The following is a guest post by Aki Balogh, CEO and co-founder from DLC.Link
Bitcoin (BTC) entered 2023 with enormous promise. Although subject to natural ups and downs, the momentum indicated a maturing asset class ready for mainstream adoption. A year later, that promise has grown even further – especially around the evolution of BTC ETFs. But while the industry has seen an increase in crypto adoption, institutional investors are cautious and the political sphere remains skeptical.
Build trust
The industry is grappling with a fundamental question: how do we restore trust in BTC and cryptocurrencies? Originally designed to decentralize ownership and control, they have often centralized and pooled assets, often with disastrous consequences.
One critical area that requires a trust overhaul is packaged Bitcoin. Designed to integrate BTC with other blockchains, Wrapped Bitcoin (wBTC) offers undeniable utility in the liquidity of Bitcoin holdings, to be used in borrowing, staking and investing. Simply put, locked-in BTC holders can take advantage of the features and benefits of DeFi without having to sell their BTC for ETH or other tokens. Yet one glaring flaw – centralized management – undermines the purpose of wrapped BTC tokens.
Unlike traditional BTC, wrapper BTC allows people to operate their BTC within various blockchain ecosystems (e.g. Ethereum or Solana), allowing the BTC owner to unlock their liquidity for use in financial transactions.
Opening up these benefits to new audiences promotes a greater sense of financial inclusion and attracts new people to the space. Overall, BTC’s success may allow institutions to view the sector more positively.
The storage conundrum
However, WBTC has a glaring flaw in that it relies on one centralized custodian. Until recently, there was no way to package BTC for use in DeFi without introducing centralized custody. This custodian acts as the “trusted” third party responsible for safeguarding user funds, while simultaneously enabling compatibility between Bitcoin and whatever DeFi ecosystem it will be transferred to.
For example, to mine wrapped Bitcoin, BitGo (a US-based custodian) receives 1 BTC, stores it in its private vault, and issues a corresponding wrapped BTC to the owner, allowing them to move their BTC across chains and ecosystems.
Unsurprisingly, a variety of counterparty risks can arise in crypto when an entire ecosystem is dependent on a third party. If this custodian unlocks the BTC – maliciously or mistakenly – to someone else, the underlying BTC is lost and the wrapped token becomes worthless to its rightful owner.
As BTC’s value continues its expected rise through 2024 (with some analysts suggesting it could peak on $150,000 by the end of 2025) users are becoming increasingly wary of such custodial risks. Imagine a scenario where your savings, represented in wrapped BTC, disappear due to failed custody, bad trades, counterparty risk, government/regulatory seizures, or embezzlement.
Not to mention that under current law, FDIC deposit insurance coverage does not apply to non-bank custodians – implying that the majority of crypto firms offering custodial services are involved.
The illusion of innovation
There are plenty of packaged BTC options on the market, underscoring the demand that exists among BTC holders eager to bring their crypto to DeFi. The reality is that the vast majority of these options involve the same custodial models and their inherent risks. At the same time, we have the rise of Bitcoin ‘Layer 2’ (L2) solutions that add a new layer of complexity. These solutions lure users with high returns, often without adequately exposing the underlying risks.
Here’s the truth: these L2s are not true second layers built on top of the Bitcoin blockchain itself, but rather sidechains – separate blockchains attached to Bitcoin. Connecting BTC to these sidechains exposes users to potential exploits and vulnerabilities that simply do not exist on the secure Bitcoin network. Furthermore, the promised returns offered by these L2s are often unsustainable. They depend on complex incentive mechanisms that cannot be sustained in the long term.
The path to trust
In this environment of declining trust, there is one solution that can ensure users maintain full control over their assets. By using discrete log contracts (DLCs) within Bitcoin, crypto traders can build a theft-proof bridge to take Bitcoin. DLCs, which are native to Bitcoin, were invented by Tadge Dryja, an MIT academic and co-creator of Lightning Network.
Unlike their Bitcoin counterparts, which are packaged using DLCs, users can maintain full control of their BTC throughout the packaging process, with the support of a federated merchant network (similar to USDC’s design). This ensures the integrity of the packaged tokens.
This federated model spreads risk across a large group of participants, significantly reducing dependence on a single entity – bringing decentralization back to Bitcoin. Just as the US dollar is backed by a diverse set of assets held by the Federal Reserve, packaged BTC with DLCs is backed by a collective of traders, eliminating the single point of failure inherent in custodial models.
The future is safe
We have seen Bitcoin withstand so many challenges so far and yet continue to thrive – a testament to his power. From my perspective, Bitcoin’s future is undoubtedly secure, especially with the introduction of self-packaged BTC and the integration of DLCs. These solutions, aligned with Bitcoin’s core value of self-custody, address a key problem: centralized control over wrapped assets.
While packaged Bitcoin has been accepted, the current centralized model concentrates risks and risks security depends on user control and a commitment to decentralization – enter DLCs. Imagine users taking the reins and packing and unpacking their Bitcoin via secure, permissionless protocols. This promotes trust by empowering individuals, which fits perfectly with Bitcoin’s decentralized ethos.
Security, not the pursuit of results or blind faith in untested solutions, should be the cornerstone of all financial technology. I believe that packaging solutions that empower users, not administrators, is the key to unlocking mainstream trust. Broad adoption depends on user trust.
By prioritizing security, user control, and responsible innovation, we can unlock Bitcoin’s true potential and completely revolutionize the financial landscape. Let 2024 be the year we move forward and rebuild trust in BTC, one step at a time.