BTCFi: An Innovative Journey to Unlock a Trillion-Dollar Market Value of Bitcoin

Author: YBB Capital Researcher Ac-Core

TL;DR

• The broader context of BTCFi is: 1. The narratives of Ethereum and Ethereum killer chains are gradually weakening, and infrastructure development has become saturated, leading to a lack of fresh narratives in the industry, leaving only superficial jargon; 2. Compared to other public chains, BTC has not formed a comprehensive resource monopoly;

• The main scaling solutions for BTC include state channels, sidechains, Rollups, UTXO + client validation, large blocks, and other asset protocols, but various scaling solutions face technical challenges that must meet the criteria of "orthodoxy" verification;

• The prerequisites for the development of BTCFi are: cross-chain interoperability, solutions for Layer 2 scaling, smart contract functionality, and infrastructure and development tools that do not require one-click redundant construction;

• The main challenges facing BTCFi are: the limitations of the Bitcoin protocol and liquidity issues, security and trust issues of cross-chain bridges, the difficulty of accurately capturing prices with oracles, and finding a development path unique to BTCFi.

I. BTCFi

1.1 What is BTCFi

The Bitcoin chain was once the least active public chain, with a market cap reaching trillions of dollars but long in a "dormant" state. "Fi" stands for Finance, so the purpose of BTCFi is to establish a decentralized financial market for Bitcoin within this trillion-dollar market, allowing BTC holders to directly use Bitcoin-related staking, lending, market-making, and other financial derivative tools to generate yield, thereby bringing DeFi into the native Bitcoin ecosystem to activate more financial value.

1.2 Background

2023 is a crucial year for the Bitcoin ecosystem to officially reach its peak, with various tokens represented by BRC20 triggering significant wealth effects and stimulating market FOMO. Looking at the current state of the industry, aside from the inscriptions, another reason for the rise of the Bitcoin ecosystem is that the narrative capabilities of Ethereum and Ethereum killer chains are gradually weakening, and infrastructure development has become saturated, leaving the industry lacking fresh narratives and only superficial jargon. The Bitcoin ecosystem has also perfectly replicated the development path of Ethereum, but the essential challenge it faces is how to expand the block without undermining Bitcoin's native consensus or causing a hard fork.

As of October 1, data shows that there have been frequent financing situations in the Bitcoin ecosystem, with 14 public financing rounds totaling over $71.1 million. Currently, the only opportunity for BTCFi is that, for both users and VCs, the Bitcoin ecosystem is still full of opportunities and has not formed a comprehensive resource monopoly compared to other public chains. Non-VC financing assets have also given rise to numerous protocol assets such as BRC20, ORC20, ARC20, SRC20, and CAT20. We explore from digital gold BTC to the controversial BTCFi, questioning whether Bitcoin's Fi is a false proposition, with the core discussion point being how to ensure asset security and adopt effective scaling methods.

1.3 The First Market Trigger: Index Asset Protocols

Index assets can generally be divided into non-UTXO bound assets of BRC20 and UTXO bound assets of ARC20. The ARC20 fungible token standard is based on Bitcoin's smallest unit "Satoshi," where 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, enabling colored coin technology to be realized within the Bitcoin ecosystem, allowing these tokens to be split and combined like regular Bitcoin, paving the way for the promising AVM in the future.

Other Asset Protocols

ORC20: A token standard based on the Bitcoin Ordinals protocol extension. The Ordinals protocol allows users to assign unique markings to individual Satoshis (the smallest unit of Bitcoin) on the Bitcoin network. The goal of ORC20 is to create a token standard similar to Ethereum's 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 unlike it, SRC20 emphasizes a simpler and more efficient token issuance and transfer mechanism. It aims to reduce transaction costs and improve efficiency by optimizing the complexity of token contracts, and can be used to build token protocols on the Bitcoin blockchain;

CAT20: A similar token standard primarily used for issuing custom tokens (Custom Asset Token). Compared to ORC20 and SRC20, CAT20 focuses more 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 within the Bitcoin network for creating and managing digital assets.

