Bitcoin Staking: Unlocking Bitcoin’s Yield Potential in DeFi

How we can use BTC to participate in staking on major L1 networks like Ethereum and Polkadot.

TLDR

The lack of easy, trustless access to BTC emissions for Bitcoin holders is a notable disadvantage of BTC compared to PoS assets. To create Bitcoin staking as a product, we can explore 3 possible paths:

(1) Mining or purchasing hash rate (requires trust in operator);

(2) Using BTC to secure PoS networks (currently not possible, requires a Bitcoin fork);

(3) Synthetic BTC staking via a combination of BTC bridging, lending and swaps.

Read on to learn more about how to stake Bitcoin today via synthetic BTC staking.

Introduction

Proof-of-Stake networks such as Ethereum, Polkadot, Cosmos, Polygon, Avalanche etc. allow holders of the native asset to participate in securing the network while earning staking rewards in return. As a tokenholder intending to hold on to the asset for a while, staking rewards ranging from 5% to 20% provide an attractive and low risk way to earn more of your favorite asset while contributing to the robustness of the system. Participating in staking can usually be done with just a few clicks, while most of the major exchanges offer institutional solutions. As a result, $80bn have been staked across the top 10 Proof-of-Stake networks.

Bitcoin Mining
Participating in Bitcoin’s Proof-of-Work consensus, on the other hand, is not that simple for the average crypto user: mining has become so competitive that specialized hardware (ASICs) are needed. In addition to acquiring the hardware, miners must pay attention to electricity costs, internet connectivity, hardware wear and tear, and picking a reliable mining pool to reduce reward volatility. For a non-technical user, the options are quite limited:

• Hosted mining: acquire a miners through a trusted hosting company that commits to operating and maintaining the miner for a fee;
• Cloud mining: purchase hashrate from miners over specific time periods;
• Buy shares in a mining company.

All three approaches require trust in the mining company, involve bureaucracy and especially cloud mining has been used to scam users for millions of dollars in the past (pre-ICO era). However, apart from cloud mining, the entry budget for mining is significantly higher than for PoS networks.

Can we use Bitcoin in Proof-of-Stake?|
Using BTC to participate in staking on other Proof-of-stake networks has been a topic of interest for years, with two possible pathways:

• Engineer Proof-of-Stake on Bitcoin directly, locking BTC on Bitcoin and ensuring slashing events are propagated cross-chain. Due to limitations of Bitcoin’s Script and complexities of cross-chain communication, no trustless solutions have been deployed to date. We will discuss approaches that require changes to Bitcoin’s code in a separate blog post.
• Emulate Staking Using DeFi and Bitcoin bridges. Using (ideally trustless) Bitcoin bridges and DeFi primitives, we can provide access to staking opportunities for BTC holders, without changing Bitcoin.

Synthetic Staking Yield for BTC

Synthetic staking emulates the Proof-of-Stake for BTC through bridging, lending and trading. Tools that we need to create this product:

• (Trustless) BTC bridge, to whatever PoS network we want to stake on, e.g. Ethereum;
• Lending protocol, that allows us to borrow the PoS asset we want to stake, e.g. ETH;
• (Optional) Liquid staking protocol to make unstaking faster, e.g. stETH;
• (Optional) Decentralized exchange to acquire/exit the staking position and swap staking rewards to BTC;

Simplified, synthetic BTC staking works as follows, using Etheruem as an example:

Simple Synthetic Staking Protocol

Stake

1. Bridge BTC to Ethereum
2. Use the bridged BTC as collateral to borrow ETH
3. Stake ETH
4. Earn ETH staking rewards

Unstake

1. Unstake ETH
2. Repay ETH loan, incl. accrued interest
3. (Optional: Swap staking profits for BTC)
4. Withdraw bridged BTC back to Bitcoin

Profitability
Profitability is calculated by:

