The Promises and Perils of DeFi
The advent of Ethereum along with its flexible smart-contract language that provides developers with a broad toolkit to build decentralized applications has led to a slew of ambitious projects ranging from decentralized exchanges to trading and insurance. Hence, when speaking of decentralized finance, or “DeFi”, we inevitably think of Ethereum. While Bitcoin itself has been by far the most successful application of DeFi itself, its deliberately simple scripting language is subject to limitations for use cases such as DeFi. Conversely, the opportunities offered by the unconstrained Ethereum language has spawned a multitude of DeFi applications ranging from more traditional sectors such as payments, lending and trading to novel applications such as prediction markets and non-fungible tokens.
- The DeFi narrative has shifted notably in recent years - from decentralized exchanges (DEXs) and prediction markets to lending, stablecoins and trading, with protocols such as MakerDAO and Compound standing out. We expect this narrative to change at least one more time.
- While the DeFi stack has become broader, projects have struggled to gain traction beyond the users inherently familiar with common Ethereum terminology. There is still a palpable gap between theory and practice. Low liquidity and a lack of price discovery, unintuitive UX, high friction, capital inefficiency, hidden risks and regulation have somewhat stifled adoption and accessibility.
- Given its short history, DeFi poses a potentially systemic risk arising from the interdependencies of DeFi protocols, MakerDAO’s current too-big-too fail status as well as a lack of understanding of the underlying assets, particularly with respect to their volatility and valuation.
- We argue that Bitcoin has a much bigger role to play in DeFi. We are increasingly bullish on projects that will accelerate both Bitcoin-native DeFi and the convergence of base layers.
- Trust is the foundation that financial services are based on. Bitcoin has a competitive advantage in terms of trust in part due to its security model and history.
- The advent of decentralized identity, a cornerstone of DeFi, will allow more risk-adjusted pricing and more competitive rates - as opposed to the current generalist overcollateralized approach where trust is minimized at the expense of risk pricing.
About 700 years ago, an early form of decentralized finance started to emerge. In the 1340s, the three Florentine houses that had dominated Italian finance were wiped out as a result of defaults by two of their principal clients, King Edward III of England and King Robert of Naples. What followed was the rise of the Medici. Perhaps no other family left such an imprint on an age as the Medici left on the Renaissance. As pointed out by Niall Ferguson in The Ascent of Money, the Medici later became popes, queens of France and dukes. They also became patrons of the arts and sciences and helped funding the masterpieces of Michelangelo and Sandro Botticelli. Visitors to modern-day Florence are still marveling at the Medici’s dazzling architectural legacy. Starting in currency trading, Giovanni di Bicci de’ Medici succeeded in building up a highly successful business in the late 14th century. At the time, multiple systems of coinage such as gold, silver and a number of base metals were prevalent. Another important part in the Medici’s early business were the bills of exchange (cambium per literas), a trade financing instrument allowing creditors to draw a bill on the debtor and then use it as a means of payment or to obtain cash at a discount. While the charging of interest was condemned as usury by the Church, depositors were given discrezione to compensate them for risking their funds.
A key factor to the early Medici’s success, however, was diversification rather than size. Unlike previous banks with their monolithic structures, the Medici bank was in fact multiple related partnerships based on individual contracts. Branch managers in Venice, Rome, Pisa, Avignon, London, Bruges and Geneva were not just employees but junior partners who were incentivized through a profit-sharing model. Branches remitted to other branches, or drew on other branches. It was this decentralization that helped make the banking dynasty so successful. In addition, the Medici found a way to spread their risks by engaging in currency trading and lending, thus reducing their vulnerability to defaults. It wasn’t long before they realized that in finance only big is beautiful. So the bank became bigger and less centralized, accumulating more power and wealth. In fact, the banking dynasty got so powerful, that Pope Pius II referred to Cosimo de’ Medici, Giovanni’s son, as “King in everything but name”. Realizing the advantages of scale, the Medici were the first bankers to make the transition from financial success and hereditary power. Once Europe’s largest bank in the 15th century, the business lasted only for about a 100 years, when anti-Medici factions took control of Florence, resulting in the exile of the members of the banking family, although the Medici later returned.
