Bitcoin DeFi: A Guide to Decentralized Finance on Bitcoin
December 5, 2023
Bitcoin DeFi has been growing steadily in recent years, creating Internet-native financial products and services powered by the most secure blockchain in the world.
In this guide, you will find out what Bitcoin DeFi is and its existing use cases.
What Is Decentralized Finance?
Decentralized Finance, or DeFi in short, is a broad term for financial services operating on public blockchains.
DeFi allows users to lend, borrow, earn interest, trade derivatives, and more. These financial products and services are similar to what you typically find in traditional finance (TradFi).
However, unlike TradFi, which is run by centralized institutions like banks, DeFi is run by smart contracts on-chain. There are no intermediaries. Users transact peer-to-peer, giving them more control over their assets while allowing them to pay fewer fees since no third parties are involved.
To access DeFi products, users engage with decentralized apps (dApps) via a self-custody crypto wallet. As of now, with almost every DeFi application, there are no KYC requirements, opening up financial services to anyone with an Internet connection and a digital wallet.
What Is Bitcoin DeFi?
Bitcoin DeFi refers to decentralized financial services and products built on the Bitcoin blockchain or Bitcoin layers.
Due to the limited smart contract abilities on the Bitcoin blockchain, most Bitcoin DeFi activities occur on Bitcoin layers. Bitcoin Layer-2 protocols support expressive Bitcoin smart contracts suitable for establishing a large Bitcoin-secured DeFi ecosystem.
That said, new innovations like the proposed Bitcoin Virtual Machine (BitVM) could bring advanced smart contracts to Bitcoin Layer-1, allowing developers to create DeFi applications on-chain.
Moreover, the emergence of the Ordinals protocol has introduced the DeFi use case of asset issuance directly on Bitcoin in the form of BRC-20 tokens.
At the time of this writing, the total value locked (TVL) in Bitcoin DeFi was $240.24 million. While this amount is low when compared to Ethereum’s TVL of $26.8 billion, Bitcoin has evolved from a blockchain with limited functionality to a network securing a hundred-million-dollar DeFi market.
The graph below shows Bitcoin’s TVL performance over more than 12 months.
How Does DeFi on Bitcoin Work?
DeFi on Bitcoin leverages smart contracts to process transactions on decentralized applications. These self-executing, autonomous lines of code act to replace intermediaries, enabling dApp users to transact peer-to-peer.
Each Bitcoin layer that supports DeFi uses a different smart contract language to power its dApps. For example, the Stacks network is built with Clarity, while Rootstock (RSK) smart contracts are Solidity-based, allowing developers to deploy them on Ethereum as well.
On the contrary, projects enabling native Bitcoin DeFi do so on a very small scale since they work with the protocol as it is, rather than altering the code. They leverage existing features like Unspent Transaction Outputs (UTXOs) to append the data necessary to create fungible or non-fungible tokens.
Having said that, all DeFi transactions settle on the Bitcoin blockchain whether the product is enabled natively or on a secondary protocol.
Bitcoin DeFi Use Cases
Now, let’s take a look at some of the existing and potential future Bitcoin DeFi use cases.
The Lightning Network (LN), a layer-2 network built on Bitcoin, is the largest enabler of Bitcoin DeFi payments. It offers near-instant, high-volume, and cheap transactions between parties.
According to data on DeFi Llama, payments contribute more than half of the Bitcoin DeFi TVL. Currently, the Lightning payments TVL is $187.7 million, as shown in the table below.
Decentralized Exchanges (DEXs)
DEXs are peer-to-peer platforms where users can swap tokens directly from their wallets. These exchanges are built on the Bitcoin layers, such as Stacks and Rootstock. Some of the popular Bitcoin DEXs are ALEX, Velar, and Sovryn.
Bitcoin stablecoins are backed by stable fiat currencies like the dollar. They allow holders to safeguard the value of their crypto asset holdings from high volatility. Moreover, users can mint stablecoins on lending and borrowing protocols by locking up a digital asset as collateral.
RSK has several stablecoins like Dollar on Chain (DOC), XUSD, and BRZ. Additionally, Stacks has a stablecoin known as USDA.
Bitcoin atomic swaps permit users to swap tokens peer-to-peer between the base layer and the layer-2 protocol. This means users can seamlessly move assets between the two layers whenever they wish. Stacks-based LNSwap is a DeFi protocol that leverages atomic swaps, enabling users to swap Bitcoin on-chain and on Lightning with Stacks tokens.
