taro sparse-Merkle sum tree, and the Taproot tree. To create one or more Taro assets, a single on-chain transaction is required. All off-chain data is signed and only the Taproot script tree’s root is committed onto the blockchain. This on-chain root can be verified by relevant parties that are involved in the asset exchange against the root’s off-chain data for the Taro asset in question. This is how one can establish proof that off-chain Taro data/specifications are correct.

In the midst of the current bear market, the future use cases of Taro, the LN, and Bitcoin shine bright. The European Central Bank (ECB) has even gone as far as to identify Bitcoin and the Lightning Network as strong competitors in the global cross-border payments market in its latest Q3 2022 report on the subject. The ability to exchange stablecoins over the Lightning Network gives the entire network more utility and further solidifies the fundamental Bitcoin peer-to-peer network as usable on a global scale. As of 2022, the global cross-border payments market is valued at over $37 trillion. Cross-border payments have long been inefficient and costly, remaining a largely unsolved problem. Lightning certainly appears to have the foundation to address this striking issue on top of providing a host of DeFi solutions as a Bitcoin L2. But despite the high level of optimism surrounding its projects, there are still notable drawbacks to the network.

Identified vulnerabilities, drawbacks, and tradeoffs

Although Lightning has over 5,000 BTC (and growing) deposited into the network, there is roughly 340,000 BTC wrapped and bridged onto Ethereum. Additionally, public node capacity in USD totals less than $100 million, which also pales in comparison to the Total Value Locked (TVL) on a network like Ethereum (~$24 billion as of end-November). Both of these statistics indicate that LN’s size is still relatively small and has a long way to go to compete in the DeFi space.

As of Q1 2023, one of the most significant vulnerabilities detected on the Lightning Network is channel jamming, which is when a bad actor blocks up liquidity by making a payment to themselves via third-party channels and then never revealing the secret, such that the payment never completes. Essentially, a malicious entity or series of entities can use a denial of service attack (DOS) to prevent the routing nodes from successfully passing along the transaction in an L2 peer-to-peer engagement on LN. Because two nodes do not need to interact directly, this prevents execution, resulting in a failed payment. As failed payments build up over time, Lightning’s reliability is compromised, and the network slows down. A bigger issue with this concept is that the payments don’t technically fail, as they can’t time out after the forwarding process has begun between routing nodes. The network effectively faces congestion until it stops functioning entirely.

This can pose serious roadblocks in terms of LN adoption and utility. Lightning is directly competing with various global cross-border payment solutions, including other blockchain networks. Even in the event of widespread stablecoin use, if there is a reasonable expectation that a transaction may fail, this might incentivize consumers to use other payment options. There have been several proposals regarding the best way in which to counteract channel-jamming attacks. One proposal is to increase the slot limit to allow more than the current allotted 483 slots in any given channel. This would make it more challenging to successfully execute a jamming attack, but not impossible. The cost of the attack would linearly scale upwards, but it wouldn’t stop it from being initiated. This solution may not justify the cost as it would require substantial effort to implement from protocol researchers.

Another possible solution is to monitor individual peer activities and implement transaction controls. In theory, this would be able to limit heavy and suspicious inbound activity like that of a DOS attack. The problem is that the privacy technology and pseudonymous nature of Lightning makes identifying individual activities purposefully more difficult. Moreover, privacy is a big appeal to LN users and curbing that benefit may be more harmful than helpful. As of Q1 2023, there’s no consensus as to the best implementations to prevent such attacks. Many proposals are simply untested at scale and could result in a greater deal of cost or difficulty for minimal impact in negating channel jamming attacks.

Another weakness of the Lightning Network is the lack of economic incentives for a router. Solutions are being worked on, such as Lightning Pool, which provides a market where LN users can lease liquidity for payment channels. This creates a financial reward/incentive for other Lightning nodes to provide routing and increase liquidity. Lightning Pool is still in its early-stage growth, however, as it’s mostly individual Lightning users creating the volume as opposed to businesses.

In terms of privacy concerns, it’s important to be cognizant of the history of UTXO(s) you’re using to open a Lightning channel. If you buy bitcoin from an exchange, send it to your wallet, and then use that UTXO to open a Lightning channel, it’s trivial for the exchange to know that you’ve opened this channel. To avoid this type of surveillance, it’s important to CoinJoin your UTXOs if you want to reap the full privacy benefits possible when transacting over Lightning. The Lightning Privacy Research team has explained some of the different ways in which you could CoinJoin before opening a channel. What’s lacking is the ability to close a Lightning channel and have your UTXO sent straight to a CoinJoin. Sadly, there’s no solution for this problem at the moment.