II. Layer 2 Scaling Solutions: Who Will Capture the Market Potential of BTCFi

The development of BTCFi is inseparable from DeFi, and the further expansion of DeFi relies on blockchain scaling. However, there is currently no unified and clear division of paths for blockchain scaling, and the trade-offs between feasibility, decentralization, and security still exist in controversy, all facing a common technical challenge: they must meet the verification of Bitcoin's "orthodoxy."

Source: DeFiLlama: Bitcoin Sidechains / Total Value Locked All Chains

By observing the relevant data from DeFiLlama on November 5, 2024, we can also see that among the current sidechain-related projects, the four projects CORE, Bitlayer, BSquared, and Rootsock have the highest TVL, accounting for a total of 76.56%. Currently, BTCFi, compared to similar nested yield and "ETHFi," shows the following similar characteristics:

• BTCFi's coin-based Buff yield comes from: Babylon-like + LRT rewards + BTC scaling chain rewards + ETH chain LRT bundled yields (similar to Pendle and Swell);

• ETHFi's coin-based Buff yield comes from: POS interest + re-staking rewards + LRT rewards + ETH scaling chain rewards.

Source: Pendle / BTC Bonanza

2.1 State Channels

State channels are a scaling solution that allows users to conduct multiple transactions off the mainnet, only submitting to the mainnet when the channel is opened or closed. Currently, in Bitcoin, there are Lightning Network and Ark, where users deposit BTC into a multi-signature address and conduct daily transactions through state channels, ultimately verifying the transaction results through mainnet consensus to ensure security.

2.2 Sidechains and Rollups

From the perspective of developing the Bitcoin ecosystem from the market side, achieving fast transactions, Turing completeness, and interoperability, sidechains and Rollups are more suitable for the ecological development of Bitcoin. Bitcoin's sidechains and Rollups have strong independence, with Rollups aiming to move complex operations to Layer 2, where the mainnet is only responsible for verifying the proofs submitted periodically by Layer 2, thereby increasing throughput. This mechanism ensures that the ledger of Layer 2 is secure and consistent with the mainnet. However, for sidechains, the mainnet cannot directly verify whether cross-chain behavior on the sidechain is legal; cross-chain bridges will lock mainnet assets and map assets on the sidechain, often increasing the decentralization of the chain through additional verification methods to ensure asset security, while currently, sidechains and Rollups still show good market performance in releasing liquidity.

2.3 UTXO + Client Validation

In terms of native characteristics and security, the UTXO solution stands out and aligns more closely with the definition of "orthodoxy." UTXO + client validation is an off-chain solution based on Bitcoin's characteristics, aimed at improving transaction efficiency and privacy while inheriting Bitcoin's security. Since Bitcoin natively uses the UTXO (Unspent Transaction Output) model instead of the account model, the core idea of client validation is to shift transaction verification from the consensus layer of the blockchain to off-chain, with the client related to the transaction responsible for the verification. Specifically, users need to verify the validity of the transfer declaration on their own clients to ensure transaction security and efficiency. This off-chain verification reduces the burden on the blockchain and ensures user privacy by having each client store only the data relevant to itself.

The RGB protocol is a concrete implementation of this concept, first proposed in 2016 by Peter Todd with the ideas of "one-time seals" and "client validation." RGB uses Bitcoin's UTXO as "seals," binding the state changes of off-chain assets to Bitcoin's UTXO, 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 drawbacks. Users' clients only store transaction data relevant to themselves, leading to data silos that hinder the development of applications like DeFi. UTXO + client validation achieves efficient and privacy-friendly off-chain transaction verification by inheriting Bitcoin's security, but there is still significant room for improvement in data transparency, operational convenience, and the completeness of development tools.

2.4 Large Blocks Changing the Original Consensus

Changing the original consensus also means changing today's Bitcoin, and there are hard issues such as consensus and ecological development in realizing the vision of BTCFi, which will only be elaborated here.

