Bringing DeFi to BTC

bitcoin Dec 09, 2019

As Bitcoin and the broader cryptocurrency ecosystem continue to mature, it’s becoming increasingly clear that public blockchains will replace today’s financial infrastructure with networks that are more open, programmatic, and sovereign. While Bitcoin has begun to reach scale as a global store of value, it’s use is still largely siloed in centralized services that expose users to a great deal of risk. To minimize this risk, developers and entrepreneurs have long sought to use Bitcoin in more expressive smart contracts that would enable users to access a variety of financial services, while remaining in control of their wealth at all times, rather than trusting a third party. Innovation has been strong to date, but still lags the true potential of Bitcoin-backed financial applications. That’s why we’re building Echo: a network for creating sovereign, decentralized applications that work with Bitcoin. With Echo, developers will be able to build a wide range of applications that integrate Bitcoin, helping usher in a new era of usability for the world’s first and largest cryptocurrency.

Decentralized Finance Today

What first started as a rallying cry amongst a few Ethereum-based protocols has quickly turned into a mass movement focused on bringing cryptocurrency enabled financial services to the masses. Decentralized Finance, or DeFi for short, represents an entirely new paradigm of financial services that aim to be more permissionless, censorship resistant, trustless, transparent, and programmable relative to their centralized counterparts.

Hundreds of networks, companies, and projects have already formed, attempting to decentralized services like lending, derivatives, payments, and insurance. It’s important to note that up until today, a majority of development activity has taken place on Ethereum. Growth to date has been impressive, with nearly $500 million USD worth — roughly 2 million Ether — in value locked in decentralized financial contracts. In particular, lending applications seem to have reached product market fit as users can take out a line of credit against their cryptocurrency in a matter of seconds. And even though a majority of this growth has come from existing cryptocurrency holders using it as an alternate financial system, some DeFi projects have even begun targeting mainstream users, offering them competitive interest rates on dollar-collateralized stablecoins.

While growth in DeFi has been strong, today’s ecosystem still leaves much to be desired. For one, all of these financial contracts require heavy overcollateralization, making it rather capital inefficient to use DeFi. Another issue is that a majority of the oracles used throughout DeFi applications are operated by a few developers, creating a great deal of centralization risk. But most importantly, today’s DeFi users can’t use BTC in their financial applications without a centralized custodian and instead, are forced to use cryptocurrencies that are less sound, stable, or liquid.

Decentralized Finance without Bitcoin capabilities has resulted in more volatile and stagnated financial markets. Take for example over collateralized loans. Since they’re primarily secured by Ether, liquidations create far more price volatility than they would with Ether given how much more liquid Bitcoin spot markets are. Similarly, since demand to hold Ether is far lower than demand to hold BTC, far less interest is paid to lenders since there will be fewer borrowers.

This inability to use BTC in DeFi today is arguably the largest obstacle preventing decentralized financial services from reaching scale. Bitcoin is far and beyond the most successful and sufficiently decentralized cryptocurrency. It has the greatest market capitalization, the strongest liquidity profile, the largest number of active addresses, the most secure blockchain, and the largest ecosystem of supporting companies. Similarly, institutions are unable to interact with a lot of the DeFi ecosystem as their holdings are far more concentrated in BTC relative to other cryptocurrencies.

When we talk about “BTC in DeFi,” what we’re referring to is using Bitcoin in smart contracts that are a bit more expressive than those found in native Bitcoin script. This doesn’t necessarily mean not using core Bitcoin script. For example, applications like Discreet Log Contracts could theoretically be used to create Bitcoin-native futures contracts. But it’s no secret that Bitcoin script is limited and that constructing financial applications on other networks with different security properties  would be far easier for developers.

Apart from utilizing core script, there are already a number of different ways developers are trying to bring decentralized functionality to Bitcoin. Cross-chain atomic swaps attempt to create decentralized exchange with Bitcoin, Federated Sidechains are a way to use Bitcoin without making changes to the base layer (more on this later), and other blockchains like Ethereum can be used to tokenize BTC and integrate it into their financial stack.