Looking forward

Given its high volume of growth and maturity, many spectators are optimistic about the Lightning Network. Its scalability solution of providing quick and seamless transactions is a vital step towards the goal of building a flourishing DeFi ecosystem on top of the Bitcoin base layer. Even famous BTC bulls, such as MicroStrategy CEO Michael Saylor, have expressed optimism in the establishment of “true decentralization via “LiFi” or Lightning Finance:

Other voices are skeptical regarding Lightning-based DeFi projects, such as Alex Berge, Editor of Bitcoin Development Center:

Whether or not Bitcoin-based DeFi projects will achieve success remains to be seen. But the fact is there are many Bitcoin holders that continue to crave these solutions. The Lightning Network is an important step, but only suitable for payments at the moment. To unlock activities, such as borrowing, lending, and staking, one must explore more general-purpose protocols that offer smart contract capabilities on top of Bitcoin.

Rootstock (RSK)

The Rootstock blockchain was launched in 2017 by IOV Labs with the goal of enabling smart contracts on Bitcoin and making transactions on the network cheaper, faster, and more accessible. RSK is an EVM-compatible protocol that exists on top of Bitcoin. Therefore, it supports programming languages, such as Solidity, Julia, and even Vyper. RSK inherits some of Bitcoin’s security features through merge mining, which is why the team boasts its blockchain as being the most secure and censorship-resistant smart contract platform.

RSK’s native utility token is RBTC. RBTC pays for smart contract fees, similar to ETH on Ethereum. Through merge mining, users can bridge their BTC to RBTC’s 1:1 pegged token and put that RBTC towards Ethereum-like smart contracts. This two-way peg was bootstrapped using a federation of nodes managing a Bitcoin multisignature. However, RSK has transitioned its federation to a PowPeg, a multi-signature management system where nodes have no direct access or control over private keys. Keys are controlled by tamper-proof hardware security modules (HSMs). These HSMs run lightweight RSK nodes, which obey commands originating from an RSK smart contract called the Bridge that orchestrates peg-outs. Only when these commands are confirmed by thousands of blocks produced by the mining network does the HSM then proceed to sign peg-outs requests. This PowPeg security protection greatly reduces the attack surface for the most common security breaches.

In terms of scalability, RSK currently has an average block rate of one block/30 seconds. A simple RBTC transaction consumes 21k gas, so the platform can execute 11 transactions/s. As the first “official” Bitcoin sidechain, RSK has seen a lot of growth and activity.

As you can see, RSK has a large ecosystem with a wide variety of financial services spanning from stablecoins, staking, and wallet support. One of the largest DeFi apps on RSK is Sovryn. Sovryn acts as a DeFi one-stop shop. The app lets you borrow, lend, LP, margin trade, stake, and swap (And even 0% interest loans!) The protocol is non-custodial, censorship-resistant, and runs solely on smart contracts. Their team also recently announced the launch of a stablecoin, Sovryn Dollar, which looks to combine Bitcoin’s decentralization with a stablecoin’s consistency. With these services, Sovryn and the larger RSK community show signs of promise.

However, promising projects still have tradeoffs. Current Bitcoin bridges, such as RSK, still have centralized trust components that can lead to potential points of failure. Merge-mined sidechains could potentially be attacked by malicious Bitcoin miners. As such, Bitcoin holders may reject RSK altogether since the exposure to additional risk may outweigh all of the benefits.

It will certainly be intriguing to follow RSK going forward. Their team is currently working on an integration with Litecoin and, in the past, has worked to present a drivechain proposal to the Bitcoin mailing list for evaluation in 2016. They failed to achieve consensus about sidechain integration as those were turbulent times for the Bitcoin community. Although promising, time is needed for the BTC DeFi ecosystem to mature and for projects like RSK to flourish.