In crypto, the term decentralized finance, or DeFi, means something entirely different than during the heyday of the Medici. The acronym has become a trending topic within the blockchain community, not least due to the rapid rise of MakerDAO which has become somewhat of its showcase project. In the Bitcoin whitepaper, Satoshi Nakamoto introduced the cryptocurrency as a peer-to-peer version of electronic cash that obviates the need to rely on a financial institution. Bitcoin is therefore often referred to as a Swiss bank account in everyone’s pocket. A Swiss bank account used to epitomize secrecy, discretion and trust, especially prior to 2008 when banking secrecy protections were rolled back by Switzerland after pressure from US and EU authorities. As Andreas Antonopoulos put it, rather than just a Swiss bank account, Bitcoin resembles a Swiss bank in everyone’s pocket given its censorship resistance. Hence, one can make the case that decentralized payments themselves are the prime DeFi application.
Broadly speaking, DeFi is an ambitious attempt to decentralize the infrastructure that supports financial applications and markets that run on blockchains similar to base layer protocols such as Bitcoin and Ethereum. DeFi has been established as a general term (or more precisely, a hodgepodge) for both traditional and innovative financial services that do not rely on a central authority. In practice, however, decentralization is often limited in that the mechanism to control the financial application is distributed between different entities and custodial, in part because of the field’s nascent stage. Likewise, centralized companies that build products on top or around Bitcoin and other public protocols or offer crypto-related financial services (e.g. centralized exchanges, lenders or custody providers) do not constitute DeFi either.
DeFi protocols and applications are enabled by open and permissionless networks that allow us to code the rules of our financial interactions into smart contracts. The capabilities of the Ethereum network not only resulted in a slew of ICO projects that issued ERC-20 tokens but also in the emergence of new types of more complex financial instruments based on smart contract functionality. It therefore comes as no surprise that almost all current DeFi projects have been developed on Ethereum to make use of the platform’s more advanced smart contract functionality. Given the rapid growth of protocols and applications fueled by the favorable ICO environment of 2016/2017, the term DeFi has become inextricably linked with Ethereum. DeFi projects now account for a substantial chunk of Ethereum’s sprawling ecosystem, particularly with respect to Ether locked in smart contracts and the growing number of stablecoin projects that run on Ethereum.
Importantly, DeFi and “Open Finance”, sometimes referred to as “banking the unbanked”, are by no means synonymous and essentially two different things. The latter aims at promoting fair and open access to finance to people that lack such services, something that is still absent in many regions across the world today (see also our in-depth piece on the banking the unbanked). As pointed out by Joel John, the terms DeFi and Open Finance may converge at some point in the future given that they share similar attributes.
While DeFi does not aim at replacing the current financial system, it has enormous potential to transform the global financial landscape, bringing transparency, speed, and accessibility to an industry that has traditionally been opaque and sluggish with respect to innovation. In order to understand DeFi, we need to take a step back and dig deeper into the differences between Bitcoin and Ethereum.
Ethereum was conceived at a time when developers recognized the limitations of Bitcoin, especially when attempting to move beyond the cryptocurrency design. They were faced with a tough decision: they could either build on top of Bitcoin or launch a new protocol. Building upon Bitcoin inevitably meant dealing with the deliberate constraints of its scripting language (Script) given its limited set of transaction types, data types and block size. This would have severely confined the applications that could run directly on Ethereum. More advanced applications would have required off-chain layers or sidechains.
In 2013, Vitalik Buterin published a whitepaper that introduced Ethereum – a Turing-complete, general-purpose programmable blockchain that runs a virtual machine capable of executing more complex code. The new protocol offered boundless possibilities due to the unconstrained Solidity programming language. Often described as “the world computer”, the Ethereum platform runs smart contracts, that is, decentralized code or computer programs that run deterministically (i.e. pre-determined) in the context of the Ethereum Virtual Machine (EVM).
Although it emerged roughly 5 years after Bitcoin, Ethereum quickly became the dominant smart contract platform and was the catalyst for the emergence of decentralized applications, or dapps, that used smart contract functionality. It has since become the dominant smart contract platform. Among other things, the new ecosystem spawned a multitude of DeFi protocols ranging from more traditional sectors such as payments, lending and trading to novel applications such as prediction markets and non-fungible tokens. Importantly, many of these dapps with non-trivial usage and features cannot be replicated on Bitcoin yet. That said, the term dapp warrants caution and needs to be put into perspective. We understand that very few of the applications in question, if any, are meaningfully decentralized yet.
