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Bitcoin Smart Contracts Could Create a New DeFi Ecosystem

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If you speak to certain people within crypto, they’ll tell you that Bitcoin represents outdated technology. Some researchers have even suggested that the cryptocurrency “may not last much longer,” given its relative lack of scalability, as well as the fact that it doesn’t support advanced smart contracts.

Bitcoin community members might argue that last November’s Taproot upgrade, which reduces the data needed to be recorded on the Bitcoin blockchain, already gives it the potential to run smart contracts. However, while Taproot enables the execution of transactions by meeting certain conditions, such smart contracts will be narrower in scope and far less complex than those seen on a platform like Ethereum.

As CoinShares wrote in a report on Taproot: “To be clear, Taproot will not enable the same fully expressive and recursive smart contracts that exist in alternative blockchain systems (Ethereum, Solana etc.) and this will almost certainly never happen as recursive smart contracts are widely considered to be unacceptably risky for Bitcoin.”

But this may soon change. Last year, developers at the DFINITY Foundation started the process of integrating the Internet Computer blockchain with the Bitcoin network. They now report that a developer preview of the API will soon be ready, with an experimental release on the mainnet to follow in March. When the integration is complete, features natively belonging to the Internet Computer will be available for Bitcoin, including advanced smart contracts.

According to developers and experts, the introduction of smart contracts to Bitcoin could significantly change its ecosystem, opening the floodgates to DeFi and other applications. In turn, the incorporation of Bitcoin into DeFi could promote wider mainstream DeFi use, which would have a lasting impact on the wider financial landscape.

Directly integrating with Bitcoin

Dieter Sommer, the senior technical program manager working on the Bitcoin integration, explains via email that the effort involves two major features. The first is the actual technical integration of the Bitcoin network with the Internet Computer Protocol, in which the Internet Computer would act like a lightweight Bitcoin node that is deployed on-chain and can be queried and used for sending outgoing BTC transactions by canister smart contracts.

“It deals with connecting from IC nodes to nodes of the Bitcoin network, obtaining Bitcoin blocks, providing blocks through IC consensus, processing them, serving UTXO [unspent transaction output] sets to canister smart contracts, and allowing canisters to submit BTC transactions to the Bitcoin network,” says Sommer.

The integration’s other key component involves translating Bitcoin’s use of ECDSA (Elliptic Curve Digital Signature Algorithm) signatures to the Internet Computer’s trust model. This will be achieved by implementing a threshold ECDSA signature protocol, which will become part of the Internet Computer’s Chain Key cryptography. Threshold ECDSA gives every canister the ability to hold BTC directly on the Bitcoin blockchain because the canister can control ECDSA signing keys.

“This feature realizes a trustless way of computing ECDSA signatures based on an ECDSA private key shared among all replicas of the Bitcoin-enabled IC subnet,” explains Sommer. “No party holds the private key, not even during its generation, and signatures are computed using a cryptographic multi-party protocol.”

Canister smart contracts are bundles of code and chain data on the Internet Computer that can automatically execute various functions and be used to implement anything from web pages to DeFi applications. Once the full Bitcoin integration is deployed, every canister on the Internet Computer will be able to act as a Bitcoin wallet and be used to hold, send, and receive actual BTC.

Both of the features were originally scheduled for release by the end of 2021 but slipped into 2022 due to the complexity of the implementation and the testing requirements. According to Sommer, they will be ready for “experimental release” by the end of March.

Despite the delays, developers have been making steady progress. The team working on threshold ECDSA recently completed and shared an end-to-end demo showing how a user-submitted message on the Internet Computer can be hashed and then signed by a canister to produce an ECDSA signature that’s indistinguishable from those produced by a conventional ECDSA key pair.

“It is a significant milestone the team has achieved, and will surely pave the way towards a successful Bitcoin integration,” says Paul Liu, a developer working on the ECDSA element of the integration, via email. “We still have a lot of work ahead of us to make sure the implementation is complete, secure, well tested, and security-reviewed before the rollout.” 

A developer preview with the release of the API for Bitcoin-enabled canister smart contracts as part of the DFINITY Canister SDK is expected in early February. Future plans will also see the release of a form of wrapped BTC on the Internet Computer, which will enable BTC to be spent on the platform without being subject to the Bitcoin protocol’s limitations.

“Clearly, whenever we transfer bitcoin on the Bitcoin network, the limitations of the Bitcoin blockchain apply: relatively high transaction costs, a 10-minute average time between blocks, only few transactions per second, and transaction finality times of an hour. These limitations apply for the transfer of bitcoin into the Internet Computer ecosystem (to a smart contract) and the transfer back out,” says Sommer.

But once BTC is on the Internet Computer, these limitations don’t apply to smart contract applications. This means that, once the integration is complete, Bitcoin really could end up having its own efficient DeFi ecosystem, without the need for BTC to be locked up in order to mint ERC-20 tokens.

Changes for Bitcoin?

While DFINITY is confident in the integration’s prospects, there are those in the cryptocurrency community who remain wary. “Trying to add smart contract functionality to Bitcoin is like putting floaties on a tank to turn it into a boat,” says Bitcoin advocate Andreas M. Antonopoulos via email. But other observers also believe that the integration can work as outlined.

“It is realistic and achievable,” says John Egan, the CEO at L’Atelier BNP Paribas, a foresight business identifying investment opportunities at the intersection of technological and social change.

“Developers will be implementing their smart contracts against the IC Bitcoin API shortly. The API will provide means for querying the UTXO set for specific addresses and for submitting transactions, and there will also be a Threshold ECDSA API with methods for obtaining the smart contract’s public key and signing,” he adds.

Egan notes that the Bitcoin smart contracts on the Internet Computer will be a direct integration, not an indirect substitute like wrapped Bitcoin or a bidirectional payment system for off-ledger transactions like Lightning. He thinks it will have a significant impact on Bitcoin and on crypto more generally.

“This will give birth to a Bitcoin-based DeFi ecosystem. Simply put, IC is extending Ethereum-like functionality to Bitcoin albeit in a manner that is much faster, more scalable, and less expensive than current options,” he says. “Given Bitcoin’s absolute size of almost $1 trillion and its relative size to the cryptocurrency space (almost 40% market share), the resulting DeFi ecosystem could be quite large.”

Bitcoin currently has no real application beyond being a store of value and investment asset. If the Internet Computer’s integration were to tap into even a fraction of its value and liquidity, the resulting DeFi ecosystem could be substantial.

Applications involving lending (with BTC deposited directly as collateral) could prove a particularly big draw, given the stronger trust model of the direct integration. Indeed, wrapped BTC — an ERC-20 token pegged 1:1 with BTC and used on Ethereum-compatible DeFi applications — has already become the 18th biggest cryptocurrency by market cap, with some 271,000 WBTC tokens minted as of this writing at a value of approximately $10 billion.

A range of other potential applications could also emerge following the integration, says Dieter Sommer.

“For example, a class of novel use cases is made possible by blending social applications with Bitcoin, e.g., allowing users to transfer bitcoin to friends in social applications like OpenChat,” he says. “Or users could pay for their cycles [a unit of usage like gas] on the IC using BTC by going through a decentralized exchange.”

If the Internet Computer’s Bitcoin integration ends up supporting new use cases within crypto, we may yet see a wave of DeFi applications that are built to leverage the world’s largest cryptocurrency.

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