A Dive into Bitcoin Programmability & DeFi Prospects - Just Hype?
Diving deep into smart contract functionality, decentralized finance (DeFi) & what it means for the BTC ecosystem...
Bitcoin, first introduced to the world in 2009 by Satoshi Nakamoto, has sparked a financial revolution. The pioneering cryptocurrency, BTC was conceived as a peer-to-peer, decentralized transactional system outside the confines of governmental control or traditional intermediaries, and is anchored on the bedrock of blockchain technology.
As Bitcoin’s ecosystem continues to mature, the vision for its capabilities have expanded as well. The emergence of programmable blockchains, principally through Ethereum's smart contracts, marked an industry milestone. Recently, however, momentum is building bringing such programmability to crypto's foundational layer: Bitcoin itself. This represents a paradigm shift where Bitcoin not only transforms value transfer but also becomes a cornerstone for a multitude of applications.
In this primer, I explore the prospect of enhancing Bitcoin's functionality. By dissecting the opportunities and challenges, investigating its potential, and shedding light on how Bitcoin could catalyze the next evolutionary phase in blockchain technology, I uncover emerging, sustainable use cases in decentralized finance and offer potential recommendations on how to capitalize as an investor in the space.
TLDR;
An introduction of smart contract programmability on Bitcoin unlocks a myriad of potential applications that leverage the blockchain’s fundamentals, network effects, and liquidity
Stacks is the leading layer 2 offering smart contracts and a major network upgrade called the Nakamoto Release, where bitcoin can be used directly in smart contracts (through sBTC) is set to release in Q4 2023
Given the nascency of ecosystem, the quality of infra & DeFi is similar to that of the Ethereum ecosystem around 2019 but growing at a much faster rate given precedent
The two primary use cases emerging are revolving around Lending & Borrowing and Earning Real Yield
BTC & ETH DeFi ecosystems can mature in parallel fashion similar to bonds and equities/derivatives markets we have traditionally. Potential is in the tens of billions if not hundreds.
Novel DeFi narratives have arisen and may be interesting as an area of investment. Certain infra projects (explored in the last section) are worth exploring as well. A lot of community support for projects is also present from both institutional and retail.
If you just want the main course, jump HERE for my conclusions & key recommendations
Thanks to many members from the Bitcoin community, with special thanks to Franklin Bi from my time with Pantera Capital this summer for the initial research idea and extensive feedback.
1. New Functionality On Bitcoin
The Draw of Bitcoin
As we’ve seen with traditional asset managers recently attempting to become more involved with Bitcoin, its attractiveness can be broken down into core 3 facets:
Robust Fundamentals: With proof-of-work backed cryptographic security and decentralized architecture, Bitcoin ensures transaction integrity and is censorship resistant, making it an ideal settlement layer and foundation for developers. Its open, permissionless nature promotes financial inclusivity. Since 2009, the network has proven its durability and stability.
Network Effects: As the inaugural cryptocurrency, Bitcoin enjoys network effects that expand beyond the world of web3. Its institutional and borderless adoption, particularly in emerging markets, positions it as the go-to medium of exchange and value reserve, establishing itself as an industry benchmark and contributing to its flagship status for both institutional and retail investors.
Liquidity and Expanding Utility: Bitcoin's ongoing dominance in market capitalization of over $600 billion and trade volume make its potential liquidity more attractive than other cryptocurrencies, a key challenge we’ve seen for DeFi. The ability to now leverage diverse applications can amplify its utility, allowing it to transcend its role as a passive store of value.
2. The Rise of Stacks
The Stacks project started in 2017 when Muneeb Ali finished his PhD from Princeton and released the Stacks whitepaper alongside Ryan Shea. After the successful launch of Stacks 1.0 in 2017, the project moved on to establish a non-profit organization, the Stacks Foundation, in 2020 to ensure long-term governance and development. The real turning point arrived in 2021 with the launch of Stacks 2.0, which brought smart contract capabilities to Bitcoin and introduced the novel "Proof of Transfer" consensus mechanism, effectively marrying Stacks security to Bitcoin's. It is also the first crypto to receive SEC qualification for sale in the US. Here’s how stacks has performed over the past year:
A quick glance at Stacks Key Metrics for Q2 2023, per Messari Research.
sBTC, Nakamoto Release and What It Means
With the upcoming hype of the Nakamoto Release in late Q4 of this year, here’s how it changes the Stacks ecosystem:
sBTC: The introduction of sBTC, or 'Stacked Bitcoin,' aims to offer a direct bridge between Bitcoin and Stacks. sBTC represents a novel 1:1 decentralized, non-custodial pegged representation of Bitcoin on the Stacks network (peg is maintained by Stackers through a liveness incentive). By not only reading but also modifying Bitcoin state, it will enable Bitcoin to be used within Stacks' smart contracts (“Native Bitcoin” smart contracts) and decentralized applications (aka writing Bitcoin transactions to the Bitcoin chain in a trustless manner), unlocking a myriad of new possibilities for Bitcoin within the Stacks ecosystem, from scaling Ordinals/BRC-20s to consumer apps to DeFi. sBTC doesn’t need users to pay a “wrapping fee” and reduces friction from the UX process, which currently requires STX to interact with smart contracts.