A look at the numbers shows that the Ethereum network and ecosystem has experienced rapid growth, particularly with respect to active developers and projects that build on the protocol. Overall, a total of more than 2,500 dapps have been created on the platform. There were the 1,243 developers active in June 2019, with full-time developers growing by 34% year-on-year during the same period to more than 400. Equally impressive, the Truffle Suite, a development framework for Ethereum smart contracts and dapps, among other things, has been downloaded almost 2.3 million times, with monthly downloads hitting a new high at more than 143,000 in August 2019. Elsewhere, the Ethereum network’s gas usage recently rose to an all-time high on the back of a spike in Tether (USDT) transactions that have accounted for roughly 25% of network activity while making up 20% of the total gas fees. The bulk of the centralized stablecoin used to run on the Bitcoin-based Omni Layer but has recently moved the majority of tokens to the Ethereum network. As a result, the number of daily USDT transactions has increased more than ten times to 188,000 since July, according to Coin Metrics data.
Likewise, Ethereum’s financial system has also evolved rapidly in terms of recent data points, spurred by generous VC funding and the emergence of decentralized stablecoins to name but a few. The DeFi “stack” as the ecosystem is often referred to, has grown to more than 700 applications, currently exceeding the combined number of gaming and gambling dapps at about 700. Meanwhile, the DeFi narrative has shifted notably in recent years – from an initial focus on decentralized exchanges (DEXs) and prediction markets to lending, stablecoins and trading. The total USD equivalent locked into DeFi projects currently amounts to an equivalent of USD 590mn after peaking at an equivalent of almost USD 700mn in June 2019, according to defipulse.com.
The stablecoin and lending protocol MakerDAO stands out, briefly accounting for more than 70% of the USD 700mn equivalent. At the moment, MakerDAO represents about 55% of DeFi volume, with about 2.2mn Ether locked into its smart contracts. Put differently, the dominance is highlighted by the fact this represents about 2% of all Ether in circulation. That said, data by on-chain analytics provider Glassnode suggests that the recent all-time high in gas used on the Ethereum network can be partly attributed to smart contract interactions which make up roughly 45%, with DeFi accounting for a large chunk of those transactions.
Among the DeFi protocols, MakerDAO has become something of a cornerstone. It not only accounts for the lion’s share of funds locked into DeFi, but the permissionless creation and distribution of its stablecoin DAI along with its indispensable oracles positions it as a key component for other DeFi applications. In fact, we understand that more than 85% of all DeFi projects are built upon DAI. Moreover, DAI is used by both centralized and decentralized applications. The latter include large applications such as Compound, Dharma, Nexus Mutual, and apps such as Wirex with many more DAI integrations in the works.
But how does present-day DeFi’s most vital protocol work? In other words, what is MakerDAO? Given the protocol’s crucial role in the current DeFi ecosystem, we give a brief overview of its main features. In a nutshell, MakerDAO is a non-custodial credit facility that issues secured loans. It runs on Ethereum smart contracts and creates DAI, a stablecoin whose value is has a “soft” peg to the USD. That is, DAI is designed such that it algorithmically tracks the value of the USD hovering at USD 1. In essence, DAI is a secured loan that is issued against collateral in the form of Ether. To obtain a loan, borrowers lock up a given amount of Ether through an Ethereum transaction. This process creates a so-called collateralized debt position (CDP). Users can borrow Dai up to about two-thirds of their Ether’s value. Put differently, the borrowers can take out a DAI loan with a maximum loan-to-value (LTV) ratio of 66%, or conversely, 150% overcollateralization. As usual, DAI debt also incurs interest in the form of a so-called “stability fee”. By design, the interest due upon repayment needs to be paid in MKR – the Maker token. The MKR amount is subsequently burned along with the repaid DAI notional amount. Ideally, the burning mechanism boosts token value similar to how share buy-back programs can lead to higher prices in equity prices of traditional companies.
“What on earth is MKR good for?”, the reader might ask. MakerDAO’s second token is essentially a governance tool. Holders of Maker’s MKR get to vote on risk parameters such as the level DAI’s stability fee. In addition, MKR holders also act as the “last line of defense” in case of a black swan event, as Chris Burniske put it. On the downside, if systemwide collateral value falls too low too fast (i.e., the value of Ether in today’s single-collateral DAI system; all types of eligible collateral in the future multi-collateral DAI system), fresh MKR is minted and then sold on the open market. While this emergency strategy helps to re-establish full collateralization by raising more collateral, it also dilutes MKR holders. These holders will also vote on which new assets to support as part of its plan to upgrade to Multi-Collateral DAI (MCD) later on this year. Once DAI is issued to a borrower, the newly-created tokens can then be exchanged for any cryptoasset it trades against while also allowing borrowers to purchase other goods and services. In practice, borrowers expecting the price of Ether to appreciate against the USD have frequently used their newly-issued DAI to lever up to purchase more Ether.