Bitcoin in Decentralized Finance

There’s a reason that so many different development efforts have been kicked off, seeking to bring DeFi to Bitcoin. It is very much the value layer the internet always needed, and as more holders buy into Bitcoin’s monetary system, the more value there is to build financial services around. Similarly, blockchain-based financial applications align closely with Bitcoin’s core ideological tenets: permissionlessness, trustlessness, and self-sovereignty.

More complex financial applications using Bitcoin only further the best in class decentralization that the Bitcoin network has. Whereas today’s DeFi implementations limit access to those holding less liquid assets like ETH, XLM, or TRX, decentralized financial applications with Bitcoin capabilities allow users to access all of their financing needs with a form of sound money that’s actually reaching global scale. Furthermore, DeFi applications for Bitcoin will only bolster its liquidity, stability, user base, and network effect.

Adding DeFi capabilities to Bitcoin would be superior to today’s ecosystem across a number of dimensions:

  1. Liquidity: Deeper Bitcoin markets make it easier for users to access financial services and decrease transaction costs associated with accessing them
  2. Larger user base: More users of Bitcoin-enabled financial applications means greater liquidity, ecosystem support, and counterparty discovery
  3. Stability: More liquid markets with natural demand better absorb selling pressure for margin liquidations, eliminating drastic price decreases
  4. Collateralized Loan Demand: Being able to easily take out a crypto-backed loan against Bitcoin will help scale loan originations, meaning more lender capital can earn interest
  5. Less Centralization Risk: Financial application users don’t have to worry about the underlying monetary and technological system changing abruptly
  6. No Complex Tokens: A Bitcoin-based financial ecosystem would get rid of unnecessary tokens that hamper today’s DeFi user experience.

Once Bitcoin-enabled DeFi markets have been bootstrapped with liquidity, use cases past traditional financial services can emerge. Really any type of decentralized application can utilize Bitcoin once it’s easily accessible by a smart contract. In a not so distant future, users will work together, coordinate, and transact — all in Bitcoin, a global reserve currency for the digital age.

Enter Echo

Today’s attempts at extending decentralized finance functionality to Bitcoin are promising, but have either fallen short of galvanizing a global user base or are still in the R&D phase. As evidenced by Bitcoin’s realized capitalization, number of unique addresses, total hashrate, and market dominance, there is an immediate demand for using Bitcoin in decentralized financial applications. Echo was built to bridge today’s gap and ultimately allow users to do more with their Bitcoin.

Echo is a new network for creating permissionless, decentralized smart contract applications that interact with Bitcoin. Echo is unique across a number of dimensions. One, it is capable of native Bitcoin support, meaning developers can build applications that utilize Bitcoin and validators can accept Bitcoin for transaction fees. Second, it is more trustless than leading sidechain implementations because it uses a fast, final and scalable BFT consensus system based on Proof of Weighted Randomness (PoWR). Lastly, Echo is extremely developer friendly — offering support for writing smart contracts in Solidity, C++, Go, Python, Rust, and many more languages.

Echo isn’t just another “high-throughput” blockchain — we built Echo as a solution to all of the issues plaguing current “DeFi on Bitcoin” technologies, namely the inability to easily build trust-minimized financial applications with Bitcoin. Echo is a system that extends smart contract functionality to Bitcoin without sacrificing decentralization or user sovereignty.

Another ideal that was integral in our pursuit was that we wanted to free cryptocurrency users from being forced to convert their bitcoin to alternate forms of money as a prerequisite to accessing decentralized financial applications. The bounty for being able to do more with Bitcoin is obviously large, and rather than channel their rewards into innovation, developers have attempted to create their own sovereign currencies that markedly lagged Bitcoin to date. Echo is not focused on creating another form of money, but rather on one simple mission: to allow users to do more with their Bitcoin.

