DeFi has attracted significant attention over 2020 as hundreds of projects on Ethereum have emerged at the intersection of blockchains and open financial instruments ranging from collateralized stablecoins to derivatives products.
While much more feasible at this point on a smart contracts platform like Ethereum, the notion of decentralized finance does not explicitly exclude bitcoin from the broader implications of DeFi products on the legacy cryptocurrency’s network.
Although not expressly DeFi, as they are hybrid instances of blending crypto assets and conventional financial structures, companies like BlockFi already offer borrowing and lending with bitcoin.
Similarly, sidechains (e.g., RSK) may eventually furnish the type of smart contract capabilities, similar to ethereum, that can enable more sophisticated financial products built on bitcoin.
However, there are some other intriguing takes on extending bitcoin’s protocol to more advanced financial applications, and specifically, one interesting proposal that has gained traction over the last couple years is called discreet log contracts.
Why Use Bitcoin for DeFi?
Approaching DeFi applications on bitcoin is somewhat precarious. For example, significant value underscores the proposition that bitcoin’s simple, stripped-down design is an enormous advantage for its long-term sustainability and robustness.
Many core bitcoin proponents view the OP_RETURN function for arbitrary data storage as unnecessary, citing the ability to deposit non-transaction information into the blockchain as opening additional attack incentives.
Conversely, concepts like bitcoin’s lightning network (LN) have presented an entirely new design space for bitcoin. Via layered scaling, applications can be created on top of bitcoin’s core protocol that do not directly detract from its security model.
This is a compelling narrative as it has opened the doors for the exploration of applications that leverage hash-time locked contracts and other clever technical tools. The results are the already growing prevalence of apps (i.e., “lapps”) built using the LN.
So, what exactly are the trade-offs with building DeFi on bitcoin?
The big limitation is the complexity of DeFi applications. RSK may ultimately prove a valuable sidechain for bitcoin, but federated peg sidechains inherently require trust in the federation managing the chain.
Eventually, improvements in the underlying tech may minimize the trust further, but for now, the type of variation in DeFi projects seen on ethereum is not possible directly on bitcoin’s protocol without some compromises on trust — like with a sidechain.
On the other hand, bitcoin’s security model, such as its socially conservative approach to change and ballooning hash rate, make it an ideal medium for censorship-resistant finance.
Similarly, bitcoin’s fixed monetary policy and supreme liquidity among all crypto assets make it even more of a profound case study for the long-term implications of DeFi due to the underlying confidence in its native value and predictable supply.
Skipping over some of the fascinating projects working on ideas like decentralized swaps and other financial instruments with bitcoin, let’s focus on extrapolating the underlying mechanics of the LN to DeFi — specifically with discreet log contracts.
What Are Discrete Log Contracts?
Initially proposed by Thaddeus Dryja of the MIT Digital Currency Initiative, and incidentally, co-author of the original LN paper, discreet log contracts are a method for minimizing the trust in acquiring data from external sources to the blockchain — popularly referred to as oracles.
At a high level, discreet log contracts do not enable Turing-complete smart contracts on bitcoin. Rather, they hinge on using Schnorr signatures to mask the agreed upon contract details from the oracle, effectively creating a situation where payouts on publicly known data (i.e., a number) are possible between three parties in the process.
The immediate advantages are better privacy and more flexible smart contracts without the trust compromises at the scale of a sidechain.
- For example, and within the context of DeFi, Alice and Bob can open a futures contract between each other speculating on the future price of bitcoin on a specific date. Using the power of multi-sig outputs, the details of their contract can be masked from the blockchain, with the contract containing the committed funds of both Alice and Bob.
- Subsequently, a third-party oracle publishes signed messages that are incorporated into the contract details as the pivotal data that determines how the funds in the contract should be allocated.
- In the case of Alice and Bob’s futures contract, funds committed to the contract would be delivered based on the supplied price of bitcoin at the expiration of the futures contract.
Importantly, the oracle is blind throughout this entire process to both the fact that Alice and Bob are using its price data and about the actual details of the contract.
This prevents the oracle from front-running or manipulating the contract with bad price data. Additionally, the setup precludes the oracle from becoming a decisive party in the agreement between Alice and Bob (i.e., 2-of-3 multisg), and instead, enables Alice or Bob to withdraw funds based on the (blind) signed message that is publicly published by the oracle.
The downstream consequences of such a model are that the inherent trust assumptions of oracles connecting blockchains to the outside world, known as the oracle problem, can be reduced to a point where more advanced smart contracts can be run on bitcoin without making prohibitive trust trade-offs.
Applied to DeFi, the ability of two parties to leverage discreet log contracts unleashes the potential of futures, derivatives, and other financial instruments.
More sophisticated financial products tied directly to bitcoin can create future instances where standard institutional and speculative practices, like hedging risk on commodities and other assets, become viable via bitcoin’s network.
Micro-insurance contracts are even possible using discreet log contracts by relying on oracle-sourced data for payouts of specific claims.
Notably, discreet log contracts rely on similar technology to the LN. According to the discreet log contracts paper:
“Similar to the currently developing Lightning Network software , parties agree on the contract state but hold variations of the same transaction…While in the Lightning Network these scripts are used to maintain consistency in a payment channel such that either party broadcasting an old state allows the other party to take all the funds from both outputs, in DLC the same output script is used for a different purpose. Alice and Bob do not reveal secrets to each other; rather it is Olivia who reveals a secret to everyone.”
As a note, Olivia is the oracle in the above quote.
The salient takeaway from the discreet log design is that users can privately set up financial contracts, and only have to trust the oracle to sign the correct data, such as the price, rather than perform the role of intermediary. Dryja goes on to conclude in the paper:
“As the transactions look the same as Lightning Network transactions, it will remain difficult to estimate the total usage of DLCs across the network, and they should allow extensive complex smart contracts to occur without unduly taxing the global network.”
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