eBTC and the Future of Bitcoin in DeFi

Bitcoin was the original cryptocurrency, and its invention changed the face of finance forever. Even today, it leads all other digital assets by a wide margin - its $540B market cap is more than double its closest competitor. In the marketplace of ideas, however, the seminal orange coin has seemed for a long time to have lost the battle for public attention. Year after year – generations, in crypto time – it was innovations in the altcoin space that drove narratives and launched bull runs. Consider Ethereum’s introduction of smart contracts, the birth of decentralized finance, and the explosion of interest in NFTs - these are just a few examples of when alternative ecosystems forced BTC into the backseat. For a time, newer entrants to the space even began referring to Bitcoin – wrongfully, shamefully – as the “Boomer Coin.”

Recently, however, focus has begun shifting back towards Satoshi’s brainchild. Things are happening again on Bitcoin, and we might do well to take notice. What exactly is going on these days?

It was sometime in the last few months that the tide began to turn. Commentators on Crypto Twitter began to remember the 2024 halving, when supply inflation will decrease due to a reduction in mining rewards. Anticipation for the halving has historically led to a resurgence of interest in BTC and a corresponding pump in price, and this is exactly what we’ve started to see.

Yet while this set the stage for Bitcoin’s present moment, it was the introduction of Bitcoin Ordinals that brought all eyes back home. Launched in January, Ordinals are non-fungible inscriptions on individual satoshis – essentially, Bitcoin-native NFTs. Ordinals caused a surge in network usage, with over 50,000 minted in their first few weeks. Perhaps more important than any numbers, however, Ordinals have created a general sense that more could be done with Bitcoin than we previously believed.

Fortunately for all of us, this rebirth is more than just a change in sentiment. The charts bear it out as well, with the BTC market cap ballooning from $303B to $544B between November and March. Bitcoin dominance – the percentage of the total crypto market cap accounted for by Bitcoin alone – rose by a dramatic 20.78% over the same period.

Now, how and why would a thing like that happen?

To begin, Bitcoin has a few major value propositions over and above other cryptos.

1. There will only ever be 21 million Bitcoin. Its maximum supply was pre-defined from the very genesis block, meaning it can never be increased. By this principle alone, Bitcoin is an antidote to the fiat monetary system, where the purchasing power of our savings can be inflated away by people in power. It was designed, in a sense, to hedge against dilution of the money supply.
2. Bitcoin has a powerful first mover advantage, so in times of economic downturn, liquidity will flow into it from altcoins as a relative safe haven.
3. Bitcoin is a truly public blockchain, with no entity or foundation responsible for its original issuance. This is important for reasons we’ll get to momentarily.

While Bitcoin had begun to reemerge in conversation before the new year, these qualities make it particularly well-suited to certain macro environments. And as it turns out, a series of events have occurred that may be producing a minor renaissance for the original cryptocurrency.

BTC’s current pump began with the run on Silicon Valley Bank and its subsequent collapse on March 10th. The bank failure, driven by the fall in value of its below par treasuries, could arguably be traced back to a year of rate hikes by the Federal Reserve. When similar events followed at Signature and Credit Suisse, it sent the first clear message that the Fed’s hiking cycle has begun to exact a toll on the well-being of the financial system and - according to the market, anyway - a pause might be on the horizon.

Compounding this sentiment were the February CPI numbers that came a few days later, cooler than expected at a 0.4% month-over-month increase. Digesting these two macro signals, markets began to price in the possibility of a pause, and Bitcoin skyrocketed by 47.88% in only 12 days.

So, what’s the takeaway here?

To recap, the consequences of the inflation battle are inching us towards a recession and potential Fed pivot, and we’re learning yet again that we need a store of value more reliable than fiat currency in commercial banks. Bitcoin, as we’ve described, is perennial hard money subject to neither debasement by central banks nor mismanagement by custodians.

The obvious conclusion is that BTC will likely continue to assert its value as a hedge against current conditions, and it will likely lead the pack against other digital assets. Weeks earlier, when asked to identify which cryptocurrencies the US Government considered securities, SEC Chairman Gary Gensler responded by saying, “Everything other than Bitcoin.” Not only is BTC tailor-made to survive the worsening monetary situation, it may be uniquely able to withstand the onslaught of regulatory actions that began in the weeks after last month’s bank run.

But what if we want to do something with BTC besides keep it locked up? What if we want all the benefits of a banking sector, without the custodial risk?
This brings us to the second part of our thesis: the role that Bitcoin can play in decentralized finance.

If Bitcoin was designed as an alternative store of value, permissionless smart contracts were designed as an alternative financial system. They provide a method of not only purchasing digital assets outside of centralized channels, but of seeking yield and hedging one’s positions. The benefits for Bitcoin holders are obvious, and as Bitcoin becomes more and more attractive as a long-term hold, DeFi usage should logically increase alongside it as more users engage with the system.

