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The concept of decentralized finance (DeFi) first rose to prominence during the 2020–2022 cryptocurrency bull market. Built almost entirely on Ethereum at the time, the basic idea was to expand the decentralization and censorship resistance bitcoin enabled for payments and savings to other areas of finance (e.g., borrowing, lending, and trading). While DeFi has been mostly proven out on Ethereum and other blockchains with more expressive smart contracting capabilities, there has been a more recent expansion of interest in bringing these use cases to the bitcoin network.
For many, combining the strongest and most credible cryptocurrency with some of the technical development that has taken place on other networks in the 15+ years since bitcoin was introduced could be the perfect way to build out the next evolution of the DeFi ecosystem.
Let’s dive deeper into why there is so much excitement around bringing DeFi apps to bitcoin.
How Bitcoin Is Different From Other Cryptocurrencies
At the base layer, bitcoin is specifically designed to serve as a global, digitally native, decentralized, and apolitical monetary system that prioritizes and rewards savers more effectively than the current U.S. dollar-dominated financial system. As the first digital asset that requires no permission to use, has a monetary policy that was “set in stone” when the network first launched, enables wealth to be stored as information, and has censorship-resistant payments, bitcoin makes sense as the perfect native money of the internet’s financial system.
No other cryptocurrency, whether focused on payments or other use cases, comes close to bitcoin in terms of the credibility of its monetary policy — enabled by the high degree of decentralization in the system. And it is the credibility of that monetary policy that makes bitcoin the best digitally-based store of value.
Other cryptocurrencies tend to have various centralizing forces and other factors that put the credibility of the monetary policy into question. For example, Elon Musk’s outsized influence over Dogecoin, as indicated by the effect his X posts have on the Dogecoin price, indicates that the cryptocurrency’s monetary policy could be altered if Musk desired to change it. While stablecoins have become a popular medium of exchange in the Web3 space, the reality is these tokens are pegged to fiat currencies (usually the U.S. dollar) and centrally issued with the backing of real-world financial accounts, which makes it unclear if they’ll remain permissionless and censorship-resistant over the long term. Even ether, which is sometimes referred to as the only real competition to bitcoin, has seen its issuance rate altered on several occasions, and discussions have begun regarding another potential change in the near future.
As bitcoin creator Satoshi Nakamoto wrote in the early days of the project, one of the key benefits of the system is that a central bank does not need to be trusted to not debase the currency. This enables long-term clarity and predictability in terms of the monetary supply. With alternative digital assets, the central bank has been replaced by some other third party, as the level of decentralization and widespread adoption achieved by bitcoin has not been replicated. As a recent example, the validators of the Solana network have altered that cryptocurrency’s monetary policy in order to increase their revenue.
Any truly decentralized financial system must have a decentralized monetary system at the base layer, and that’s what bitcoin provides.
Due to its monetary credibility, bitcoin is able to act as the best possible money and collateral for DeFi use cases such as collateral-backed stablecoins and decentralized derivatives trading. As bitcoin continues to become a trusted, reliable store of value in the free market, more financial tools can be built on top of that solid, sturdy foundation.
The Block Size War As A Case Study
Bitcoin’s block size war can be seen as clear supporting evidence for the difficulties associated with changing any rules of the bitcoin network. While the vast majority of large miners, exchanges, and wallet providers pushed for a hard-forking (backwards incompatible) increase to bitcoin’s block size limit, the plan was ultimately abandoned due to a lack of consensus among the underlying userbase. No other cryptocurrency network has successfully withstood this sort of strong-armed social attack on its underlying ruleset.
While soft-forking (backwards compatible) feature additions with widespread consensus take place in bitcoin from time to time, more controversial alterations, such as an increase to the block size limit via a hard fork, or an alteration to bitcoin’s monetary policy, are effectively nonstarters as the incentives are to keep everyone on the same network and only implement changes with clear benefits to pretty much everybody participating in the system, i.e., an overwhelming consensus must occur for any change to take place.
