5 Challenges of Bitcoin DeFi and How Nakamoto Could Address Them

5 Challenges of Bitcoin DeFi and How Nakamoto Could Address Them

5 Challenges of Bitcoin DeFi and How Nakamoto Could Address Them

May 29, 2024

General Wallet Use

5 min

The smart contracts-led growth of decentralized finance (DeFi) applications began on Ethereum. In February 2024, the total value locked (TVL) in DeFi protocols crossed $80 billion, with almost 60% market dominance by Ethereum.

Initially, it was difficult for Bitcoin to participate in this DeFi economy because the blockchain didn’t support smart contracts natively. But the Bitcoin Layer 2 network, Stacks, introduced smart contract functionality for Bitcoin, opening up opportunities for Bitcoin DeFi

Similar to any fledgling ecosystem, Bitcoin DeFi faced several primary challenges that needed to be addressed. The Stacks Nakamoto update aims to solve these problems, paving the way for a more robust and secure Bitcoin DeFi ecosystem.

In this article, we’ll explain five primary problems of Bitcoin DeFi and how the Stacks Nakamoto update solves them. Before that, let’s briefly explain the meaning of Bitcoin DeFi. 

What Is Bitcoin DeFi?

Bitcoin DeFi refers to the decentralized exchanges, lending-borrowing platforms, NFT marketplaces, and other financial protocols that leverage the Bitcoin network. The Bitcoin DeFi protocols use BTC as its primary asset and the Bitcoin chain as a transaction settlement layer.

Thus, Bitcoin DeFi can unlock BTC's potential while relying on the Bitcoin network’s security and decentralized architecture. A Spartan research report suggests that Bitcoin DeFi has a 7x growth potential.

The report explains that as of December 2023, Bitcoin’s market cap was $850 billion, 3.1 times more than Ethereum’s $270 billion. But Ethereum’s DeFi TVL was $76 billion or 28% of its market cap whereas Bitcoin DeFi had just $320 million.

Without considering any additional liquidity influx and user adoption as we’re seeing today, Bitcoin DeFi already has a $238 billion market opportunity.

However, Bitcoin DeFi faces major problems in terms of scalability and high network latency, which results in slow transaction speeds.

Let’s look at how the Stacks’ Nakamoto upgrade aims to address Bitcoin DeFi’s problems.

How Does The Stacks Nakamoto Upgrade Solve Bitcoin DeFi’s 5 Challenges?

No Native Support For Programmable Applications

DeFi protocols don’t depend on centralized intermediaries; instead, they run on programmable smart contracts for executing financial transactions. However, the Bitcoin chain has limited programmability and doesn’t support smart contracts, so it’s difficult for developers to build direct on-chain applications.

Stacks solves the problem by providing smart contract programmability for complex financial transactions on the Bitcoin chain.

Stacks uses the Clarity programming language for its smart contracts that help developers build Bitcoin-compatible DeFi apps. The Clarity-based contracts can directly interact with Bitcoin’s on-chain data and seamlessly process BTC transactions.

Therefore, Stacks enables DeFi apps to simultaneously leverage the security of the decentralized Bitcoin network and unlock the value of BTC assets.

Slow Transaction Speed

In traditional finance, customers are accustomed to almost instantaneous transaction settlements using banking services. If DeFi apps are to become mainstream, they must execute transactions faster.

Bitcoin DeFi suffers from slow transaction speeds that affect a user’s app experience. Moreover, transaction delays can negatively impact users when they trade on a crypto exchange, especially during high market volatility.

The Stacks network introduced microblocks to improve transaction speeds for Bitcoin DeFi apps. The microblocks receive transactions from the mempool and validate them before updating on the Bitcoin chain.

However, Stacks couldn’t guarantee proper transaction storage in the microblocks, and new miners could remove recently confirmed transactions. The Nakamoto upgrade aims to resolve the problem through an indexed block hash, the first block hash of the previous Stack miner.

In post-Nakamoto Stacks, miners can add the indexed block hash to the Bitcoin chain during the block commit transaction. Thus, the Nakamoto upgrade ensures faster DeFi transactions by facilitating smoother data synchronization between Stacks and Bitcoin.

Delayed Block Finality

Block finality refers to the process when Bitcoin DeFi transactions become finalized and irreversible on the Bitcoin blockchain. Changing transaction history after achieving Bitcoin finality is difficult as it requires huge computational power and economic resources.

For Bitcoin DeFi apps, quick block finality is necessary to ensure the transaction settlement is final and unchangeable. However, Bitcoin suffers from slow block confirmation time, which affects DeFi’s performance.

The original Stacks design faced a similar problem with a slow block time of around 10 minutes. Stacks was slow because its block production rate was fixed to the Bitcoin block production in a 1:1 ratio.

However, the Stacks Nakamoto upgrade reduces block production time to around 5 seconds by de-coupling the Stacks and Bitcoin’s block production. The post-Nakamoto Stacks achieves 100% Bitcoin finality much faster through tenure-based block production.

Each Bitcoin block begins a new tenure where a single miner can mine several Stacks blocks instead of just one block. The tenure-based mechanism speeds up block finality, thereby helping DeFi apps achieve faster transaction settlements on Bitcoin.

Lack Of Scalability

Most blockchains, including Bitcoin, suffer from the blockchain trilemma, where they can’t do justice to all three elements of blockchain security: decentralization, security, and scalability. For Bitcoin, the network remains highly secure and decentralized but lacks scalability.

A surge in user activity leads to network congestion and high network latency, resulting in slow transaction confirmation time. However, Bitcoin DeFi apps must handle a large volume of transactions without compromising on speed and efficiency.

Stacks address the scalability challenges by increasing transaction throughput and reducing processing time. The Nakamoto upgrade further bolsters Stacks with enhanced scalability to address Bitcoin DeFi’s rising demand.

No Composability

DeFi apps must be composable for optimum fund usage and seamless asset transfers. Composability refers to the DeFi app’s characteristics by which digital assets can interact with multiple protocols for diverse use cases.

Since Bitcoin cannot do much beyond peer-to-peer transactions, DeFi operations become difficult. Thus, L2s like Stacks make DeFi apps composable so developers can build any protocol by leveraging the BTC assets.

The Stacks Nakamoto upgrade enhances Bitcoin DeFi’s composability by encouraging developers to develop apps using the human-readable Clarity programming language. These DeFi apps, like a lending protocol or an automated market maker, make BTC transactions easier across different apps.

The Future Of DeFi Lies With Bitcoin

The Nakamoto upgrade has made Stacks conducive for Bitcoin DeFi protocols by offering immediate block finality and faster transaction speeds.

As we approach the DeFi summer, the Stacks Nakamoto upgrade will play a crucial role in unlocking the liquidity of underutilized BTC reserves. In many ways, Stacks has ensured that the future of DeFi indeed lies with Bitcoin.

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