What Is Bitcoin DeFi (BTCFi)?

Since its inception in 2009, Bitcoin has paved the way for an entirely new asset class and established itself as the largest cryptocurrency with a market capitalization now exceeding a trillion dollars. However, the vast majority of bitcoin remains idle in cold storage, unproductive and underutilized. A new trend is emerging that seeks to unlock this dormant liquidity to increase the utility of both bitcoin the asset and Bitcoin the network.

In the last few years, decentralized finance (DeFi) has grown from a small niche industry to a fully-fledged onchain economy. DeFi enables anyone with an Internet connection to participate in a global ecosystem of financial services operating onchain. This innovation has largely been confined to platforms with smart contract capabilities, such as Ethereum and various other blockchains, layer-2 networks, appchains, and other onchain environments.

As Bitcoin gains recognition as a trillion-dollar asset, there is increasing demand to enhance its utility. With advancements like the Taproot upgrade in 2021, DeFi on Bitcoin is becoming a possibility, and onchain innovators are exploring how to unlock the vast liquidity that Bitcoin represents.

In this post, we explore Bitcoin DeFi (BTCFi), its benefits, and the use cases it can enable.

What Is DeFi?

Decentralized finance is a significant breakthrough in financial application development, enabled by blockchains, smart contracts, and oracles. DeFi enables users to access onchain financial services that operate without centralized intermediaries, with their underlying rules governed by deterministic smart contracts.

By using DeFi protocols running on censorship-resistant and decentralized networks, DeFi applications can provide global permissionless access, mitigate counterparty risk, and compose with other onchain applications to enable more advanced financial products.

While DeFi started by replicating traditional financial instruments onchain, it has since expanded to offer a wide range of services, serving as a proof-of-concept for demonstrating the benefits of blockchain technology for both everyday users and institutions exploring the future of finance and Bitcoin.

Advantages of DeFi on Bitcoin

Why bring DeFi to Bitcoin? Bitcoin remains the largest cryptocurrency by market capitalization, with strong network effects and a unique status as an asset. Some of the main benefits of BTCFi include:

• Unlocking liquidity—One of the most significant advantages of BTCFi is the ability to unlock the trillion-dollar Bitcoin liquidity currently sitting idle in cold wallets. While Bitcoin’s primary use case as digital gold or decentralized money is well established, BTCFi proponents argue that some of this idle BTC could be put to more productive use.
• Using Bitcoin in DeFi—Another advantage is the ability to use bitcoin as a native asset in DeFi. Providing more utility and programmability to the largest crypto asset could unlock more adoption of Bitcoin technology both for ordinary users, traditional institutions, and nation states.
• Supporting Bitcoin’s security budget—A possible benefit of Bitcoin DeFi is its potential to address the issues with Bitcoin’s long-term security budget. Bitcoin’s inflation rate is halved every four years, reducing the rewards paid to miners. While this was crucial for Bitcoin’s early growth, some worry that Bitcoin’s security budget may be insufficient in the long run if transaction fees do not increase. As the surge of ordinals and BRC-20 tokens showed, BTCFi could generate more activity on the network, thereby boosting fees and supporting Bitcoin’s long-term security budget.

How Does Bitcoin DeFi Work?

Bitcoin DeFi is an evolving field with many approaches aimed at enhancing Bitcoin’s smart contract capabilities. Bitcoin’s purposefully limited scope has been key to its success. However, since Bitcoin was not originally designed for smart contracts, BTCFi presents a significant open research problem, with the challenge of expanding Bitcoin’s functionality while maintaining the network’s security and decentralization.

An important milestone for BTCFi was the Taproot upgrade, activated in November 2021, which expanded Bitcoin’s capabilities by improving privacy and programmability. Prior to Taproot, Bitcoin’s smart contract functionality was extremely limited—Taproot unlocked the possibility of building more complex DeFi applications on Bitcoin.

Use Cases of Bitcoin DeFi

The use cases for Bitcoin DeFi are similar to those of traditional DeFi but are deployed on Bitcoin and often use BTC as the native asset. 

Chainlink has supported the DeFi ecosystem since its inception, fulfilling the need for high-quality data, compute, and interoperability services that have been instrumental in turning DeFi into the success that it is today. DeFi can’t fully realize its potential without reliable oracle services—Bitcoin DeFi has the same requirements for it to enable secure, decentralized financial applications on the Bitcoin network.

 Some potential use cases of BTCFi include:

• Bitcoin-native assets—Bitcoin DeFi unlocks the ability to issue both fungible and non-fungible assets on the Bitcoin network, which can be transferred using either the Bitcoin mainnet or layer-2 solutions. Early experiments, like Colored Coins, attempted to represent assets on Bitcoin, but more recent efforts, such as Taproot Assets and BRC-20 tokens, are advancing the creation of fungible tokens natively on Bitcoin. Another way to leverage Bitcoin in this ecosystem is through wrapped Bitcoin. For example, dlcBTC is using Chainlink Proof of Reserve and CCIP to enhance reserves transparency and enable cross-chain transfers of its wrapped Bitcoin.
• Staking—While staking is commonly associated with proof-of-stake blockchains or backing the security of oracle services, BTCFi enables staking mechanisms that allow users to lock up their Bitcoin and earn rewards or participate in other network activities. An example of this is Solv which integrated Chainlink CCIP to enable cross-chain transfers for its SolvBTC ecosystem tokens with $1B+ TVL.
• Borrowing and lending—Decentralized money markets are a core feature of any DeFi ecosystem, and BTCFi is no exception. These protocols enable users to use their Bitcoin as collateral to earn interest or borrow other assets, unlocking new financial opportunities on the Bitcoin network.
• Decentralized exchanges—BTCFi enables decentralized exchanges (DEXs), such as automated market makers (AMMs), allowing users to trade Bitcoin-based assets directly with one another, further enhancing liquidity within the BTCFi ecosystem.