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    What exactly is Bitcoin DeFi, and how does it work?

    Tanya Sharma
    Tanya Sharma
    Published on January 12, 2023 7:58 AM

    Updated on January 16, 2023 11:27 AM

    DeFi refers to peer-to-peer financial services on public blockchains, most notably Ethereum. Wrapped tokens and DeFi initiatives are allowing Bitcoin holders to enter the world of decentralized finance.
    What exactly is Bitcoin DeFi, and how does it work?
    Source: Unsplash

    Since the emergence of decentralized finance (DeFi) in 2020, the bulk of DeFi initiatives have been developed on the Ethereum blockchain.

    Bitcoin holders who want to use DeFi frequently employ wrapped versions of Bitcoin, such as WBTC. This has enabled them to employ tokens that are linked 1:1 to Bitcoin.

    However, there have been significant changes in the world of DeFi between 2021 and 2022. Not only have prospective "Ethereum killers" like Solana snatched DeFi market share away from Ethereum, but DeFi initiatives built around the Bitcoin network itself have grown in size and viability.

    What Is Decentralized Finance (DeFi)?

    Decentralized finance (DeFi) is a new financial system that is built on secure distributed ledgers, similar to the ones used by cryptocurrencies.

    In the United States, the Federal Reserve and the Securities and Exchange Commission (SEC) set the rules for centralized financial institutions such as banks and brokerages, which customers rely on to gain direct access to capital and financial services. DeFi disrupts the centralized banking system by enabling users to conduct peer-to-peer digital transactions.

    Also see: DeFi is transforming the way forward

    DeFi reduces the fees charged by banks and other financial institutions for using their services. Individuals keep their money in a secure digital wallet, can transfer funds in minutes, and can use DeFi from anywhere with an internet connection.

    What is Bitcoin's relationship to DeFi?

    The majority of DeFi platforms continue to be created on smart contract platforms like Ethereum. However, there are many Bitcoin owners who want to participate as well. As a result, a variety of solutions have been developed to assist Bitcoin holders in investing in DeFi.

    Because Bitcoin is the most valuable cryptocurrency in terms of market capitalization, there is an unavoidable desire for solutions among Bitcoin holders.

    How does Bitcoin DeFi function?

    Bitcoin DeFi operates differently depending on the blockchain on which it is deployed.

    Ethereum-based Bitcoin DeFi:

    Bitcoin holders must use a token such as Wrapped Bitcoin to utilize Bitcoin on Ethereum (WBTC). Wrapped Bitcoin is a 1:1 replica of Bitcoin that can be used on different blockchains. Wrapped Bitcoin (WBTC) ERC-20 token on Ethereum can be utilized on DeFi platforms exactly like any other asset on the Ethereum network.

    A Bitcoin owner might convert their Bitcoin to WBTC and then borrow stablecoins using a platform like MakerDAO. The stablecoins can then be re-invested in the DeFi ecosystem. The risk with this technique is that the WBTC utilized as collateral will be liquidated.

    Bitcoin DeFi based on Stacks:

    Stacks, like Bitcoin, is a layer-1 independent blockchain. The Stacks and Bitcoin networks are linked via a technique known as Proof-of-Transfer. Miners must pay Bitcoin to the Bitcoin network in order to mine Stacks. Multiple Stacks of network transactions can correspond to a single Bitcoin network transaction.

    On the Stacks blockchain, a variety of DeFi applications are conceivable, ranging from "stacking" the Stacks token to earn Bitcoin rewards to exploring decentralized applications (dapps) that enable typical DeFi methods like staking and yield farming.

    Rootstock (RSK)-based Bitcoin DeFi:

    The RSK blockchain operates as a sidechain to the Bitcoin blockchain, and its utility token is Smart Bitcoin (RBTC). On the RSK blockchain, RBTC is used to pay smart contract fees, the same as ETH is used to pay fees on the Ethereum blockchain.

    Smart Bitcoin (RBTC) is linked to the price of Bitcoin 1:1. (BTC). Because the RSK blockchain is a sidechain of Bitcoin, there is a two-way peg between RBTC and BTC, and the two assets can be transferred back and forth between the two blockchain networks interchangeably.

    Making passive money with Bitcoin DeFi:

    Why would someone want to deposit their Bitcoin into DeFi when they can buy Ethereum directly? Many people hoard Bitcoin as a form of safekeeping. Though not without hazards, using Bitcoin for DeFi can possibly unlock passive income on top of that store of wealth.

    What are some examples of Bitcoin DeFi projects?

    • Wrapped Bitcoin (WBTC) - An Ethereum blockchain ERC-20 token linked 1:1 to the price of Bitcoin and backed by an equivalent amount of Bitcoin held in a digital vault. WBTC, which was founded by BitGo, Ren, and Kyber, is now maintained and administered by the WBTC DAO.

    • Ren VM - A network that uses the RenBridge to package and send currency such as Bitcoin to other blockchains.

    • RSK (Rootstock) - A smart contract blockchain that works as a Bitcoin sidechain and supports a number of DeFi systems.

    • BadgerDAO - A decentralized autonomous organization (DAO) that offers Bitcoin solutions in the DeFi ecosystem, BadgerDAO was hacked for $120 million in late 2021.

    Stacks is a layer-1 blockchain that is independent of the Bitcoin network and supports a variety of dapps.

    What does the future of Bitcoin DeFi look like?

    Wrapped Bitcoin had over $9 billion in Bitcoin locked up as of May 2022. (WBTC). This is an increase from a market cap of slightly more than $4 million (not a billion) dollars at the start of 2020.

    While the rise in WBTC is just one metric indicating an increase in Bitcoin holdings flowing into DeFi, Bitcoin holders now have a growing number of options. The success of Bitcoin DeFi systems and protocols will be determined by their long-term security and durability, as well as the benefits offered to investors.

    Bitcoin DeFi FAQs

    What Is the Purpose of Decentralized Finance?

    Defi's purpose is to question the use of centralized financial institutions and third parties in all financial transactions.

    Is Bitcoin a Decentralized Financial System?

    Bitcoin is a type of cryptocurrency. DeFi is built to leverage cryptocurrencies in its ecosystem, therefore Bitcoin isn't so much DeFi as it is a component of it.

    Is it possible to perform DeFi on Bitcoin?

    DeFi is a movement that uses decentralized networks to transform traditional financial products into trustless and transparent protocols that operate without the use of middlemen. According to the sources, 191 DeFi projects are listed, with 17 of them utilizing Bitcoin.