DeFi In Practice, Not In Name Only
Many Layer 1 blockchains other than bitcoin make the mistake of focusing on tech features and mass adoption. These pursuits have the side effect of harming the trustworthiness of the base asset as a store of value through increased centralization and inefficient use of block space. Instead, the features that have been implemented in many of these alternative Layer 1 cryptocurrency networks can simply be added as Bitcoin L2 networks. This allows the base monetary layer to remain stable and trustworthy, while more experimentation can take place on secondary layers.
For example, much of Ethereum’s Layer 1 block space is filled up with transactions involving centrally issued tokens, such as stablecoins and non-fungible tokens (NFTs). This increases costs for those who actually need the level of decentralization offered by a Layer 1 blockchain to transfer a crypto-native asset such as ether. Indeed, much of the activity in the DeFi space today is built around centrally issued stablecoins, which puts into question how much of the DeFi sector is decentralized in name only (DINO). On the bitcoin network, the focus is on the promotion and utility of the bitcoin asset itself as money, especially at the base layer.
Scaling and enabling additional use cases via Layer 2 networks in bitcoin is also quite different from how things work on other cryptocurrency networks. For example, Solana is focused on processing every activity directly on its Layer 1 blockchain, while Ethereum has a rollup-centric roadmap that enables more blockchains to eventually settle back down to its Layer 1 network. With bitcoin, the use of the base blockchain or even Layer 2 blockchains is limited as much as possible. Indeed, various Bitcoin L2 networks do not involve a new blockchain at all. Examples include: the Lightning Network, Ark Protocol, Fedimint, and Mercury Layer.
The general scaling and development philosophy in bitcoin is to interact with the base blockchain as little as possible in order to both preserve decentralization and increase user privacy. While throwing everything onto a blockchain can lower transaction costs and enable more people to onboard onto the system today, this is not seen as a practical solution over the long term due to the negative impact such a plan has on decentralization and privacy. This is a trend seen in alternative Layer 1 cryptocurrency networks more generally.
As mentioned previously, much of the activity in DeFi today is built around centralized stablecoins. While these tokens have undoubtedly helped DeFi grow in its early days, it’s also created a situation where the vast majority of this activity could be outlawed with the strike of a pen.
As indicated by the relatively slow and patient bitcoin development process, the bitcoin network is intended to last more than 100 years and not simply attract investors by jumping on every new crypto-crazed buzzword. Instead, that sort of activity can take place on Bitcoin L2 networks. The aforementioned hard-forking block size increase associated with the block size war would have been the easy way out for scaling the bitcoin network to more users over the short term; however, taking the slow and steady approach of multi-layer scaling allows the network to get both increased capacity and retained decentralization over the long term, while also offering better privacy.
A Note On Tokenization
In addition to a slow and steady approach to development that leads to sturdier DeFi protocols built for the long term, another aspect of bitcoin culture relevant to DeFi is an avoidance of tokenization. It’s basically impossible to keep up with all of the cryptocurrencies and tokens that exist these days, and nearly all of them are useless. Even when looking at the top digital assets ranked by market capitalization, it’s clear that the platforms with expressive smart contracts could be operating as Bitcoin Layer 2 networks without a new “gas” token.
This is not to say that no new tokens need to exist. However, there’s no reason to reinvent the money aspect of a DeFi app when bitcoin is already available and much more liquid and trustworthy than any new cryptocurrency that is going to be created. A digitally native asset that is used for governance or revenue sharing, for example, makes great sense in the bitcoin realm. However, going back to the long-term development approach, it’s also possible these sorts of tokens could eventually be removed from the equation in various bitcoin DeFi protocols. Only time will tell.
Bringing DeFi Capabilities To Bitcoin
Bitcoin’s approach of keeping the base layer decentralized and difficult to change protects the credibility of the underlying bitcoin asset, which allows it to act as the best base money in DeFi. Tech experimentation is then able to take place on secondary layers, which allows bitcoin to get the best of both worlds in terms of stability for bitcoin as an asset and experimentation in terms of new capabilities for that asset.
Additionally, bitcoin users’ slow and steady approach to the development process should lead to DeFi apps and protocols that actually include decentralization, rather than DINO projects involving risky shortcuts. While networks such as Ethereum and Solana have clearly provided some value over the short term, it is now time for Bitcoin Layer 2 networks to bring these capabilities to the world’s most valuable cryptocurrency.
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