Here’s how to use DeFi on Bitcoin without ‘polluting’ the blockchain

Bitcoin ordinals or stamps have failed to provide an answer to Bitcoin’s DeFi problems.

Bitcoin is known for its immutability and the hard-coded rules that make the system secure but slow to modernize. However, that doesn’t mean the Bitcoin blockchain — the underlying network that empowers the original cryptocurrency — is closed to innovation and development. Even though the initial efforts to introduce decentralized finance (DeFi) to Bitcoin such as cross-chain bridges and wrapped tokens resulted in a massive wave of hacks and exploits in the DeFi space, developers continue to look for new and more reliable ways to tap into the unmatched liquidity of the BTC pool.

Launched in November 2021, the Bitcoin Taproot upgrade was an important step in adding extra functionality to the base layer of Bitcoin. Among other benefits, including cheaper and more efficient transactions, the Taproot upgrade also introduced rudimentary smart contracts — the backbone of DeFi — to Bitcoin for the first time.

Bitcoin DeFi: The first attempt

Smart contracts are automated agreements between multiple parties that are stored on a blockchain. They enable a wide range of DeFi functionality. The introduction of smart contracts to the Bitcoin base layer hinted at the possibility of common DeFi trends such as nonfungible tokens (NFTs) appearing on the Bitcoin network, and developers rushed to work on it.

Shortly thereafter, Bitcoiners came up with their version of NFTs with the Ordinals protocol, sparking a hot debate about adding more usability to the Bitcoin base layer versus “congesting” it with nonessential content. Ordinals, also known as Bitcoin NFTs, allow users to inscribe digital content on the Bitcoin blockchain. Launched in January 2023, ordinals quickly became a popular way to interact with the base layer, surpassing over 3 million inscriptions.

Following the launch of ordinals, BRC-20 tokens emerged as an experimental token standard based on the Bitcoin Request for Comment (BRC) protocol. These tokens represented fungible assets on a 1:1 basis. However, the influx of memecoins such as Pepecoin (PEPE) on the BRC-20 standard led to a congestion problem, resulting in a backlog of 500,000 transactions awaiting settlement. This surge in demand caused transaction fees to skyrocket to $30 per transaction, significantly impacting the efficiency of the entire Bitcoin network.

Bitcoin DeFi: The second attempt

To make NFTs more efficient on Bitcoin, a new protocol called Bitcoin Stamps, or “Secure Tradeable Art Maintained Securely,” was launched shortly after the ordinals. And unlike the ordinals, Bitcoin stamps allow the minting or embedding of image data into the Bitcoin network by storing image data across multiple unspent transaction outputs to increase decentralization and immutability.

Although the second attempt to add NFT usability to the Bitcoin network is widely considered an improvement over ordinals, Bitcoin stamps are far from providing ideal results. The protocol requires a canvas size of 24 by 24 pixels, which limits the possibilities to pixel-art NFTs.

Meanwhile, the issue of “polluting” the Bitcoin blockchain by storing data directly on the base layer remains unsolved. Moreover, a controversial topic still hovers over the Bitcoin community: Do we need NFTs on the main Bitcoin chain?

Additionally, just as BRC-20 spawned from ordinals, stamps formed their own tokenization standard called SRC-20. However, while SRC-20 tokens have greater immutability, they take up even more block space than BRC-20 tokens, and if their popularity would grow, it would further congest the Bitcoin network.

Bitcoin DeFi using Layer 2

An alternative approach aims to solve all the shortcomings of layer-1 (i.e. Bitcoin), DeFi by moving NFT and tokens to layer 2 thus decongesting Bitcoin, lowering fees, and adding additional use cases. Like the Lightning Network solved many aspects of Bitcoin payments as a layer-2 solution, NFTs and tokens can also be moved to the second layer to keep the Bitcoin base layer clean and efficient. This reduces the need for all transactions to use Bitcoin for settlement.

Mintlayer, a layer-2 solution that builds the tools to enable DeFi on Bitcoin, aims to open Bitcoin to NFTs along with smart contracts, atomic swaps, and decentralized applications (DApps). Using a layer-2 network directly on Bitcoin enables lower minting and transfer costs while adding smart contract features and reducing congestion on the base layer.

Instead of trying to get DeFi onto the Bitcoin network through unreliable gateways such as cross-chain bridges and wrapped tokens, Mintlayer enables direct swaps of native Bitcoin for other tokenized assets minted directly on Mintlayer, eliminating all intermediaries between Bitcoin and DeFi.

To tokenize assets with tailored protocols designed for specific use cases, Mintlayer has introduced three tokenization standards. The MLS-01 is created for securities, stablecoins, and stock tokens to function on Bitcoin, while the MLS-02 is designed for confidential transactions. The third one, MLS-03, is built for NFTs only. Since it’s developed specifically with NFTs in mind, there’s no need to write a smart contract — unlike ordinals and Stamps. MLS-03 also unlocks the limits introduced by layer-1 attempts by leveraging the freedom of layer-2.

“It’s exciting to see innovation on the Bitcoin blockchain,” said Enrico Rubboli, CEO of Mintlayer, adding, “But, ultimately, NFTs and tokens need to be on layer 2. There are many constraints for NFTs and tokens in terms of size, smart contract capabilities, and immutability that Mintlayer won’t be subject to.”

DeFi on Bitcoin allows the sustainable and efficient use of decentralized financial applications on the Bitcoin network. By offloading the complexity of DeFi to layer 2, Bitcoin users can now benefit from improved scalability, reduced transaction costs, and a wider range of financial services while still leveraging the security and robustness of the underlying Bitcoin blockchain.

Source: https://cointelegraph.com/news/heres-how-to-use-defi-on-bitcoin-without-polluting-the-blockchain