Stacks

Stacks is another smart contract protocol built on top of the Bitcoin base layer. Previously known as Blockstack, Stacks was designed and created by Muneed Ali. Through VC money, the project was transformed into Stacks, and after raising millions in the first-ever SEC-qualified coin offering, the project upgraded to Stacks 2.0 (which rolled out a slew of new features and updates). Stacks and Bitcoin are linked through Proof of Transfer, meaning bitcoin needs to be sent to the Bitcoin network to mine STX (its native token required to pay for transaction fees). To establish consensus over Stack’s transaction history, pseudonymous block creators compete for the right to produce blocks. They do so by bidding Bitcoin through mining to win the next Stacks block, transferring BTC to entities referred to as stackers in the process. The greater the amount of bitcoin transferred, the higher the probability of mining a new Stacks block and claiming rewards in STX.

Stacks Proof of Transfer diagram — Proof of Transfer. Source

Stackers can earn some of the BTC submitted in mining by participating in Stacking, in which they lock their STX for a two-week cycle. This provides value to the network. As miners submit bitcoin, it provides confidence in the STX they’re mining. By holding and locking STX, value accrues to Stacks’ native sidechain asset. The value of STX contributes to security by functioning as an incentive for consensus participants. In summary, Stacks’ full transaction history is broadcasted and recorded on Bitcoin itself. To create a Stacks block, a Bitcoin transaction has to be initiated. This transaction records the hash of a respective Stacks block and makes sure the block is connected to a block on the Bitcoin blockchain. Although Stacks is not EVM-compatible like RSK, the protocol feels similar to other smart contract platforms. Stacks boasts a large and growing habitat as developers recently published 5,000+ contracts having $150+ million capital locked earning bitcoin rewards.

Through Stacks, clients can choose from multiple DeFi solutions. Whether it’s taking advantage of the self-repaying loans through Arkadiko, trading assets from a decentralized exchange, such as ALEX (Automated Liquidity Exchange), or joining a Bitcoin-based lending pool through Zest, there are plenty of options for DeFi advocates. Between all of these projects and the stacking program, the Stacks protocol appears promising. However, concerns still linger.

Stacks holds $35+ million in Total Value Locked (TVL). However, ~95% of this capital is in one protocol, ALEX. For Stacks to truly take off, it is critical that the platform cultivates a thriving ecosystem of developers despite Bitcoin's programming limitations. Traditional Layer-2 (L2) architectures fail to thrive in the Bitcoin ecosystem without foundational changes at the opcode level. This process, historically, has been characterized by slow progress and intense debate among stakeholders.

Bridging and Bitcoin Derivatives on Stacks

Stacks currently lacks a native mechanism for minting synthetic BTC (bridging), unlike its counterparts RSK and Liquid. The BTC derivative employed on Stacks is xBTC, which utilizes Anchorage as the default custodian for the backing. This has posed a significant challenge for Stacks, as many BTC holders harbor apprehensions about using a trusted third-party bridging solution. This reluctance contradicts Stacks' core team's objective of integrating the idle $500 billion BTC capital into DeFi and possibly explains why Bitcoin L2s have struggled to gain traction.

In late 2023, Stacks plans to unveil sBTC, a synthetic BTC asset with a 1:1 peg to BTC maintained through economic incentives involving the STX token. STX stackers are responsible for signing peg-out transactions and maintaining the BTC:sBTC peg in return for the BTC yield they receive from Stacks miners. In this arrangement, miners have the motivation to follow the canonical Stacks chain for STX block rewards and transaction fees.

An important security measure is the sBTC supply cap, set to 60% of the total value of all STX stacked. This cap is designed to protect against malicious actors signing invalid peg-out transactions. This cap is decided by the consensus protocol mechanism that prices the BTC/STX exchange rate using a 90-day moving average. This approach minimizes reliance on centralized oracle providers and bolsters decentralization, albeit with some trade-offs.

A potential issue arises if a stacker controls 70% of the total value stacked. They could unilaterally sign BTC peg-outs, manipulate the BTC/STX exchange rate, or choose a malicious fork on the Stacks chain. In light of the bug experienced in April, if sBTC had been live then, the consequences could have been more severe.

The Stacks and RSK Rivalry: Bridging Bitcoin Smart Contract Development

RSK, another notable player, is attempting to bring smart contract development to Bitcoin, thus posing a significant competitive challenge to Stacks. RSK relies on a ‘Federated Multisig’ approach, which involves a trusted set of signers for its bridge. Herein lies an essential distinction: the element of trust. Stacks stands apart by prioritizing a trustless architecture in line with the original vision of cryptocurrency.