While you would think Bitcoin and DeFi would go hand in hand though, BTC is surprisingly underrepresented here. The DeFi TVL is $47.8B, yet the top three Bitcoin derivatives (wBTC, hBTC, and renBTC) have a combined market cap of only $4.59B. While BTC claims 48% of the total crypto market cap, it commands only 9.6% of DeFi’s TVL. Clearly something is amiss, so what’s holding it back?

Perhaps we can find out by examining the Ethereum ecosystem, undisputed center of the DeFi universe. With $27.93B in TVL, it commands 58% of decentralized finance, nearly three times as much as its next two competitors – TRON and BSC – combined. If BTC has a presence in DeFi at all, this is where it’s going to live.

Bitcoin’s Ethereum presence mostly takes the form of ERC-20 tokens that are backed 1-to-1 by BTC. The three biggest options by market cap are wBTC, hBTC, and renBTC.

• wBTC ($4.21B): The most widely used Bitcoin derivative, wBTC was created by BitGo in 2019. Users custody their BTC with BitGo, then a “merchant” mints or burns an equivalent amount of wBTC on-chain for them.

• hBTC ($248.9M): hBTC is similar to wBTC, but it’s issued by Huobi. BTC is custodied on Huobi’s centralized exchange, and hBTC is minted in return.

• renBTC ($114.2M): renBTC is a decentralized alternative to wBTC and hBTC. Users send their BTC to a network of darknodes, and renBTC is then minted against it. Locking BTC on a smart contract like this is theoretically a way of avoiding centralization risk.

You may notice a pattern. Holders send their Bitcoin somewhere else, then it’s bridged over to Ethereum. If this seems like a red flag, there’s a few reasons for that.

Centralization Risk: Crypto was invented to escape institutional mismanagement, and we’ve seen over and over again what happens when we forget this central tenet. We saw this over and over last year, but as far back as Mt. Gox, we’ve learned that funds have a funny way of disappearing when you store them with someone else.

renBTC is a particularly stark cautionary tale, as it appears to be the most decentralized option for minting Bitcoin derivatives. Users were understandably surprised, then, to learn last year that all renVM nodes were operated by Ren itself. On top of that, the company was acquired by FTX before its downfall and was subsequently tied up in the bankruptcy proceedings. They announced that they would be winding down the Ren 1.0 network in December, and all renBTC should be bridged back to Bitcoin immediately. That this could happen in a purportedly decentralized alternative should mildly terrify anyone with a stake in DeFi.

Bridging Risk: Even when custodians are not involved, smart contract exploits are still an extreme risk factor. Bridges have historically been one of DeFi’s greatest vulnerabilities, and over $2.5B was lost to bridge hacks in 2022 alone. Many Bitcoiners are security maximalists by nature, so the inherent danger of bridging BTC over to Ethereum is likely a major reason for Bitcoin’s limited presence in the DeFi system.

Alternatives to these three do exist - tBTC is a good example of a trustless and decentralized Bitcoin bridge, which avoids some of the pitfalls we discussed above. A decentralized custodial solution is still a custodial solution, though - and the threat of a bridge exploit is no less serious here than it is in any option that bridges BTC to Ethereum.

Clearly Bitcoin derivatives leave a lot to be desired, but what other options are there?

One solution that avoids both of these pitfalls is synthetic derivatives. While these tokens are pegged to the price of an underlying asset, they aren’t actually backed by the asset itself. They are minted against some other form of collateral, which means that a user can get exposure to the asset’s price without having to own it – or without it even existing on the same network.

Synthetix’s sBTC is a good example of this. Users own Synthetix’s native token, SNX, and stake it in a large collateral pool. They are then able to mint synthetic assets against their SNX, avoiding liquidation as long as they maintain a certain collateral ratio. The end result is exposure to the price of BTC, with no bridges involved and without trusting any entity – centralized or otherwise – with custody of their actual Bitcoin.

In this case, however, users do carry exposure to SNX, which they may or may not want. There is always a risk of liquidation if one’s collateral ratio gets too low, and this could happen by no fault of one’s own if the price of BTC ever rose while SNX went down – not an uncommon occurrence in risk-off environments. Synthetix also charges a fee for their services, which could eat away at one’s position.

So at this point, we’ve made the bull case for Bitcoin going forward, we’ve established the need for a more robust DeFi presence, we’ve looked at the available options on Ethereum, and we’ve identified the risk factors that are likely preventing people from using them. Now we’re left with the question of where to find a synthetic derivative that requires no custodied Bitcoin, involves no bridging of funds, has no fees, and limits its exposure to volatile alt coins. We know what we’re looking for, and we now arrive at the true substance of this report: an introduction to BadgerDAO’s newest product, eBTC.

eBTC is a new BTC derivative being released by BadgerDAO that aims to solve many of the problems we see in existing products and seeks to elevate Bitcoin to its rightful place as a core asset of decentralized finance. An ambitious goal, but the design is clever and the need is certainly there. Let’s take a look at how exactly eBTC works.

