💿Challenges within Bitcoin

1. Lack of reliable smart contract layer solution

Currently, there are three solutions:

a) Bitcoin Smart Contract Layer Solutions

Bitcoin lacks native complex smart contract capabilities. While solutions like RSK and Liquid Network use sidechains to introduce these features, these include security concerns with less robust sidechain protections, centralization risks due to reliance on federations, and added complexity that may hinder adoption.

b) Bitcoin Staking Protocols

Direct staking isn't possible with Bitcoin's Proof of Work model, complicating the process and requiring manual management of staking operations.Projects like Stacks use indirect methods for staking, involving auxiliary layers or wrapped tokens.

c) Trustless Bridges Between Bitcoin and Other Ecosystems

Trustless bridges like tBTC and the Avalanche Bridge utilize wrapped BTC to facilitate transactions without central authorities. Achieving fully trustless operations is complex due to the need for reliable oracles and secure multi-signature schemes, with a higher potential for security vulnerabilities.

2. Lack of trustless bridge between Bitcoin and other Ecosystems

Trustless bridges aim to minimize reliance on centralized entities but still require some level of trust in validator or custodian groups. Examples like tBTC and Avalanche Bridge decentralize custody and use incentives to align behavior, yet they're not fully trustless due to potential impacts from these groups

The only “trustless” solution that can inherit the safeness of the Bitcoin network is a BitVM-based bridge, which several projects have claimed but not achieved (Cireta, Bitlayer) due to lack of smart contracts on Bitcoin.

3. Too many BTC standards

At present, there are three different types of Bitcoin assets:

a) Native Bitcoin Native Bitcoin refers to the original form of Bitcoin (BTC) as it exists on the Bitcoin blockchain. It represents the native currency of the network, and it is the form of Bitcoin that exists without any additional layers, modifications, or protocols built on top of it.

b) Bitcoin Liquid Staking Tokens

Bitcoin Liquid Staking Token, is a tokenized form of Bitcoin that has been staked and then re-staked into additional protocols to generate further rewards or yield. Bitcoin staking protocols like Lombard and Solv rely on Babylon to stake Bitcoin and allow it to participate in liquid staking protocols where Bitcoin can earn staking rewards. Staking protocols then restake it into DeFi applications to generate further yield or provide collaterization.

c) Wrapped Bitcoin

Wrapped Bitcoin is a tokenized version of Bitcoin (BTC) that exists on a different blockchain, typically the Ethereum blockchain. It is a token that represents Bitcoin at a 1:1 peg, meaning each wrapped BTC is backed by an equivalent amount of Bitcoin held in reserve by custodians. There is an increasing number of Bitcoin standards, with more protocols and exchanges creating different versions of BTC to serve various purposes. On the liquid staking side, protocols like Lombard (LBTC), Solv Protocol (SolvBTC), EtherFi (eBTC), and Lido (stBTC) are emerging. On the wrapped Bitcoin side, major players such as WBTC, cbBTC, BTCB, tBTC, and BGBTC are introducing their own wrapped versions of Bitcoin, with no signs of slowing down.

The growing variety of Bitcoin assets is proving to be a challenge for ecosystems and DeFi protocols, making it difficult to choose, integrate, and ensure compatibility with these assets. This fragmentation hampers ecosystem growth, complicates DeFi integrations, and reduces utility for BTC holders. Ecosystems and DeFi protocols are constantly grappling with the issue of selecting and managing the integration of different BTC standards, a process that is time-consuming and inefficient.

3. Integrating BTC assets within DeFi

Integration of LST assets has always been proven tricky and risky for ecosystems and DeFi protocols.

BTC Liquid Staking assets, as previously explained, are assumed to be always backed 1:1 by native Bitcoin and typically can be seen in value in Bitcoin. However, due to the complexity and different standards of Bitcoin staking, there is a lack of transparency on how the native Bitcoin is being stored and managed. As such, ecosystems and DeFi protocols face a variety of issues when integrating new bitcoin assets:

a) Depegging risk for BTC Liquid Staking Tokenss There is currently no established standard or solution for Proof-of-Reserve regarding Bitcoin LSTs, leading to a lack of transparency about whether these assets are truly 1:1 pegged to native Bitcoin. When Bitcoin LSTs are integrated into lending protocols and used as collateral for other assets, any depegging could result in bad debt and potentially trigger a domino effect across other assets.

b) Liquidity and Slippage Risk

When a new asset is introduced into a DeFi ecosystem, it’s crucial to have adequate liquidity on DEXs to ensure users can execute swaps smoothly and avoid high slippage. Without sufficient liquidity, high slippage may occur, making the asset unproductive and difficult to use across DeFi protocols.

c) Utilisation Rate and Productivity on DeFi Protocols

Historically, interoperable wrapped assets have been spread across multiple ecosystems with low productivity and utilization rates. The reason is straightforward – the issuers of these assets have little incentive or responsibility to help users fully leverage their assets across different DeFi protocols. Instead, they primarily focus on seeding liquidity without ensuring the asset’s usability within the ecosystem. This approach undermines the purpose of introducing new assets to new ecosystems, turning what should be a valuable partnership into more of a marketing gimmick.

d) Pricing Efficiency Because BTC LSTs and wrapped BTCs are treated as native BTC, there is a challenge with price efficiency for these assets. Arbitrage is necessary to ensure that their prices align with the value of BTC. This is particularly problematic for newer ecosystems, where arbitrage opportunities are less common. Without proper monitoring, these BTC assets often trade at inefficient prices, causing them to lose their utility.