Borrowing and Lending
Borrowers can secure loans without going through an intermediary on Bitcoin-secured lending and borrowing protocols such as Tropykus and Sovryn on RSK or Zest and Liquidium on Stacks. On the other hand, lenders earn interest for lending their crypto assets to borrowers.
Both fungible and non-fungible tokens are being issued directly on Bitcoin and layer-2 protocols like Stacks, Liquid, and RSK. Fungible tokens include stablecoins, wrapped versions of Bitcoin, as well as security tokens.
Decentralized Autonomous Organizations (DAOs)
DAOs are community-led groups established to decentralize the decision-making process of DeFi protocols. Community members who own the governance token of the protocol are allowed to vote on all development proposals.
DAOs have been built on RSK and Stacks by various DeFi protocols like Sovryn, Lydian, and Money On Chain.
Prediction markets on Bitcoin - powered by a type of Bitcoin smart contract known as a Discreet Log Contract (DLC) - could enable users to bet on real-world or blockchain-based outcomes. A DLC is a multisig transaction that uses oracles to execute predefined conditions of a smart contract.
Examples of Popular Bitcoin DeFi Projects
Now, let’s take a look at examples of popular protocols in the Bitcoin DeFi ecosystem.
ALEX is a Stacks-based decentralized exchange with several offerings. Users can swap tokens, stake, earn through yield farming, and trade BRC-20 tokens in a decentralized manner.
Arkadiko is a DeFi lending and trading protocol on the Stacks network. It allows users to get native Bitcoin-backed loans, swap tokens, and lock STX tokens, xBTC, or the governance tokens of the ALEX protocol to mint the USDA stablecoin.
LNSwap is an atomic swap platform that enables traders to swap tokens between the Bitcoin base layer and the Stacks network and vice versa. The platform is even compatible with Lightning to enable fast and affordable transactions.
Sovryn is a trading and lending DeFi protocol built on RSK. Users can lend and borrow digital assets, earn through staking and stability pools, and swap tokens. The protocol also offers its own stablecoin, the Sovryn Dollar (DLLR).
What Does a Growing Bitcoin DeFi Market Mean for Bitcoin?
A growing Bitcoin DeFi market will expand Bitcoin’s utility, potentially enabling it to compete with Turing-complete smart contract blockchains such as Ethereum, which has dominated the DeFi market for years.
Going forward, it will be exciting to see how Bitcoin transforms from a DeFi perspective as developers continue innovating and building the ecosystem.
Is Bitcoin DeFi?
No. Bitcoin is a layer-1 blockchain. Builders develop DeFi applications either directly on top of Bitcoin or on layer-2 protocols running parallel to the Bitcoin network. Most applications are built on the layer-2 side of things. All DeFi transactions within the Bitcoin ecosystem eventually settle on the base layer.
Bitcoin layers enabling DeFi include RSK, Stacks, Liquid, and Lightning. Newish layer-2 protocols like RGB, Taproot Assets, and MintLayer will also contribute to Bitcoin DeFi in the future.
What’s the difference between Bitcoin and DeFi?
Bitcoin is a layer-1 independent public blockchain released in 2009. You can think of it as a ledger or database that stores a record of transactions arranged in a chain-like manner, with each block of transactions connected to the blocks before and after it. A copy of this ledger is held by many computers that are distributed across the globe.
In contrast, DeFi is an umbrella term for financial services running on a public blockchain like Bitcoin. These services are mainly provided to users through decentralized apps built on Bitcoin layer-2 protocols like Stacks and RSK.
What’s the difference between Bitcoin-native DeFi and DeFi on Ethereum and other chains?
Bitcoin-native DeFi is limited to very few simple use cases like asset issuance, due to the simplicity of the blockchain’s Turing-incomplete smart contracts. However, projects, mainly around Ordinals, have come up with innovative ways of enabling asset issuance without requiring advanced smart contracts.
On the contrary, DeFi on other chains like Ethereum is more extensive due to Turing-complete smart contracts. That means the smart contracts on these platforms can be programmed to power complex decentralized applications.
Nonetheless, Bitcoin-native DeFi enjoys better security than DeFi on any other blockchain.