A major driver behind the success of MakerDAO has been the ability to circulate DAI between different DeFi platforms and to use it as a unit of account on these dapps. However, the price stability of DAI has not always lived up to expectations. Although it is theoretically engineered to remain stable, that is, maintain its “soft” peg at USD 1, the price has seen notable swings in 2019. A vivid example was the period between February and May 2019 when the price of DAI was subject to significant overshooting and undershooting, briefly dropping by more than 5% to below USD 0.95. The prolonged period of “breaking the buck” resulted in MKR holders hiking the stability fee eight times from 0.5% in February to 19.5% in June. After a renewed deviation from its soft peg in July amid increasing demand for DAI, the fee were raised to 20.5%. By making loans more expensive, the MKR community aimed at retracting market supply of DAI to push up the dollar valuation. The fee of a DAI loan is currently at 12.5% p.a. The recent rollercoaster ride turned out to be a setback for those hoping that the cost of secured decentralized loans could compete with those offered by traditional financial institutions.
The budding DeFi ecosystem has led to the creation of at least 9 DAI variants. Those include Compound’s interest-rate bearing cDAI, the Ethereum sidechain xDAI, the privacy-centric ZkDAI and perhaps most interestingly, SwanDAI. The latter allows users to hedge exposure to potential DeFi black swans using the UMA protocol. It essentially tracks the deviation of the DAI price from its dollar peg. The payout increases exponentially as the deviation increases.
Another core element within DeFi are Maker’s oracles: In the blockchain world, the term oracle stands for external sources that feed smart contracts with real-world information, that is, they submit information from beyond the chain. As previously described, a key component of the Ethereum platform is its virtual machine (EVM) which has the ability to execute programs and update the state of Ethereum, subject to the consensus rules. The range of what people consider to be an oracle is fairly broad and might include exchange rates, results of football games or data transmitted by sensors of IoT devices. In the context of MakerDAO, DAI oracles update immediately in the event of price fluctuations in ETH of more than 1%. But the use of Maker’s oracles currently extends far beyond the protocol itself. The extent to which different DeFi projects approach oracles varies, but many applications in the space are using MakerDAO’s oracle when fetching prices.
Admittedly, DeFi has come a long way and the pace of development and usage growth over the past three years is impressive. This cannot belie the fact that today’s sprawling DeFi ecosystem is at the mercy of Ethereum’s long term success, particularly with respect to its scaling issues. True, increased gas usage in the DeFi realm indicates ongoing user growth. Whether DeFi is viable on Ethereum in its current form if its user base were to experience substantial growth is highly questionable given the current bottlenecks in terms of throughput. At a recent panel discussion, Joseph Lubin acknowledged that Ethereum was a project “that we knew wouldn’t be scalable”. As for Ethereum 2.0, its envisaged scaling solution, a reality check shows that the project clearly lags behind expectations, which begs the question as to how the network will cope until then. Ethereum 2.0 also faces multiple technical roadblocks, most notably regarding Plasma, Raiden and Sharding. Hence, we are under the impression that the fate of DeFi adoption is tied to the scalability and usability of Ethereum going forward.
Similarly, the MakerDAO protocol is arguably the most critical piece of infrastructure within DeFi given the space’s reliance on oracles and stablecoins. The protocol has considerable implications for the progress and security of DeFi in short to medium term. Maker was the first decentralized stablecoin to emerge on Ethereum and the rapid progress made by the project incentivized the vast majority of DeFi projects to build on its protocol, not least because it appeared to be the only workable solution.
As MakerDAO has grown exponentially, there are concerns about its too-big-to fail status and the mechanisms underpinning it. At present, market participants are faced with few viable alternatives to the dominant lending protocol and its oracles. Upon closer inspection, Maker’s categorization as a non-custodial application is iffy since its oracles are essentially in control of the platform and its collateral.
