Bitcoin DeFi (BTCfi): A Deep Dive into the BTC Liquidity Landscape

Bitcoin is the largest and most recognized crypto asset, but as the first blockchain, it was designed for security and simplicity—not smart contracts. Programmability was an afterthought.

Bitcoin’s foray into decentralized finance (DeFi) has been a gradual yet persistent process, largely driven by the growing demand for BTC liquidity and the limitations of Bitcoin’s base layer, which lacks the native programmability to support smart contract applications.

However, this challenge has spurred the development of various solutions that expand BTC’s functionality, enabling users to earn yield and access DeFi applications while preserving Bitcoin’s renowned security and decentralization. These solutions include Bitcoin Layer 2s, restaking protocols, and alternative BTCFi innovations.

Bitcoin Layer 2s

Bitcoin Layer 2 networks are built on top of the Bitcoin blockchain to address its scalability challenges, offering solutions that improve transaction speed, lower fees, and enhance functionality.

The main types of Bitcoin L2 solutions include:

State Channels: State channels move transactions off-chain, allowing users to bypass high transaction fees. In practice, two parties lock Bitcoin into a multisig wallet and send payments within the channel, which keeps a record of all transactions until it’s closed. Once they finish transacting, the parties sign and broadcast the final channel state to Bitcoin’s Layer 1 as a single transaction.

This setup significantly reduces costs by reporting only the opening and closing balances to the Bitcoin network, eliminating the need to pay mainnet fees for every transaction.

Side Chains: A sidechain is an independent blockchain that runs in parallel to Bitcoin’s Layer 1 and is connected to Bitcoin through a two-way bridge. While sidechains often use Bitcoin as their native currency, they can also issue their own native tokens.

Unlike true Layer 2 solutions, Sidechains have separate consensus mechanisms rather than fully leveraging Bitcoin’s security or verification process. However, some sidechains periodically settle on the main chain or leverage Bitcoin’s security to varying degrees.

A defining feature of sidechains is their communication bridge with Bitcoin, which involves locking assets on the Bitcoin network and minting an equivalent amount on the sidechain.

Rollups: Bitcoin Layer-2 rollups move transaction execution and data off Bitcoin’s Layer 1 to a separate rollup chain while leveraging Bitcoin for data availability and consensus. This solution allows transactions to be executed on the rollup chain, where data is compressed and periodically posted to Bitcoin’s Layer 1 for validation.

Rollups primarily function as an execution layer, maintaining a relationship with the Bitcoin network as the consensus layer.

There are two types of rollups:

Optimistic Rollups: These rollups assume that all transactions are valid unless proven otherwise. They batch transactions off-chain and submit a single “rollup” transaction to Bitcoin’s Layer 1, which includes a Merkle root of all transactions and a fraud proof.

If any transaction is disputed, a sequencer can be penalized by slashing their bond, which serves as a deterrent against submitting invalid transactions.

ZK Rollups: These rollups use advanced cryptography to generate a succinct proof that attests to the validity of all transactions in a batch without revealing individual transaction details. This proof is then included in the rollup transaction on Bitcoin’s Layer 1.

Compared to Optimistic Rollups, ZK Rollups offer higher privacy and lower gas costs but require more technical expertise for development.

Here are some of the notable Bitcoin L2 networks:

Stacks: Stacks is a Bitcoin sidechain that operates on a Proof of Transfer (PoX) consensus mechanism. PoX combines Proof of Stake (PoS) and Proof of Burn to create a system that connects Bitcoin miners with Stack participants, known as “Stackers”.

Similar to PoS, Stackers lock their STX tokens to secure the Stacks network and Bitcoin miners offer BTC to incentivize Stackers for the right to validate blocks. A miner’s selection chances increase based on how much BTC they commit to Stackers.

When a BTC miner is selected, they validate the block and earn STX rewards in return and their BTC rewards are proportional to the amount of STX they lock.

Stacks also features a native DEX called XSwap, a lending protocol called Arkadiko Finance, and a liquid staking service called Lido for Stacks. These applications, combined with Stacks’ EVM compatibility, contribute to a growing DeFi ecosystem on the Bitcoin sidechain.

Rootstock Infrastructure Framework (RIF): Rootstock (RSK) is an EVM-compatible Bitcoin sidechain. It connects to the Bitcoin network via a two-way Proof of Work Peg (PoWPeg) protocol. This mechanism allows users to lock BTC on the Bitcoin network and mint RBTC on Rootstock at a 1:1 ratio.

Rootstock’s consensus layer mirrors Bitcoin’s, sharing the same hash rate through merged mining, where Bitcoin miners can validate blocks on both chains simultaneously. Miners on Rootstock are incentivized with RBTC.

The Rootstock Infrastructure Framework (RIF) operates on top of the RSK blockchain, providing a suite of decentralized services for dApp development.

Key components of RIF include:

RIF