Security: The Nakamoto release introduces a new security model: most of the Stacks chain history will have Bitcoin finality, meaning 100% of Bitcoin’s hash power will secure the immutability of the Stacks layer, except for the most recent 150 blocks. Even for those recent blocks, the security budget will increase from being just the BTC spent by miners to including the capital locked by Stackers (hundreds of millions of dollars today). To attack the recent history (new 150 blocks), an adversary needs both a majority of Stacks mining power and at least 71% of Stackers to allow a fork carrying out the attack, which is a very difficult threshold.
Scalability: The upgrade introduces two types of blocks at the Stacks layer:
1) Fast blocks will be produced every 5 seconds through a BFT-style quorum signing mechanism by Stacks miners, which decouples the Stacks layer bandwidth from the time in-between Bitcoin blocks. These fast blocks provide quicker transaction confirmation times, improving the user experience.
2) Settlement blocks will be produced at every Bitcoin block. Settlement blocks do not contain any new transactions but only settle the recent sequence of fast blocks on the Bitcoin chain.
Forks are not allowed in the fast blocks, but rather are only allowed at the level of settlement blocks. Beyond that, it is estimated that TPS will sit around 70-100 post release. For context, BTC itself is about 5-7 TPS, ETH is around 20-30 TPS, and L2s on ETH boast TPS in the thousands. There is still a need for even greater scalability.
After the Nakamoto Release, Stack’s plans to introduce subnets will allow Stacks to process transactions and smart contract executions more efficiently, greatly enhancing the network's scalability. With the introduction of the Nakamoto release & sBTC for Stacks in Q4, which enables BTC to be deployed directly into contracts in a completely decentralized manner, the community expects a wave of liquidity and volume to flow into Stacks DeFi. Unlocking previously passive BTC and allowing it to be used in a productive vector through frictionless pegging, financial interactions become a clear cut, immediate use case.
Beyond subnets, Muneeb & the Stacks Whitepaper has highlighted opportunities to implement rollups and fraud proofs as more scalability solutions in the future. With the introduction of the Nakamoto release, more use cases will become available across Infra/DA, Social, and particularly DeFi & NFT/Ordinals. Check out what’s being built on Stacks here.
3. State of Bitcoin DeFi
With the rise of solutions like Stacks, Bitcoin is evolving beyond a store-of-value asset into a vibrant ecosystem that could underpin a new wave of decentralized financial applications.
Stacks TVL (~$20M, in blue) and Daily Volume (~$1M, in green) from DeFiLlama. Activity has bounced back in recent months to 2022, bull-market levels. The immediate uptick in March/April can partly be attributed to hype around the Ordinal Inscriptions/BNS fiasco, which has caused many to explore BTC and activity to be greatly disseminated into DeFi.
An Analogy to Ethereum DeFi
Although it is difficult to compare the timelines of BTC & ETH, DeFi on BTC is analogous to late 2018 to 2019 year (pre-DeFi Summer era), where most projects are in beta/testnet and only recently getting traction, but will likely grow in the next bull market (BTC’s ecosystem will largely grow in a parallel fashion given ETH’s precedent). However, Bitcoin DeFi will continue to lag due to key infrastructure limitations and scalability issues. For that reason, it’ll take some time for Bitcoin’s ecosystem to mature to a level similar to that of Ethereum. Still, it's crucial to note that Bitcoin will catch up quicker than it took Ethereum and that both are likely to offer distinct use cases within DeFi. Ethereum’s versatile programmability will serve as the hub for complex and experimental DeFi protocols, while Bitcoin, revered for its security and stability, could become a preferred choice for risk-averse users and large-scale financial applications. For protocol specific breakdowns, reach me at 0xJuicetin on Twitter.
