The Bitcoin finance revolution Part 1: Unlocking value for BTC holders

Bitcoin (BTC) has spent years proving itself as a store of value and a secure gateway for institutional clients to access the digital asset ecosystem.  As the digital asset landscape evolves, BTC holders are looking to embark on the next evolution of decentralised finance, transitioning BTC from a passive asset to an active participant.

To understand why BTC has been a passive asset, it is important to understand the way in which the Bitcoin network operates. BTC is built on a Proof of Work (PoW) protocol, which means it innately does not support yield-bearing as network stability is through validation via mining in return for tokens, unlike Proof of Stake (PoS) protocols that rely on holders to stake tokens to validate the network and earn a reward.

The challenges with BTC therefore lie in the fact that Bitcoin does not natively support a yield-bearing mechanism, the BTC base layer is also restricted due to its limited transaction throughput, and Bitcoin has a less developed ecosystem for decentralised financial apps (DApps) – limiting liquidity options.

To address these challenges – which limit the usability and access to DeFi opportunities for BTC holders – a new wave of innovation is required.

Introducing Bitcoin Finance (BTCFi)

In its simplest form, BTCFi refers to the decentralised financial applications being built on or secured by Bitcoin (Layer-2 and BTC-native). Their value lies in enabling BTC holders to participate in the Ce-DeFi ecosystem through lending, borrowing and “staking”* thus changing the asset from a passive store of value to an active instrument for generating returns.

These decentralised applications (DApps) are maximising the utility of holding BTC, engaging in strategies and use-cases seen in the TradFi world, bridging the gap between traditional markets and the digital asset ecosystem.

A growing Bitcoin Ce-DeFi ecosystem is being developed, bridging Bitcoin’s security with seamless access to cross-chain Ce-DeFi functionality. The most recent news regarding Cantor Fitzgerald’s Bitcoin venture is further testament to this.

For BTC holders, this evolution offers the ability to maintain BTC exposure whilst simultaneously accessing liquidity, generating yield and improving usability.

BTCFi is being deployed via the below use-cases:

• Bitcoin Staking*
• Bitcoin Tokenisation & Wrapping
• Bitcoin Collateralisation
• Bitcoin DeFi Ecosystems

*Bitcoin staking is the term used to indicate when BTC is locked to generate a yield, it is coined as such, as it is similar to the stake mechanism in a PoS protocol.

Deploying BTCFi use-cases

Staking:

As mentioned, BTC does not natively support staking due to the PoW protocol, however, innovative solutions are being built that allow BTC holders to engage in staking mechanisms either directly or indirectly to generate yield.

For example,  Babylon introduces Bitcoin- ‘native’ staking directly on the BTC blockchain, by enabling holders to ‘lock’ their BTC to secure Babylon’s Proof-of-Stake network directly from their wallets. In return for securing the Babylon network, participants earn rewards while maintaining long-term BTC exposure.

Tokenisation & wrapping:

Tokenising Bitcoin unlocks BTC liquidity across multiple blockchains. Similar to many other security tokens like USDC, BTC can be converted into wrapped or synthetic assets on other blockchains.

The wrapped BTC is backed 1:1 in reserves by BTC and as it is deployable on a different blockchain it can be used to access the wider DeFi ecosystem.  This approach has its limitations as BTC is locked as a reserve with a custodian to mint the WBTC.

Synthetic BTC follows a similar approach, but is backed 1:1 in BTC-based assets, where the underlying holders BTC does not need to be locked up as a reserve in BTC, thus unlocking cross-chain liquidity and DeFi opportunities; including staking & yield-bearing, and enhanced trading strategies.

Collateralisation:

The evolution of BTCFi is illustrated by Bitcoin collateralisation. Bitcoin-backed loans, facilitated by decentralised lending protocols, allow holders to access liquidity across an open market.

In addition, outside of the DeFi space, even centralised lending institutions are continuing to expand their offerings and are providing credit facilities and financing, with Bitcoin used as collateral. It’s clear that BTC holders can gain efficient access to liquidity across the ecosystem.

Navigating the BTCFi revolution with confidence

To fully unlock BTCFi’s potential, holders must consider several key questions:

• Risk:  With an array of new innovative products available to access BTCFi, have you defined your goals, the core use cases you want to enable, and your risk appetite?
• Infrastructure: How do you ensure that your BTC held is safe, and access to these financial applications is through a secure environment? Is the right level of oversight in place?
• Liquidity & Return: Whilst BTCFi can unlock liquidity, it can also restrict it (staking / yield-bearing / lending), based on the use-case.
  • What are the liquidity requirements you need to have in place to make BTCFi effective and sustainable?
  • Have you considered what APY meets your needs? And in what type of token reward?
• Regulatory: Have you assessed the regulatory implications on holding BTC / offering these solutions to your underlying clients?

A unique opportunity for BTC holders

The Bitcoin Finance revolution presents a unique opportunity for BTC holders to access new and sophisticated financial products and utility layers that transform BTC from a passive store of value into an active financial asset.

With advancements in staking, BTC wrapping, and collateralisation, the BTC ecosystem and access to it, is expanding rapidly.

As interest accelerates to enable the potential of institutional Bitcoin, how you deploy and navigate BTCFi will be key in unlocking value and defining your digital asset strategy.

Need some help navigating your options?

Zodia Custody is here to help you on your BTCFi journey. Reach out to [email protected] to register your interest.