Echo’s Sidechain Technology

At the heart of Echo’s native Bitcoin support is a Bitcoin sidechain that allows BTC to be represented as a native currency within the Echo Protocol. This allows contracts and apps running in the Echo virtual machine to interact with BTC balances natively, enabling developers to build applications that transact in Bitcoin.

Echo’s sidechain technology builds upon the previous work of federated models like RSK and Blockstream’s Liquid. In these sidechain designs, a fixed set of nodes are chosen to secure the chain. Typically, most of these node operators are real-world, known corporations, exchanges, wallet providers and infrastructure companies. While this model is simple to implement, it requires some trust in the federation members — these companies collectively control all the bitcoin locked in the sidechain and can collude to prevent withdrawals, freeze funds or even steal all of the bitcoin secured. The companies serving as federation members may also be the subject of denial of service attacks, bribe attempts, or government intervention.

Echo's implementation iterates on this model by replacing the fixed committee of companies with a pseudonymous, dynamic, rotating committee that's selected through the Echo PoWR consensus mechanism. This allows the federation to be open, permissionless and censorship-resistant. Any node on the Echo network is eligible to participate in the federation by meeting two conditions:

  1. Running a special version of the Echo node software that includes a Bitcoin full node
  2. Locking up a threshold amount of Echo tokens in escrow, with a cooldown period

By introducing a dynamic, pseudonymous, open federation, Echo improves on the trust-minimization of existing sidechain architectures. Open participation shifts the trust model of the system from trusting known companies (essentially custodians) with a trust in the economic incentives and VRF selection process of the Echo protocol. We think this is a significant step forward in the design of trust-minimized sidechains, but certainly not the end state. To that end, we will continue to research, test, and fund R&D both Bitcoin Core upgrades (e.g. Taproot and MAST) and layer 2 architectures (e.g. Statechains) that will improve the usability and security model of BTC sidechains.

Today’s Leading BTC in DeFi Implementations

There are two notable technical implementations working on bringing Bitcoin into other decentralized finance ecosystems like Ethereum today: Wrapped Bitcoin (WBTC) and tBTC.

While these are promising innovations for the space, we believe that both solutions fall short in fostering the same level of trustlessness, permissionlessness, and sovereignty that’s offered by  Echo.

Wrapped Bitcoin (WBTC)

Wrapped Bitcoin attempts to bring Bitcoin support to Ethereum’s existing DeFi ecosystem by tokenizing BTC in the form of ERC20 tokens. Each WBTC is supposed to be backed 1:1 by real BTC and can be used in a variety of Ethereum’s financial applications including DEXs, money markets, and margin lending platforms. The relationship between Wrapped Bitcoin and BTC is similar to Tether’s relationship with USD — a centralized custodian verifies deposits and then issues and burns tokens.

By design, WBTC is a much more centralized approach to bringing Bitcoin to DeFi. It relies on a number of trusted actors — DAO members, Merchants, and Custodians — to keep the system running as designed. Similarly, there are only a few custodians signed up to mint WBTC, all of which take sizeable transaction fees for their service. And based on its adoption since launch, it seems evident that the market wants a more trust-minimized solution. For context, daily trading volumes rarely exceed $1 million USD and very few loans backed by WBTC have been originated through DeFi lending platforms.

tBTC

tBTC takes a different approach than WBTC in bringing Bitcoin support to the Ethereum DeFi ecosystem. With tBTC, Bitcoin holders can trustlessly mint tokenized representations of BTC by trustlessly verifying Bitcoin transactions on the Ethereum blockchain. To do this, tBTC leverages SPV proofs, which essentially allows Ethereum smart contracts to verify payments on the Bitcoin network. While a full deep dive is outside the scope of this post, a full deep dive is available here.

The tBTC system is similar to MakerDAO — it relies on external price feeds, bonds, and arbitrage opportunities to keep everything stable. To mint tBTC, a user deposits Bitcoin into an address that’s created by a group of bonded signers. Both the depositor and the bonded signers are required to put down a bond in ETH to initiate the process, and this bond is relative to how much risk each signer is exposing to the system. Also, this bond must be of greater value than the amount of tBTC minted. Overcollateralizing the bond keeps the system safe, but also makes it extremely capital inefficient. And just like in MakerDAO, signers are expected to ensure the value of the bond backing the tBTC never falls below a certain collateralization threshold.