BCH (Bitcoin Cash) is a hard fork of Bitcoin due to Bitcoin's scalability issues at Block 478558 (August 1, 2017), with Bitcoin Cash having a block size of 8MB, while Bitcoin's block size was decided on the same day to increase from 1MB to 2MB within six months. The plan for Bitcoin Cash was first proposed by Bitmain, a Chinese Bitcoin mining machine company, and related hard fork tokens include BSV.

III. BTCFi's Fi Needs to Better Release Liquidity

Source: pixabay.com

As mentioned at the beginning, Bitcoin's trillion-dollar market cap cannot remain in a long-term dormant state like Ethereum, where the only storage options are secure hardware wallets or trusted centralized exchanges. How can BTCFi gradually circulate such a massive market cap through on-chain financialization?

3.1 Prerequisites for Development

1. Cross-chain interoperability
   Unlike other smart contract platforms like Ethereum, the Bitcoin blockchain does not have native smart contract functionality. The primary task of BTCFi is to develop trusted cross-chain bridges so that Bitcoin can participate in DeFi applications on other blockchains with smart contract capabilities. These bridges can allow Bitcoin to be "mapped" onto other chains while retaining its value and enabling more functionalities;

2. Layer 2 scaling solutions
   Compared to Ethereum's Layer 2, Bitcoin's Layer 2 faces greater difficulty in balancing the triangular problem, often sacrificing decentralization to some extent. However, for the market, more centralized development often generates new wealth effects more easily, and how project teams can provide the market with more wealth effects to compensate for the lack of decentralization may be a primary consideration;

3. Smart contract functionality
   To support DeFi applications, Bitcoin needs some form of smart contract functionality. Currently, there are no native smart contracts in the Bitcoin network, and developers are exploring ways to provide smart contract support for Bitcoin through second-layer solutions (such as RSK, AVM, Bitvm) or sidechains. This will enable Bitcoin to directly support lending, liquidity provision, derivatives, and other DeFi functions;

4. Strong developer tools and infrastructure
   Developers need comprehensive tools and infrastructure to create and deploy BTCFi applications, but the Bitcoin ecosystem seems to lack the need for one-click chain-building redundancy.

3.2 Major Challenges Faced

1. Limitations of the Bitcoin protocol
   Bitcoin was designed as a secure and reliable means of value storage and lacks the flexibility of Ethereum or other blockchains specifically designed for DeFi. Due to the absence of built-in smart contract functionality, developing BTCFi applications must overcome the limitations of the protocol itself, which may involve complex technical innovations;

2. Liquidity issues
   Even if Bitcoin is brought into Ethereum and other smart contract-supporting blockchains through cross-chain bridges, its liquidity in DeFi is still far lower than that of Ethereum and other tokens. 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 key to the development of BTCFi, but these bridges themselves pose security risks. In recent years, cross-chain bridge attacks have been frequent, resulting in significant financial losses. Ensuring the security of cross-chain bridges and preventing risks from centralization or technical failures remains an important challenge for BTCFi;

4. Oracles struggling to capture prices accurately
   The architectural limitations of the Bitcoin blockchain make it difficult to deploy oracle services on the Bitcoin blockchain as easily as projects like Chainlink on Ethereum. This limitation complicates the deployment of oracle systems within the BTCFi ecosystem, potentially requiring reliance on second-layer or sidechain solutions. In the dependency on cross-chain bridges and the challenge of price synchronization, BTCFi may primarily rely on cross-chain bridges to map Bitcoin onto other chains for cross-chain price synchronization in the future. Overall, it faces greater technical and security challenges in oracle accuracy compared to Ethereum;

5. Finding its own development path rather than merely imitating Ethereum
   The core goal of Bitcoin's design from the beginning was security over functionality, and in the design of BTCFi, market acceptance and security will always take precedence over functionality. Bitcoin's adoption globally is primarily focused on value storage and payment, so BTCFi may focus on financial products related to payment and value storage, with the concept of PayFi being more applicable to Bitcoin than to Solana.

Reference article:

“Comparison of Four Mainstream Bitcoin Scaling Solutions: Who Will Truly Unlock the Trillion-Dollar Market Potential of BTCFi?”