The rise of DeFi and open finance applications launching trustlessly from different smart contract platforms could be a potential threat to Bitcoin’s security in the years ahead.
As DeFi becomes mainstream and the BTC tokenization rate continues to rise, Bitcoin’s incentivization model through fees could become increasingly eroded, exposing the multi-billion dollar project’s underbelly.
It could be a distant issue for now, but its early specter is rising amid Ethereum’s explosive DeFi lead so far.
The Tokenized Elephant in the Room
Justin Drake, an Ethereum researcher, observed that 0.1% of all bitcoin in circulation has already been tokenized on Ethereum. Based on existing data, the amount of BTC flowing to Ethereum has been increasing ten-fold every six months for the last one-and-a-half years.
At this rate, 10% of all circulating bitcoin could be living on Ethereum, and at the expense of mining fees on Bitcoin, in the foreseeable future.
According to BTC on Ethereum, a site that tracks the number of tokenized bitcoin on Ethereum, there were 72.42 BTC on Ethereum as of February 2019. This number has since risen to 188,820 by July 30th, 2020, marking a +26,000% increase.
This figure is over 15x the amount of bitcoin secured by the Lightning Network—a Layer 2 scaling solution that’s still being trialed (but has its fair share of security troubles and centralization concerns).
Is the community voting with its feet, preferring drastically extended functionalities in Ethereum over LN nodes? Or, are there more arbitrageurs over spenders considering diverging objectives of DeFi (lending, liquidity provision, payments over L2 channels) and LN (spending)?
This migration to open finance really kicked into gear when MakerDAO Vaults started accepting wrapped Bitcoin (WBTC), an ERC-20 bitcoin token pegged 1:1 with BTC, as collateral. This immediately invited a new wave of bitcoin holders to participate in the blossoming DeFi arena.
While this may be temporary, largely depending on the community’s reception of DeFi and irresistibly high lending rates (yeah, Yield farming), the fact that BTC is flowing to Ethereum as holders seek to diversify their income streams is seemingly a threat to Bitcoin’s security in the long run.
Here’s why: the fees of ERC-20 bitcoin transactions are paid to the Ethereum network, not the Bitcoin network. So as more bitcoin comes to Ethereum, the Bitcoin network loses out on more fees. And Bitcoin is deflationary so once the project’s last BTC is mined, Bitcoin’s security will depend on a thriving fee market. Yet if activity keeps migrating from Bitcoin to Ethereum, such a fee market will be increasingly challenged.
Zero Sum or Mutualistic?
A few years back, it was inconceivable that another project could give Bitcoin a run for its money. Earlier on, the focus was on models that would complement BTC. Then Ethereum came along and changed the blockchain arena forever. And here we are years later in 2020, and Ethereum is having its best breakout year yet.
What if this trend continues, and Ethereum becomes the dominant public infrastructure for the next century and beyond?
Notably, the final bitcoin will be mined in 2140. By this point, Bitcoin creator Satoshi Nakamoto expected the network could have grown enough that miners could survive on fees after block rewards ended.
But if Ethereum continues to suck in would-be bitcoin transaction fees, there could come a day when there aren’t enough fees to robustly shield against a 51% attack. The risk of a majority attack might even be amplified if malicious agents smell blood at a time when the Bitcoin incentivization model is in transition.
For now, this issue is a faraway concern. And it might not all be gloom and doom for Bitcoin either, particularly if the BTC price keeps edging higher. Moreover, it’s possible tokenized bitcoin only cements BTC’s position as a useful store of value, i.e. digital gold, and the Bitcoin-Ethereum relationship becomes increasingly mutualistic and reinforcing. Could DeFi continue to position BTC as an optimized settlement layer, with Ethereum scaling the most valuable ledger? Only time will tell.
Of course, it will be a long time before maximalists throw in the towel and concede that Ethereum drives any kind of major utility, yet Ethereum is by far the most popular Bitcoin scaling solution so far. It’s happening now, the symbiosis is on, so whose side are you on? Ssssh, I’m not being tribal!
This article was first published on Voice and was re-published with permission on SCN