Primary Emerging Use Cases
Leveraging Bitcoin as the settlement layer, its stability, market cap, and network effects, some preliminary use cases in DeFi have been explored:
1. Lending & Borrowing: Using Bitcoin as a more stable collateral for lending and borrowing, Bitcoin holders can take loans against their BTC assets in a more secure fashion, providing a method to access liquidity without selling the underlying Bitcoin. Stability and security permit larger LTVs (in the future), making it attractive for borrowers. For lenders, these platforms offer a way to earn passive interest on supplied Bitcoin all through a trustless manner.
2. Earning Real Yield: Beyond simple price appreciation, new opportunities for investors to generate more risk-averse, sustainable returns on their Bitcoin holdings will arise (imagine a risk-reward of MMR/treasuries). Through yield farming or liquidity mining, BTC holders can earn rewards by providing liquidity to decentralized exchanges or lending platforms. These mechanisms capitalize on Bitcoin’s innate liquidity, allowing BTC holders to put their otherwise idle assets to work in a more secure way, earning passive income while still benefiting from potential long-term price appreciation of Bitcoin to optimize returns and capital efficiency.
3. Other Use Cases: Decentralized exchanges (DEXes) and stablecoins represent additional DeFi use cases on Bitcoin. DEXes facilitate non-custodial trading of Bitcoin-based assets, often through atomic swaps, providing an additional layer of security for traders. Stablecoins pegged to traditional fiat currencies offer another form of value storage and transaction within the Bitcoin DeFi space. The concept of a Bitcoin-backed stablecoin also presents a different approach to maintain value stability with Bitcoin as the underlying asset.
Beyond these, we may likely see insurance and asset management arise as well. As DeFi on Bitcoin continues to develop, it may align with the range of applications seen within Ethereum's DeFi landscape. Bitcoin's unique attributes, such as its security, decentralization, and market recognition, are particularly suitable for these use-cases.
BTC’s Role in a Greater Ecosystem
sBTC’s introduction will mark a major upgrade to functionality and infrastructure to the DeFi ecosystem by allowing Bitcoin to be directly used in smart contracts, thereby unlocking key use cases mentioned above, allowing initial scalability, and a strong first step in providing more tooling and sophistication. Although more development needs to happen from the protocol end, more talent will continue to build on Bitcoin and we will begin to see the true effect after many projects release mainnet beginning early next year. As per my belief, Bitcoin DeFi will coexist alongside ETH’s, and although they will share similar types of applications, each will have its own major use cases – Ethereum largely for trading/DEXes, perpetuals/prediction markets which require more complex financial instruments, and higher-risk activities (including riskier yield farming, flash loans, etc.) while Bitcoin will find its niche in providing long-term BTC holders opportunities to earn lower, sustainable yields and lending/borrowing functions – a potential great option for institutions.
4. Where The Ecosystem is Headed
Path To Adoption
As Bitcoin DeFi presently stands, the existing infrastructure is only in its nascent stage, with the applications built atop it being rather elementary. The advent of sBTC boosts the underlying infrastructure, opening doors for a first wave of more intricate and diverse applications. After an onset of initial applications, further infrastructure focused on scalability will be required, which will then bring more refined/mature applications, and so on. It will be a process of iterations, and I expect the timeline for this to occur within 2-3 years (spurred by a bull market).
Wide adoption would likely come from new sources of users (e.g. traditional institutional asset managers/LPs & web2 players) and current BTC holders (both retail and some crypto-native funds), rather than largely from degens in the Ethereum ecosystem. That said, tons of challenges arise with the UX/DX in every step of the process, which needs to be miles easier for both the average user and institutions.
The recently filed Bitcoin ETFs indicate that traditional asset managers are showing interest in the crypto space, primarily through Bitcoin exposure. As these ETFs come to fruition, we can expect a broader demographic, including institutions, to adopt Bitcoin to some degree, leading to a key catalyst in the Bitcoin DeFi space. All said and done, regulatory clarity is a must, and most likely the biggest barrier to adoption at this point.
Challenges & Limitations
Bitcoin DeFi indeed faces several challenges and limitations that may impede its growth trajectory. One notable challenge originates from the behavior of certain Bitcoin holders. A segment of these holders either solely buy-and-hold Bitcoin, who are store-of-value maxis, or have lost their holdings permanently. Moreover, there's a group that prefers to hold their Bitcoin on institutional custodial services (estimated ~12.5%), limiting their participation in DeFi. Even more, a portion of institutional holders will never actively play a role in DeFi.
From a technological standpoint, the infrastructure built atop Bitcoin still leaves a lot to be desired. For example, Clarity is decidable and not turing complete, which poses a number of tradeoffs. DeFi loans still demand overcollateralization, posing barriers for potential borrowers. Similarly, the yields on offer need to be adequately enticing to outweigh the risk-reward calculus. As of this point, the yields are not attractive enough, especially compared to DeFi elsewhere.
