Bitcoin DeFi 101: The Essentials of DeFi in the Bitcoin Ecosystem

Less than $170M worth of Bitcoin is at work in DeFi according to DefiLlama. Which then begs the question: what’s happening with the rest of the $550B+ locked in Bitcoin’s market cap?

Type
Deep dive
Topic(s)
Bitcoin
Published
May 25, 2022
Author(s)
Content Marketing Manager
The Basics of Bitcoin DeFi
Contents
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Bitcoin DeFi isn’t nearly as robust as DeFi on other chains. While that’s a problem for holders that want to put their Bitcoin to work, it’s also an opportunity for developers to get in on the ground floor of the future of finance on Bitcoin.

There’s an opportunity to mix and match existing DeFi primitives to create new use cases of compounding utility for Bitcoin holders. Let’s take a look at some of the essential building blocks of a robust DeFi ecosystem to inspire you to build a new wave of Bitcoin DeFi applications.

Tokenization in Bitcoin DeFi

Tokenization is the process of transforming tangible and intangible assets into natively digital assets stored on a blockchain. Tokenization is a core primitive on DeFi ecosystems because it’s responsible for creating the assets traded between users in DeFi. In other words, tokenization is the process of creating the building blocks of DeFi. You can create and launch different tokens for use in Bitcoin DeFi through the tokenization parameters on Stacks. Some of the different types of tokens you can create include:

Fungible Tokens

Fungible tokens refer to blockchain assets that are interchangeable. BTC is an example of a fungible token: any 1 BTC is the same as any other 1 BTC. Fungible tokens are the fundamental blocks for DeFi and serve as units of account, store of value, and medium of exchange.

In DeFi, fungible tokens are broadly issued as security tokens, utility tokens, or governance tokens. Security tokens are tokenized securities that represent an ownership stake in a company or protocol. Utility tokens give the holders access to a DeFi platform or serve some function (hence utility) inside that platform. Governance tokens are used in DeFi to include the community in the decision-making process and let users vote on decisions that impact the DeFi protocol.

Stablecoins

Stablecoins are an extension of fungible tokens in that they are interchangeable. However, the difference is that stablecoins are designed to be immune to the volatility common in cryptocurrencies because they are pegged to a traditional fiat currency, often the US dollar.

Arkadiko’s USDA is an example of a stablecoin in Bitcoin DeFi that provides a unit of value with minimal volatilty. USDA is pegged to $USD on a 1:1 basis. The stablecoin is designed to maintain that 1:1 value regardless of what is happening in the broader crypto world. If the peg destabilizes, and the stablecoin becomes worth more or less than the currency it is pegged to, stablecoins have different mechanisms in place to regain that peg.

Stablecoins are valuable in crypto because they offer a stable unit of exchange, which helps create more liquidity in the ecosystem. Users may not want to sell or borrow an asset whose value may be very different tomorrow, but they may be willing to sell or borrow an asset whose value is fixed.

Non-Fungible Tokens

Non-Fungible Tokens (NFTs) are unique assets that aren’t replaceable or interchangeable with another similar asset. Each one is unique, like a work of art. Indeed, digital art has been the first use case for NFTs to take off in the mainstream. However, NFTs are converging with DeFi through collateralized loans, in which users can leverage their NFTs as collateral. The platform NFTfi has been an early pioneer in this model.  

Decentralized Exchanges in Bitcoin DeFi

Decentralized exchanges (DEXs) are platforms that enable the non-custodial peer-to-peer (P2P) trading of crypto assets. Think Coinbase, a centralized exchange (CEX), but without a central company holding your assets and managing the order book. Cryptocurrencies are fundamentally supposed to enable P2P transactions of value. In many ways, handing over your crypto assets to a centralized intermediary in order to trade contradicts the core essence of decentralization. On DEXs, users retain control over their assets in their wallets, and smart contracts manage the order book and trades.

Sovryn is an example of a DEX for the Bitcoin ecosystem — it enables the non-custodial, permissionless, and smart contract-based trading of Bitcoin and Bitcoin-based assets. Other Bitcoin DEXs include LNSwap, which enables trustless swaps between Bitcoin and Stacks.

Decentralized exchanges are growing in popularity as a non-custodial way to trade assets without the need for a middleman. The DEX to CEX spot trade volume has grown from about 0.94% in May 2020 to 12.63% in May 2022 (meaning DEX volume is gaining on CEX volume), and DEXs now have a TVL of about $37B. Some of the core components of DEXs include:

Trading

This one goes without saying, but peer-to-peer trading is at the core of an exchange. Creating liquidity and enabling trade is at the heart of the business. Beyond straightforward trading of assets, some exchanges also allow margin trading, in which traders borrow funds/assets from other users to take larger trading positions. 