Expanding the credit facility’s collateral pool to multiple cryptoassets, while certainly beneficial to its borrowers, doesn’t come without challenges. Although the introduction of MCD (incl. bitcoin) is long overdue, it has yet to stand the test of time. The past months showed that MKR holders had to go to great lengths to maintain the USD 1 peg under the current SCD system. It remains to be seen whether MakerDAO’s price MCD oracles are reliable during times of market failure. While Ethereum-based SCD oracles update instantaneously if there is a price move on the order of 1% or more, we understand that MCD oracles update only once an hour for the sake of transparency. Whether MakerDAO’s risk model sufficiently accounts for the potential drawdown of cryptoassets, especially in the event of a market selloff, is debatable. Many of the underlying assets are not yet well understood, particularly with respect to their valuation and volatility. Furthermore, if a liquidation of MCD positions were to occur, they would be executed via MCD auction that takes “six hours or more” to liquidate positions. It goes without saying that MKR holders are exposed to significant risk when the protocol delays an auction for 6 hours to unwind large positions during a market squeeze. As Nassim Taleb writes in Antifragile, squeezes can become nonlinearly costlier as size increases. That is not to say Maker itself or the overreliance on it cannot be improved over time and the platform becomes more non-custodial over time.
DeFi critics often argue that the lack of user experience, or UX, is a considerable drag for adoption. The product-market fit is currently designed for crypto-native users that are comfortable with the UX. While the DeFi stack has become broader and more user-friendly, projects have struggled to gain traction beyond those that are inherently familiar with common Ethereum terminology. Realistically, these products are way too early to target a mainstream audience, not least because many of them require users to handle multiple tokens which introduces considerable friction. Hence, it is somewhat optimistic to assume that the average investor understands the risk profile of even simple DeFi products. Developers we spoke to have made the point that the cumbersome and unintuitive experience on these platforms will eventually give way to great UI, much like during the early days of the internet and email. Adoption takes time, no doubt, but dabbling in email is different than risking your own money in uncharted territory.
Among the most interesting fields in crypto are exchanges and lending. Projects in these areas have seen notable tailwinds, both in DeFi and centralized platforms. One the professional side, institutional or high-frequency traders still prefer the well-established custodial platforms to DEXs due to their higher liquidity, greater market depth and instant execution. This is despite numerous reports based on real data that discovered excessive wash trading (a form of market manipulation that artificially inflates the volume of a given asset), spoofing (large fake order which are then cancelled), or even front-running. Moreover, building a full DEX is one of the most difficult tasks in DeFi, if it involves centralized servers or displaying the order book. On the other hand, the appeal of DEXs has grown significantly for traders that are increasingly reluctant to go through the onerous KYC/AML process or deal with lengthy withdrawal processes or high fees. DEXs are also a compelling alternative for traders affected by capital controls or bans on crypto trading, particularly for users in high-inflation countries that can park their gains in stablecoins. DEXs also received a boost through the maturity of liquidity relays such as 0x or Kyber that allow users to engage with multiple exchanges. The latter is an on-chain protocol that aggregates liquidity across the fragmented platforms and has been integrated in a number of wallets and dapps. On the flipside, it is hard to deny the potential for manipulation of on-chain order books as well as the potential for front-running on DEXs, particularly on the part of miners on platforms such as Ethereum. It is highly unlikely that users going the DEX route can at all times count on fair and orderly markets.
Elsewhere, lending has been another major trend in crypto. In DeFi, the focus has shifted notably to protocols such as Maker, Compound or Dharma, with six out of the top 10 DeFi protocols based on their locked up USD amounts constituting lending dapps, according to defipulse.com. The fact that MakerDAO provides a high level of transparency that enables market participants to monitor the underlying transactions, credit creation and the collateral backing the loans is innovative. However, it does not necessarily lead to the origination of cheaper loans or more financial inclusion. In fact, MakerDAO is currently unable to compete as a low-fee credit provider in light of the double-digit stability fee. Rather, it serves crypto investors and the Ethereum community levering up on their Ether. Further, with respect to providing cheap loans to a broader audience, Maker has fallen short of expectations. So far, there is little evidence to suggest that DeFi lending platforms contribute meaningfully towards a more equal economic opportunity future. The promise of a lean protocol facilitating the credit process, thus leading to a lower cost of credit for all, has not yet materialized.