As more volume floods in, concerns related to the network's limitations come into sharp focus. Although reorg concerns and orphan blocks will cease to exist through the Nakamoto release, blockspace scarcity, Maximal Extractable Value (MEV) issues, and increased miner competition will pose significant challenges. These factors can potentially cause transaction delays and increase transaction costs, detracting from the overall user experience and efficacy of Bitcoin DeFi. Stackers within PoX may also pose centralization risk, although unlikely. Bootstrapping for the sBTC is also an inherent risk. The resolution of these concerns will play a critical role in shaping the future of Bitcoin DeFi.
Potential
Challenges and limitations aside, the opportunity is immense. Similar to the potential growth of Bitcoin itself, which has the upside of a multi-trillion dollar market cap, Bitcoin DeFi has the potential to represent a significant portion of that market as well given ample execution.
Let’s do some napkin analysis: BTC’s market cap currently sits at little under $600 Bn. Safely assuming 25% of total bitcoins are unrecoverable, that leaves us ~$450 Bn potentially available. From this number, a conservative ratio of 1:10 TVL to market capitalization (ETH’s current ratio, in a bear market), we estimate $45 Bn of market opportunity. In the previous bull market, ETH had a 1:5 TVL to market capitalization. Using that ratio instead, we assume over $90 Bn in potential market opportunity. Given BTC DeFi’s more collateral-based and real yield (TVL focused) use cases, the ratio is likely even tighter. That said, as the BTC ecosystem and market cap continues to grow, likely to the trillions, we are looking at a market opportunity in the tens and potentially hundreds of billions.
Despite Ethereum likely maintaining the dominant position in DeFi due to its versatile smart contract capabilities, myriad of financial products, and extensive existing infrastructure, Bitcoin's robust, secure nature coupled with its massive monetary value will pave the way for a substantial DeFi ecosystem of its own. The growth of DeFi on both Ethereum and Bitcoin is not mutually exclusive, and they can grow in tandem, each serving different needs and use cases.
With growth in both ecosystems, opportunities indefinitely present themselves for other ecosystems within crypto and bitcoin to flourish. A more robust financial system and greater velocity of money is the backbone for a new economy – more efficient ways of interacting among actors, transacting for goods and services beyond DeFi, and even ways for unique communities to develop, just like our economy today. Growth in each of these areas pose great investment opportunities.
5. How To Capitalize As An Investor
As investors in the space, I believe that we should evaluate investments at the highest level through a lens of conviction, risk-reward, and diversification. I spent some time digging through all the current dApps on Stacks I could find. Across the entire ecosystem, the top three most popular are ALEX (DeFi superapp), X-verse (most advanced and widely used wallet, who just raised a $5M seed round led by Jump), and Gamma (NFT marketplace). I do believe these three later-stage opportunities could be interesting.
Beyond alignment with conviction in Stacks, an investment into the ecosystem acts similar to play that shares in the upside of Bitcoin and diversification for our fund. That said, however, the number of quality projects that I have seen are minimal and a little underwhelming.
Although there’s no project that immediately was a “must have” to me, a couple do pose some merits of further exploring. This list includes: Zest Protocol (Undercollateralized Lending Protocol) and Velar (DeFi Liquidity Protocol). Some other interesting novel concepts (although unproven & early development) include Papaya (Liquid Stacking) and Liquidium (P2P Ordinal Lending). There are some stablecoin protocols but they are not standout as of this moment. I would like to see more robust projects targeting real yield.
Given the stage of the ecosystem, infrastructure may be a great avenue to explore. DLC.link and Deep Lake, both middleware/dev tooling solutions for Discrete Log Contracts (DLCs)/PSBTs, which enable financial apps to leverage native BTC, could be interesting (although niche and early) as the ecosystem continues to be built out. I recommend the team track these projects and occasionally keep up with the Bitcoin Frontier Fund and Bitcoin Startup Lab, the top two accelerators that almost all the top projects on BTC have been through.
As a whole, similar to the course of history, I do strongly believe there will be great opportunities that arise, but for now, I would stay monitoring the ecosystem, particularly into Q4 of this year as we see the true impact of the Nakamoto Release. Personally, I’ve copped a small bag of $STX as a r/r play that plays into BTC upside (of course, not financial advice). For the full detailed primer, where I further explore other Layers on Bitcoin, how Stacks works, the Full DeFi landscape, and dive deep into specific protocols & numbers, please reach me at 0xJuicetin on Twitter.
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