Where existing Bitcoin products almost all depend on wrapping BTC, trusting it with an intermediary, and minting a token on Ethereum, eBTC uses a CDP model. Users take out a collateralized debt position (CDP) wherein they can deposit collateral into a vault, then borrow another asset against it. Similar to how MakerDAO allows users to deposit ETH and mint the stablecoin DAI, eBTC uses staked ETH as collateral to mint eBTC. Where DAI is pegged to the price of the US Dollar, the synthetic derivative to which eBTC is pegged is, of course, Bitcoin.

For a variety of reasons, this design is considerably more resilient than any of its peers in Ethereum DeFi. When we look at the drawbacks of existing BTC derivatives, the biggest risk factors were bridge exploits and centralization risk. On the one hand, eBTC doesn’t deal with bridging risks because there are no bridges involved. On the other, it avoids centralization risk by eschewing custody altogether. BadgerDAO holds absolutely none of your tokens – instead, you lock your collateral on an immutable smart contract to which no human agent has access.

In fact, eBTC takes decentralization even farther by using staked eth as its collateral. Where MakerDAO includes USDC in the basket of assets by which DAI is backed, even eBTC’s collateral is free from any centralized issuer. While staked eth carries the same smart contract risk as any DeFi protocol, there’s no risk of the asset going to zero due to mismanagement by its issuers. By design, eBTC is free from even indirect centralization risk.

Other synthetic derivatives exist on Ethereum, of course, but we’ve already touched on some of the reasons users may shy away from them. Take Synthetix for example. While it’s a legendary project in its own right, its synthetic assets can only be borrowed against collateralized SNX. This may be fine for users who are long term bullish on the platform, but others may not want price exposure to an unrelated token.

eBTC solves this with its choice of collateral. ETH is a more conservative hold, and it’s the network’s native token, so users are more likely to be aligned with it to begin with. That Badger has chosen a liquid staking derivative as its collateral is also significant, and it brings up an important piece of eBTC’s design: its novel appropriation of staked ETH yield.

When we look at products that share qualities with eBTC – we’ve already pointed out certain attributes of MakerDAO and Synthetix, though they also differ in important ways – we notice that they tend to charge fees for their services. In any situation where lending comes into play, users typically must pay for the privilege of borrowing against their collateral.

eBTC circumvents this by choosing staked ETH as its backing. Because ETH staking yield pays out an average of 4-5% APY, staked ETH owners receive this yield simply by holding staked ETH. When using it as collateral to mint eBTC, a portion of this yield is shared by the protocol while the rest is compounded back into the users debt position, effectively repaying the debt over time.

There’s a good chance this will appeal to ETH bulls – a way to maintain exposure to ETH, earn yield on it, and gain exposure to Bitcoin too. On the other hand, it also provides a capital efficient way to speculate on the flippening by hedging against the price of BTC - long ETH, short BTC, repeat. In this regard, eBTC is essentially a one-click solution to leverage-long your favourite asset, paying zero fees, all while securing the network and continuing to earn yield on your underlying collateral. Very impressive!

Beyond the features we’ve described above, there’s an inherent benefit to launching the product on Ethereum, and it involves bridging the gap between the Bitcoin and Ethereum ecosystems. While most crypto natives hold both BTC and ETH, there are vocal partisans at either extreme who don’t see eye to eye on crypto’s future. By providing clear benefits to both BTC and ETH users, eBTC stands to encourage each ecosystem’s use by maximalists on the other side.

Benefits for BTC Users

• It provides exposure to BTC price for true believers who may not feel comfortable holding wrapped or bridged assets
• It allows BTC holders to get yield from their BTC through lending or LPing
• It will presumably be integrated into derivatives platforms, meaning that BTC-native holders can use it to hedge their long BTC positions
• When this occurs, they will also be able to access leverage and compound their BTC position

Benefits for ETH Users

• Simply put, eBTC gives people with a preference for the Ethereum ecosystem a simple way to gain exposure to BTC - extremely beneficial in times of inflation or turmoil
• Most comparable CDP products lend stablecoins against ETH, leading to high liquidation risk if the price of collateral collapses. Since the price of ETH and BTC have historically been highly correlated with one another, this liquidation risk is curtailed, as a user’s debt position will fall in tandem with their collateral.
• Since it’s backed by staked ETH, opening a long BTC CDP position is a way for ETH holders to hedge a decline in ETHBTC
• Bitcoin accounts for a massive percentage of crypto holdings worldwide. If the TradFi world begins to use DeFi to hedge and earn yield on their Bitcoin positions, it could represent a gigantic inflow of liquidity to the Ethereum ecosystem.

We’ll have to wait and see what integrations lie ahead to fully assess what eBTC is capable of. For now, though, it’s a well-thought out design that escapes many of the pitfalls of comparable products, and also has significant advantages over conventional methods of borrowing Bitcoin. By providing safer DeFi access to Bitcoin maximalists and greater BTC access for Ethereum-based DeFi natives, eBTC may well succeed in giving Bitcoin the same prominence in DeFi that it has in the broader crypto sector.

This report was written in collaboration with BadgerDAO