This is not surprising. Traditional finance is based on trust and the opportunities of financial recourse anchored in the legal system. It has flaws and inefficiencies, no doubt, and often excludes or discriminates against borrowers with lack of credit history or low credit scores (sometimes referred to as the “underbanked”). With the exception of mortgages and a few other forms of secured loans, credit in the retail space is typically unsecured. When originating loans, lenders make decisions based on the data points available to them. The more data points and the longer the credit history, the more reliable the credit score. Lenders mitigate the higher probability of default by charging higher rates. This risk-adjusted pricing allows borrowers with decent credit scores to take out competitive loans at fairly low interest rates.
On the other hand, lending in DeFi is largely anonymous and therefore needs to be secured, in order for the creditor to have recourse on collateral in the event of failure of repayment. What’s more, the rates on these loans have been less than stellar despite the high level of overcollateralization. Importantly, the US subprime crisis showed that collateralization is no panacea either. The mispriced assets such as mortgage-backed securities (MBS) created out of subprime mortgages, or worse, collateralized debt obligations (CDOs) created out of several mispriced MBS tranches, had a devastating impact on the global financial system.
In reality, borrowers that take out a loan often times cannot put down collateral. Likewise, overcollateralization is expensive and rather unappealing to borrowers with decent credit scores. In DeFi, the only way to originate a risk-adjusted loan is via self-sovereign identity. We are unlikely to see unsecured retail loans on the blockchain until digital identity technology has sufficiently matured or perhaps alternatively, on-chain income streams are commonplace.
The flexibility and ease of use offered by Ethereum has greatly benefited the nascent DeFi space. But this tradeoff comes at the expense of security and happens to make the system more vulnerable compared to Bitcoin. As we’ve seen, finance is about trust and a high level of security, especially if there is no reversibility of transactions. Eliminating counterparty risk is not worthwhile if the new financial system is on shaky ground. Likewise, while the transparency and auditability of each of the protocols is laudable, the interdependencies among many of the applications that are part of the DeFi stack might result in spillover effects to other parts of crypto. The financial crisis of 2007/2008 is a reminder that financial engineering, increasingly complex products and complacency of market participants can quickly magnify systemic risks within an interconnected financial system. In crypto, there is no benefit of the doubt, especially in the absence of a fallback option or lender of last resort.
This begs the question whether key DeFi applications can be replicated on Bitcoin. When taking the above factors into account, we believe that Bitcoin is well suited for a robust, albeit notably smaller DeFi ecosystem. By design, Bitcoin emphasizes security, something that is very important in financial infrastructure. Bitcoin’s most successful DeFi application has been the Lightning Network. The second layer protocol is based on a technology called state channels, or bidirectional payment channels, that uses a series of smart contracts, most notably Hashed Timelock Contracts (HTLC). The Lightning Network allows for ultrafast and cheap payments and has seen impressive growth in 2019, with the number of nodes with open payment channels increasing to almost 4,800 in September 2019 from less than a hundred at the beginning of the year. Likewise, the channel tally is at almost 32,000 against less than 500 in January. Its network capacity amounts to an equivalent of USD 8.5mn in Bitcoin is currently locked up in its channels.
Contrary to popular belief, dapps are indeed possible on Bitcoin but programming them is more complex and additional layer two primitives are required. Given the constraints of Script and the endless possibilities offered by Ethereum’s Solidity language, developers and investors opted to build DeFi on Ethereum. It is out of the question that smart contract functionality would be added to the Bitcoin protocol that enabled the creation of DeFi products. Instead, sidechain solutions smart contract solutions like RSK exist. As outlined by Token Daily’s Mohamed Fouda in a valuable piece, there are four ways to bring DeFi to Bitcoin. First, current technology such as cross-chain atomic swaps – cryptographically-secure simultaneous exchange of coins across blockchains – facilitated by HTLCs can be used for DEXs that execute trades between Bitcoin/crypto and Bitcoin/fiat pairs. Second, federated sidechains such Blockstream’s Liquid and RSK use a separate chain on top of the Bitcoin base layer using own validators and a token that is pegged to BTC. RSK is one such solution that allows for smart contract functionality while also supporting Ethereum’s Solidity smart contracts. That way, DeFi smart contracts could also run on RSK. A third technological approach to enable DeFi on Bitcoin is to use layer two solutions such as the OmniLayer or Lightning Network. A relatively new approach related to the latter is Discreet Log Contracts, introduced by Tadge Dryja in 2017 of the MIT Digital Currency Initiative. These contracts are based on oracles and can be used to create derivatives such as Bitcoin-settled forward contracts. Fourth, Bitcoin can also be used in DeFi using other platforms such as Ethereum or Cosmos. Admittedly, issuing an ERC-20 token backed by Bitcoin (called WBTC) that can be traded on Ethereum dapps is DeFi repackaged. As of September, only 570 BTC are held in the project’s multi-sig wallet. Unlike in WBTC, Bitcoin remains the native currency in Cosmos’ peg zones. The interoperability protocol defines peg zones where the price of assets issued on Cosmos can be tethered to other blockchain assets like Bitcoin. Interestingly, it is possible to add smart contract functionality to the pegged asset in these zones and benefit from faster finality.
