Decentralized Finance (“DeFi”) began as a playground for developers and tinkerers to build decentralized financial applications on the Ethereum network. Developers and young project teams use Ethereum’s open source tooling to create “permissionless” financial applications that replace rent-collecting intermediaries. These decentralized applications enable anyone with an internet connection to access a variety of financial products and services spanning crypto asset exchange, margin trading, financial derivatives, synthetic assets, algorithmic trading, and lending markets.
Two of the killer use cases of DeFi include high-yield savings accounts and access to credit. Holders of Ether, Dai, USDC, Tether, and other crypto assets can lend out their assets and achieve high, single digit annual returns. On the other side of the trade, borrowers can post their crypto assets as collateral and gain access to stablecoins tied to fiat currencies to trade with leverage or access a line of credit.
Beyond being built on Ethereum (the protocol), DeFi projects have mainly used Ether (the protocol’s native monetary unit) as the base asset and primary source of collateral. However, the industry is now seeing efforts to inject Bitcoin into the DeFi ecosystem. These “Bitcoin-pegs” attempt to bridge Bitcoin and Ethereum, combining Bitcoin’s superior liquidity, trading volume, and user base with Ethereum’s composability and ecosystem of open source financial applications. A few of the projects bringing Bitcoin to DeFi include WBTC (Wrapped Bitcoin), imBTC (TokenIon), tBTC (Keep Network), sBTC (Synthetix), renBTC (Ren), and pBTC (ptokens).
The common approach is to create a Bitcoin-collateralized ERC-20 (Ethereum standard) token that is pegged to the market value of Bitcoin. In broad strokes, the process involves a user depositing Bitcoin into a smart contract, and the smart contract then spits out the newly minted Bitcoin-pegged token which can then be accessed in the user’s Ethereum wallet. The smart contract utilizes an oracle price feed to monitor the value of the underlying Bitcoin collateral which equals the value of the new ERC-20 token. More centralized solutions (i.e. WBTC and imBTC) involve third-party custodians that custody the Bitcoin, mint the new token, and monitor the value of the Bitcoin collateral.
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WBTC has surged recently as the MakerDAO community voted to add the token as a form of collateral in the Maker system. MakerDAO’s Dai is the largest decentralized stablecoin pegged to the U.S. dollar and accepts various crypto assets as collateral, starting with Ethereum and later adding BAT, USDC, and now WBTC. In order to open a Vault and access Dai, users need to over-collateralize the position with those crypto assets. The inclusion of WBTC caused WBTC to surge above $22 million in cumulative on-chain value.
Although WBTC has seen a significant rise, Ether remains the largest form of collateral in DeFi with 2.6 million ETH locked in DeFi protocols, worth $520 million at time of writing. However, the trend is clearly falling in recent months with the arrival of alternative assets.
Despite WBTC’s recent success, Ethereum purists have criticized MakerDAO’s inclusion of centralized tokens WBTC and USDC. Since WBTC and USDC rely on third party custodians to hold the underlying Bitcoins and dollars, they possess counterparty risk if those entities were to be hacked or coerced by regulatory pressures. Another concern is the ability of these entities to censor and roll back transactions, which is anathema to the ethos of the DeFi space.
Since DeFi applications require crypto collateral to be locked up, they produce organic demand for the asset and reduce its supply in the market. Naturally, this leads to positive price pressure for the underlying asset. The crypto asset that emerges as the primary collateral asset in DeFi will benefit the most from these supply-demand dynamics. Users need to purchase and lock up the asset to access DeFi products and services.
It may seem that Bitcoin and Ether are in direct competition to serve as DeFi’s primary reserve asset; however, even if Bitcoin asserts dominance, Ether will also benefit since DeFi applications require users to spend, and thus demand, bits of Ether to process transactions. This assumes the Ethereum blockchain remains the dominant platform for decentralized applications, and other competing platforms such as Blockstream’s Liquid, Algorand, Cosmos, and Tezos are unable to steal meaningful market share.
The introduction of Bitcoin to Ethereum’s DeFi ecosystem is in its early days, and it remains to be seen whether Bitcoin will emerge as the leading reserve asset fueling decentralized applications. The market will dictate which crypto assets are most desirable and deserve monetary premia: value accrued to the token as users demand to hold or lock up the token. User behavior will demonstrate the crypto asset with the most favorable monetary characteristics will serve as the best collateral, and Bitcoin and Ethereum will compete for dominance. DeFi may prove to be the battleground for the fight.
Author: Leeor Shimron
Read more at: https://www.forbes.com/sites/leeorshimron/2020/05/16/bitcoin-is-invading-decentralized-finance/#6afb83e178e0