Potential Use Cases for the Echo Network

One of the most exciting aspects of Echo is that it can be used to build virtually any type of smart contract application, but with native Bitcoin support. Tomorrow, that could be anything from Bitcoin-based DAOs to crowdfunding networks, but today, Echo can be specifically leveraged to build a more robust decentralized finance ecosystem with native Bitcoin functionality. All of today’s most popular use cases could be recreated, but with support for an asset that’s more liquid, stable, and widely used.

Stablecoins

One of the most tractable use cases we’re excited to see be built on Echo is a trust-minimized stablecoin a la Dai, but with the security and liquidity offered by BTC. The system would work similar to MakerDAO, but instead of collateralizing Ether to create CDPs, users would be able to do so with BTC. While it’s a small change, it makes a world of difference in terms of the system’s security and stability. A big problem hampering MakerDAO today is the fact that all of the eligible collateral types are weak assets. They’re illiquid and have little demand, making it difficult to incentivize third party liquidators to keep the system sufficiently collateralized. With Bitcoin, the system is much more safe given it’s much easier to incentivize liquidators to protect the system. Since Bitcoin markets are more liquid, they have more confidence that they can repay debt and secure the collateral.


Lending

Another powerful financial application that we’d like to see built on top of Echo is lending markets. Whether it’s decentralized money market funds or peer to peer lending contracts, Echo can be used to build applications that allow BTC holders to trustlessly access capital or earn a yield on their passive holdings. This would solve a big problem for BTC holders as many of today’s credit products force users to sacrifice custody of their assets, something that goes against the ethos of Bitcoin. With Echo-enabled lending applications, borrowers could trustlessly lock up collateral in an Echo smart contract, and borrow any asset supported by the network. On the lending side, BTC holders could lend their assets without ever having to give up custody of their funds and earn a yield on their BTC.  

Trading

At the core of any decentralized financial network is the ability for stakeholders to seamlessly and trustlessly exchange value. As has occurred with other smart contracting platforms, we expect a number of decentralized exchanges to emerge that will facilitate peer to peer exchange of all assets represented on the Echo network, most specifically, BTC.  But unlike many of today’s architectures, DEX’s built on top of Echo can retain high throughput and user-control without sacrificing decentralization. Better yet, decentralized exchanges within the Echo network stand to be a lot more liquid as they’ll likely be one of the only avenues to give users the ability to exchange other assets for BTC, typically the most liquid and important trading pair on traditional exchanges.

Conclusion

There has never been a more exciting time to build on top of Bitcoin’s value layer. As the most widely used and secure blockchain in existence, the Bitcoin network has already secured over $2 trillion in total transactions, it continues to foster more security from miners, and at $200 billion USD in market capitalization, it’s beginning to cement itself as a currency ready for global scale.

The next phase of Bitcoin development will be focused on letting holders do more with their BTC, without forcing them to trust a third party with their funds, and providing ways for people to earn BTC. While a lot of Bitcoin’s early growth has been primarily facilitated by centralized institutions like exchanges and custodians, Echo is navigating the transition towards Bitcoin’s true utility phase. With Echo, developers will be able to build all types of smart contract applications, all of which will offer support for the most held asset in the ecosystem.

To start, we plan to focus our efforts on decentralized financial applications so that today’s Bitcoin holders aren’t forced to use inferior forms of money when wanting to access user-controlled financial services. There are a number of tractable use cases we see being built in the short-term, and we couldn’t be more excited to work with our community on building out this important infrastructure.

Join us on this journey to build new use cases and applications with Bitcoin. Get involved and learn more by:

Team Echo

Echo is a network for creating sovereign, decentralized applications that work with Bitcoin. With Echo, developers can build a wide range of applications and smart contracts that integrate Bitcoin.