The most common way to use Bitcoin in decentralized finance is by “wrapping” BTC, or locking it up and minting an alternative token that’s pegged to its value on a smart contract blockchain such as Ethereum or Solana. Wrapped Bitcoin, known as wBTC, can be an extremely useful tool for Bitcoin holders, transforming BTC into an Ethereum asset that’s infinitely more productive, but its adoption is fraught with security risks.
The challenges associated with wrapped assets stem from their validator or oracle-based consensus mechanisms, leading to trust assumptions, centralization risks and plain old smart contract vulnerabilities. These are deal-breakers for many Bitcoin users, prohibiting the widespread adoption of wBTC. That’s one of the reasons why the bulk of BTC’s liquidity remains locked on the native Bitcoin blockchain, where it cannot be used in DeFi.
Any solution to this challenge could open the floodgates to a new era of DeFi that’s fueled by Bitcoin itself. That’s why there’s a lot of hope for so-called “light clients”, which can eliminate the trust assumptions inherent with wBTC.
What’s Wrong With Wrapping Bitcoin?
The vast majority of wrapped token models, including wBTC itself, are built on consensus mechanisms that utilize validators and/or oracles. In the case of wBTC, oracles serve as intermediaries that handle the process of minting new tokens and burning them when they’re redeemed for the original BTC.
The problem with this model is that, while it works efficiently enough, it goes against the decentralized and trustless ethos of Bitcoin. The main issue is that validator and oracle-based systems are governed by a limited number of entities. That means centralization, especially when compared to Bitcoin’s highly distributed network of miners. This makes wBTC much more susceptible to collusion and other manipulation risks.
Users are also required to trust the validators and oracles to uphold the integrity of the system. In practice, a company called BitGo maintains control of the BTC that’s used as collateral to mint wBTC, which is a major no-no for anyone that adheres to Bitcoin’s trustless nature. The need to trust undermines the very essence of Bitcoin itself – why even use it if you have to rely on an intermediary, as it’s no different to fiat?
Additional concerns stem from the software code that’s used to manage these validators and oracles. It’s not impossible that a single vulnerability could cause enough panic and mayhem to bring down the entire wBTC ecosystem.
Light Clients: An Expensive Solution
Unless these security issues are adequately resolved, wBTC is unlikely to be the game-changer for Bitcoin DeFi that its creators had hoped for, which is why there’s a lot of optimism around the idea of “light clients”, which can provide genuine cryptographic and trustless security for wrapped assets.
Light clients are already pretty popular on Bitcoin and the privacy-focused blockchain zCash. They’re essentially lightweight versions of Bitcoin or Zcash nodes, which use cryptographic proofs to verify transactions are authentic, instead of downloading the entire history of the blockchain.
With light clients, users can verify Bitcoin transactions without any intermediary and without running a full node. This has big consequences for wBTC, because it provides a way for light clients to verify the state of the Bitcoin or Zcash blockchains, instead of relying on independent validators or oracles. It means they can ascertain that bridged assets are backed by BTC, without the use of any trusted entities.
The industry has been aware of the promise of light clients for some time already, but no one has seriously considered them as a viable alternative due to their high costs. They’re expensive to operate because the process of verifying cryptographic proofs requires substantial computational resources, resulting in sometimes-astronomical transaction fees for users. In general, the costs are unacceptably high for DeFi applications. After all, who is going to deposit 0.0097 BTC (around $1,000) into a liquidity pool if it costs them 0.00097 BTC to do so? Unfortunately, such costs are not unrealistic when using light clients.
Shakes Things Up in Decentralized Finance (DeFi)
Fortunately, the DeFi industry is nothing if not innovative, and we now see HOT Protocol making waves with a promise to dramatically reduce the costs of verifying cryptographic proofs for light clients. If it can do this, light clients will suddenly become a realistic mechanism for Bitcoin-based DeFi.
HOT Protocol is an open-source protocol for creating decentralized MPC wallets that utilize multiparty computation to improve security. With MPC wallets, the private key that provides access to the wallet can be split into multiple parts and stored in various locations. HOT Protocol expands on traditional MPC by leveraging NEAR Chain Abstraction to increase the resilience of each node that holds a fragment of the private key. This makes them much more secure, because a malicious actor needs the entire private key to access the wallet, and it’s much harder to obtain when fragmented in this way.
It also has incredible potential for light clients. NEAR Chain Abstraction introduces an innovative sharding architecture, wherein the blockchain is split into multiple smaller networks, known as “shards”, which can be processed in parallel as a way of increasing transaction throughput. HOT Protocol’s light client leverages this architecture to decrease the computational load, enabling it to verify Bitcoin and zCash transactions at much lower costs than previously possible.
The sharding design also means light clients can scale affordably as demand increases, ensuring costs won’t spiral out of control in the event of an influx of thousands of new users.
By reducing the transaction costs for light clients, HOT Protocol has demonstrated the viability of a much more secure and reliable infrastructure for wBTC, paving the way for truly trustless, Bitcoin-based DeFi applications that don’t compromise on the security or decentralization. DeFi protocols will have a reliable, low-cost way to verify that wBTC and other wrapped assets are backed by real BTC or Zcash deposits, secured by enhanced cryptography.
The result will be DeFi applications that leverage wBTC with much greater trust. It’s a development that could see millions of dollars of Bitcoin-based liquidity enter the DeFi ecosystem, and potentially increase the value of BTC instead by making it a more viable investing tool. With HOT Protocol, Bitcoin is no longer just about “hodling”. It’s a yield-bearing asset.
