The DeFi Eco_ Is Bleeding Value. Can Bitcoin Stem The Flow?

The DeFi industry’s total value locked has fallen far from its all-time high of $178 billion in November 2021, losing almost $140 billion of the capital it once held amid a miserable crypto winter. Today, the TVL in all DeFi protocols stands at just $38.89 billion, according to the latest calculations from DeFiLlama, and more than half of that amount is locked into Ethereum-based protocols.

It’s a far cry from the heights hit during the last crypto bullrun, when Bitcoin’s value soared to a record-breaking $69,044. Curiously though, the value of Bitcoin played no part in DeFi’s earlier rise to prominence, but new developments suggest it could be key to the industry’s long-term future.

DeFi’s Descent

DeFi’s downward trend started with the onset of crypto winter in early 2022. As the value of Bitcoin and other cryptocurrencies collapsed, so too did the TVL locked in DeFi protocols. The situation only got worse with the downfall of leading crypto exchange platforms such as FTX, BlockFi, Genesis and Celsius Network, pushing DeFi’s TVL into the sub-$40 billion range.

Earlier this year, crypto winter began to thaw and DeFi experienced a mini-revival, with TVL rising to around $50 billion in April as the value of cryptocurrencies bounced back. However the roller-coaster ride quickly resumed, as crypto’s comeback lost impetus over the summer.

The $38.89 billion in DeFi TVL today doesn’t present an entirely accurate picture of the state of play. DeFiLlama notably excludes the approximately $20.2 billion in liquid staking protocols such as Lido and Coinbase. At the time of writing, Lido boasted an impressive $13.95 billion in TVL, while Coinbase’s staking service has accrued $2.1 billion. However, DeFiLlama considers that these protocols merely deposit into other protocols, so they don’t actually add anything to DeFi’s combined TVL.

The advantage of liquid staking is that investors can stake digital assets to earn yield, while retaining access to trading liquidity via “staking tokens” such as stETH. This gives investors the opportunity to trade and earn further profits on their staked assets. On the other hand, traditional DeFi protocols force users to lock their tokens in smart contracts, where they can’t be traded. With the decline in crypto values, such protocols currently offer very minimum yields – Aave, for instance, advertises rates of 1.63% for ETH and 2.43% for USD Coin. It’s little wonder then, that traditional DeFi appears so unappealing at this time.

Bitcoin To The Rescue

It’s clear that DeFi badly needs a boost and it may be about to receive it from an unexpected source, thanks to a new project called Babylon Chain that is bringing fresh utility to the world’s most valuable cryptocurrency.

Bitcoin has long been the king of crypto but until now, it has never played a major role in the DeFi ecosystem. It’s a challenge to utilize BTC with DeFi protocols because it resides on its own blockchain, outside of the Ethereum and other ecosystems that support smart contracts. Bitcoin’s lack of native smart contracts means it cannot have its own, native DeFi protocols.

Babylon promises to change that dynamic, introducing the concept of native staking to Bitcoin. Its vision is to utilize the untapped value of Bitcoin to provide security for other, Proof-of-Stake blockchains.

Earlier this year, Babylon outlined its concept in a lightpaper authored by its creator David Tse. It describes a new timestamping protocol that can be used by other PoS chains, enabling them to leverage Bitcoin for greater security.

To participate as a validator in PoS chains, users are required to stake a minimum amount of the chain’s native token. This collateral is locked in a smart contract to guarantee the honesty of the validator. Should they act in a malicious way, they can lose their deposit through a mechanism known as slashing.

The problem many PoS chains have is that the capital deposited by validators is minimal, introducing greater risk into their ecosystem. A malicious actor may decide it’s worth risking their staked collateral to carry out fraudulent transactions that benefit them. Therefore, PoS chains could bolster their security by allowing participants to stake Bitcoin instead, increasing their capital requirements.

Staking Bitcoin

Babylon has created a function that allows non-native assets, namely Bitcoin, to be staked to secure third-party PoS chains. It also creates a way for those BTC deposits to be slashed. This is done via a cryptographic technique that will reveal the private key of PoS chain validators if they do something wrong.

According to Tse, Babylon achieves slashing using a “spending condition” that can be expressed in Bitcoin’s limited scripting language. It uses an “extractable one-time signature”. It’s a rather ingenious mechanism that’s able to secure something that’s signed once, but if signed twice, it will reveal the staker’s private key, enabling any other network participant to slash their deposit and punish them for wrongdoing.

Until now, Bitcoin hasn’t had much utility besides acting as a transaction method and a store of value. As such, the prospect of enabling Bitcoin holders to earn yield is extremely compelling. Given Bitcoin’s enormous market capitalization of $534.1 billion, Babylon’s protocol has the potential to provide the DeFi industry with an extraordinary and unprecedented boost.