Staking

Staking is participating in the consensus process on Proof of Stake (PoS) blockchains to maintain the security of the blockchain, in which users “stake” an asset (lock it up for a period of time) in exchange for block rewards. While Bitcoin doesn’t use a PoS consensus mechanism, Stacks’ Proof of Transfer (PoX) consensus mechanism enables users to earn rewards through a process similar to staking called stacking, in which users lock up their STX tokens to help secure the network in exchange for Bitcoin.

In DeFi, users can stake an asset to certain DeFi protocols in exchange for rewards as well. The protocol can then use those staked assets to do any number of functions, including securing the protocol, being a line of collateral in the event of a hack, and more.

Liquidity Mining

Users can also stake their assets in DeFi through liquidity mining. In liquidity mining, users provide liquidity on a DEX by depositing tokens of a trading pair into a liquidity pool. A liquidity pool enables users to swap two assets by depositing one asset into the pool and withdrawing the other. The deeper the liquidity in the pool, the more users can use that pool (and the more stable the price between those assets), so DEXs incentivize users to deposit the tokens of the trading pair into the pool by paying them trading fees. This creates deeper liquidity in the pool.

Yield Farming

Yield farming is a general term that describes user strategy to maximize their returns through a variety of methods, including staking, liquidity mining, and high-risk lending/borrowing markets. Yield farming often involves complex strategies and frequently moving assets from one pool or marketplace to another.

For example, when you provide liquidity to a liquidity pool, you receive liquidity provider (LP) tokens that represent your % share of the pool. When you withdraw assets from the pool, you exchange those LP tokens for the % of the pool they represent. However, it's possible to take those LP tokens and deposit them into a different liquidity pool (sometimes on a different DeFi protocol altogether) to earn returns on top of the returns you earn from the first liquidity pool. The goal of yield farming is to maximize yield, and users will follow an ever-evolving set of steps to optimize for the best returns, whether it's liquidity mining, staking, lending, or a different strategy altogether.

Personal Finance in Bitcoin DeFi

There are many personal finance use cases in DeFi on other chains, and a robust Bitcoin DeFi ecosystem could enable Bitcoin holders to put their Bitcoin to work as well. Developing personal finance applications in Bitcoin DeFi would also aid in the mass-market adoption of Bitcoin by establishing use cases for people who aren’t interested in crypto trading or investing. If you would like to contribute to Bitcoin’s adoption, some of the common components of personal finance include:

Lending

The global crowdlending industry is expected to have a transactional value of $278B by the end of 2022, but in the world of DeFi, lending apps have a TVL of just $23B. Bitcoin DeFi might be the key to increasing the adoption of P2P lending in crypto markets if Bitcoin lives up to its expectations as 21st-century digital gold.

Bitcoin holders who do not want to liquidate their BTC holdings could put their tokens to work on lending platforms to earn additional income. If you’d like to build lending applications for Bitcoin, you’re in good company. Some pioneers of lending applications in Bitcoin DeFi include ALEX, which enables lending, borrowing, and more. Zest Protocol is another Bitcoin DeFi project through which users will be able to put their BTC to work to earn Bitcoin yield through undercollateralized loans to institutional borrowers.

Insurance

Risk management and loss mitigation through insurance is a core finance function that is appearing more recently in DeFi. New DeFi insurance apps such as InsurAce and Unslashed protect users against loss from hacking, private key compromise, or rug pulls. These apps protect users from crypto-native events, such as stablecoin depegging, hacks, custodian risk, smart contract failure, and more.

Today DeFi insurance is much smaller than lending, with a TVL of about $774M compared to lending’s $23B. However, you can expect the insurance market in DeFi to grow as more institutional and retail players enter the market. Looking at the world more broadly, the global insurance market is expected to hit $6.39T by 2025. 

Investment Indexes

It’s no secret that a lot of the attention in crypto to date has been around financial speculation. Despite that interest, crypto indexes, which basket a number of crypto assets into a single investment, haven’t really taken off.

To date, only $434M is locked in crypto indexes, and TokenSets is an early example of a DeFi project offering crypto indexes across multiple chains to users. There are over 5,000 indexes in the US equities market, and providing simpler investment options could help bring more retail into the world of Bitcoin and crypto at large.

Payments

Crypto payments refer to the use of cryptocurrencies in exchange for products or services (like paying for dinner with crypto instead of a credit card). Transaction fees and volatility have hindered the early growth of crypto payment solutions, but the market need for them is increasing every year.

In the Bitcoin ecosystem, the Lightning Network enables instant and cheap Bitcoin payments at scale. GoSats also operates a payment application and offers Bitcoin cash back rewards. Payment solutions are an exciting niche in Bitcoin DeFi because they have the potential to fast-track the mass-market adoption of Bitcoin.

Mix and Match the Essentials of Bitcoin DeFi for the Future of Finance

There’s $550 billion of latent capital in Bitcoin waiting for opportunities to be leveraged in DeFi. Each of these core DeFi components can be used to turn Bitcoin into a productive asset and generate better returns for hodlers. Feeling inspired? Subscribe to Hiro’s developer newsletter to learn more about the Bitcoin app economy.

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