While these approaches are good at doing specific things surrounding the Bitcoin blockchain, they cannot serve the entire spectrum of DeFi applications. Although these technologies are still in its infancy, they warrant a closer look. Below is a summary of newer and less known Bitcoin projects that are already building on these technologies. Note that the list is not intended to be exhaustive.
- Arwen: The protocol allows users to trade at a centralized exchange without risking their funds based on trustless on-chain escrows. The underlying layer two protocol enables trades using atomic swaps. Trades are only visible to you and the exchange, protecting traders from front-running and. Arwen currently supports cryptocurrencies that use the same codebase as Bitcoin but plans on adding cross-chain atomic swaps between Bitcoin and Ethereum.
- Summa: The interoperability service connects Bitcoin and other cryptoassets to enable private, self-enforcing, and self-settling cross-chain contracts. Summa provides custom-built interoperability solutions based on its Stateless SPV technology for companies throughout the blockchain ecosystem. The solution allows validating Bitcoin transaction using Ethereum smart contracts and users can buy ETH with Bitcoin through auctions.
- Echo: The network runs dapps build on smart contracts that interact with the Bitcoin network. Echo implements a two-way pegged sidechain, or bridge, that allows users to deposit, withdraw, and use BTC with applications on the Echo network. In terms of security, the network uses a dynamic, open committee as opposed to a private and permissioned federation of known companies to secure the sidechain.
- Elements: The Blockstream project is an open source, sidechain-capable blockchain platform, that provides access to key features, such as confidential transactions and issued assets. The most prominent example of an Elements-based sidechain is Liquid. The blockchain can operate as either a standalone chain or be pegged to another and run as a sidechain.
- Tradelayer: The project plans to implement decentralized derivative markets on Bitcoin. Tradelayer forked from the OmniLayer protocol, extending it with multisig channels to allow the use of Bitcoin as collateral for peer-to-peer derivative trades. The project has their own tokens, one each for Bitcoin and Litecoin. A possible use case could be the creation of stablecoins using Bitcoin as collateral similar to how Ether is used to issue DAI on MakerDAO.
- Sparkswap: The cryptocurrency exchange built on the Lightning Network, and compatible with many of its wallets such as Zap or Node Launcher. Sparkswap has fiat onramps and allows users to transfer Bitcoin purchases instantly to their Lightning wallets without the exchange taking custody of them. The team developed a new mechanism called Cross-Network Preimage Retrieval to execute trustless atomic swaps between currencies using Payment Channel Networks like the Lightning Network. Among other things, it increases the potential reach of swaps to additional blockchains and currencies.
- Miniscript: Developed by Blockstream’s Peter Wuille, Andrew Poelstra and Sanket Sanjalkar, Miniscript is a reduced version of Bitcoin’s Script. In essence, it is a selection of “tools” that abstracts away the complexity and makes it easier to verify by developers. The tools are selected in such a way that they enable virtually anything that can be done with Script. Even though the current version of Miniscript and the compiler are not final versions, Blockstream is using it internally for the development branch of its Liquid sidechain functionary software.
There is little doubt that Ethereum has been in the vanguard when it comes to DeFi. The space has captured plenty of attention in 2019 amid its steadily growing DeFi stack and a record number of Ether being locked up in dapps. Yet, there are concerns, caveats and complexities, particularly surrounding the mainstays of DeFi: Ethereum 1.0 and MakerDAO. Overall, DeFi’s value proposition remains strong but a high-level of security is imperative for financial applications. While Bitcoin has a competitive advantage in terms of its security model and history, its DeFi protocols are only in their infancy. Bitcoin developers have increasingly set out to tap into the enormous potential of Bitcoin DeFi. We expect the DeFi narrative to change at least one more time in the next few years, probably toward a dual ecosystem.