One of the biggest tradeoffs with Stacks is that it uses a smart contract programming language called Clarity, which is Turing-incomplete. As opposed to Turing-complete languages, Clarity is more secure as it is not vulnerable to reentrancy attacks. However, Turing-complete languages, such as Solidity and Rust, tend to be more flexible and more widely used by developers. It will be a challenge to convince developers to build on Stacks and learn another language.

BTC L2s table — Source: Blockworks Research

This is certainly a protocol to monitor closely. Stacks has an assortment of DeFi offerings and has successfully rolled out Stacks 2.0. The project has even set an ambitious goal of having applications built on its infrastructure to hold a collective valuation exceeding Stacks' market capitalization or 3% of Bitcoin’s market cap by July 2023. To accomplish this, they must continue to improve network efficiency and onboard more developers to gain acceptance from onlookers.

Liquid

Liquid is a federated layer with Bitcoin peg-in and -out functionality, built upon the open-source sidechain-capable platform: Elements. Liquid’s two-way peg is a permissioned 11-of-15 federated multi-signature account based on custom HSMs. Multi-sig account holders are chosen by the Liquid Network governance, a network consisting of 60 members and three different boards. These account holders are called functionaries. Their responsibility is to create the sidechain’s blocks by processing transactions within the Liquid Network. Functionaries secure the two-way peg to Bitcoin by holding on-chain BTC in their multi-signature account using HSMs. Similar to Proof of Authority, these functionaries are in charge of the sidechain consensus. They take turns to propose new blocks, which are then verified by other federation members, achieving consensus in a byzantine fault-tolerant process. Originally proposed by Adam Back’s Blockstream, Liquid is currently operated by the Liquid Federation, a group of cryptocurrency businesses that make up the 15 functionaries. Since its founding in 2014, Blockstream has raised over $210 million from major institutional investors.

Liquid’s native asset is L-BTC, which is created through its two-way pegging structure. When creating L-BTC, on-chain BTC is locked on Bitcoin’s blockchain through a multi-signature setup secured by Liquid’s functionaries. All L-BTC is verifiably backed one-to-one by on-chain bitcoin. As of December 2021, the network’s L-BTC is pegged to 3,378 BTC.

What features does the network offer? For starters, faster transfer speeds. Bitcoin blocks are validated every 10 minutes, while bitcoin transfers on Liquid are validated within a two-minute average. This helps traders move their funds between accounts more quickly without long confirmation times. Activity is also more confidential on Liquid as the sidechain hides asset types and transaction figures from any third-party monitoring services. This is all while maintaining the ability to validate transaction amounts, wallet balances, and the asset’s total supply.

Liquid has a variety of DeFi projects ranging from NFTs to atomic swaps. One of its most notable protocols is Fuji.Money. Fuji lets users borrow bitcoin-backed stablecoins and synthetic assets using the Liquid Network as an underlying ledger and settlement layer. After the locking of L-BTC as collateral in a smart contract, a new contract can be opened to borrow any asset available on the Fuji platform. The project aims to let borrowers irrevocably grant redemption rights to other entities using a special control token.

Within the Liquid Network, 66% approval of functionaries is needed to produce a valid block. Should the 66% not be met, the chain freezes as it can no longer produce valid blocks. Many dedicated Bitcoiners will be skeptical of this centralized model since power over the Liquid Network is held in the hands of a select few. Consequently, BTC proponents are expected to gravitate toward other L2s, such as the Lightning Network, before exploring Liquid.

One of the leading benefits of Liquid is its commitment to confidentiality. Liquid also offers more custody types than the Lightning Network. However, will Bitcoiners be enticed by these benefits if it means they have to adopt L-BTC, trust Liquid’s governance model, and sacrifice two minutes of settlement speed?

The Liquid Network acts as a key infrastructure in the effort to make Bitcoin competitive in the DeFi space. Its solutions provide various functions and scalability possibilities. However, future growth and adoption will be the deciding factor. Bitcoin enthusiasts may prefer the LN design or consider Liquid’s governance board as being a direct violation of Bitcoin’s original vision.

Conclusion

Although there are other layers and sidechains attempting to build DeFi projects upon Bitcoin, these are the players making the biggest strides in the space. At the time of writing, Bitcoin has a $325 billion market cap, of which most of this capital remains dormant in BTC wallets. Although Ethereum dominates the DeFi space, Bitcoin is poised to awaken some of this capital to be used in various financial activities. For this to happen, Bitcoiners need to gain confidence in the security and reliability of these layers/sidechains

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