1. The staking rewards earned on the ETH borrowed
2. Plus the interest earned on supplying the (wrapped) BTC to the lending protocol
3. Minus the interest accumulated from borrowing ETH from the lending protocol
4. Minus the BTC bridging fees
5. Minus the swap fee and price impact on the exchange for converting the ETH to BTC
6. Minus transaction fees accumulated at the steps above

(R*C + E) — I — Fb — Fs — Ft
R… staking rewards
C … LTV specified for BTC in lending (as required by the protocol collateral rate or a higher custom LTV set by the user)
E … BTC earn APR (lending)
I … borrow APR for ETH, given the specified LTV in the lending protocol
Fb … BTC bridge fees
Fs … swap fees (ETH for bridged BTC)
Ft … accumulated transaction fees

Improvement 1: Faster Unstaking via LSTs
To unstake, the process is reversed step-by-step. The time it takes to unstake PoS assets can range from a few hours to a few days in most cases. Since we must pay back the loan that accrues interest over time, instant unstaking would be ideal. Also, it provides a quick exit option if the exchange rate between BTC and the staking asset (e.g., ETH) experiences significant fluctuatations. This is best achieved by using liquid staking tokens (LSTs) instead of staking directly.

Stake

1. Bridge BTC to Ethereum
2. Use the bridged BTC as collateral to borrow ETH
3. Stake ETH via liquid staking or swap ETH for an LST (e.g. stETH)
4. Earn ETH staking rewards

Unstake

1. Swap stETH for ETH
2. Repay ETH loan, incl. accrued interest
3. (Optional: Swap staking profits for BTC)
4. Withdraw bridged BTC back to Bitcoin

Profitability
Same as above, minus fees paid for fast unstaking of the LST.
(R*C + E) — I — U — Fb — Fs — Ft
U … unstaking fees (swap fees for stETH for ETH)

Improvement 2: Supply LST into Lending to Reduce Liquidation Risk
The risk of liquidation can be reduced by supplying the acquired LST as collateral into the lending protocol, reducing the LTV ratio. In addition, this can generate additional interest.

Note: by borrowing against this additional collateral it is possible to create leveraged positions. This incurs additional financial risk and we do not discuss such advanced strategies in this post.

Risks and Mitigations

In general, users who stake their BTC for additional yield face risks associated with the product and protocol.

Generic Risks

• Protocol Risk: As with every smart contract application, users who deposit their funds into the lending protocol face the risk that the protocol gets exploited due to a bug or security breach. This can be mitigated by using battletested and audited protocols.
• Liquidity Risk: If staking natively, the unstaking period may keep user funds locked for days. While using liquid staking assets can mitigate this risk, this approach has risks of its own: (1) LST protocol risk and (2) price impact when swapping the LST for the underlying asset during fast unstaking, e.g. if there is not sufficient liquidity on the markets.

Product Specific Risks

• Liquidation Risk: Due to the fact that the user borrows L1 staking assets like ETH, there is a risk that the price of the BTC collateral and the LST, will decrease in price compared to the borrowed ETH — up to the point where the position may be liquidated. However, the probability of this is quite low, the borrowed ETH is collateralized not only by BTC, which is usually strongly correlated with major L1 PoS assets, but also by the acquired LSTs (nearly 1:1) which closely follow the price of the underlying asset.

Challenge: Attracting Sufficient L1 asset Liquidity

For the described Bitcoin staking mechanism to work, there must be sufficient liquidity of L1 PoS assets in lending protocols. An important factor hereby is the staking ratio of PoS networks, i.e., the % of an L1 asset locked in staking. The higher the staking ratio, the less liquidity is available on the (lending) market, limiting how much BTC can be deposited into the described staking product. For the top PoS networks, these range from 18.9% on Ethereum to 70.7% on Solana. However, considering the additional protocol risks associated with LSTs, it is unlikely that these will completely replace native L1 assets in lending protocols in the near future.

Special Case: Interlay’s iBTC Bridge & Lending Synergy

Interlay’s trustless, collateralized BTC bridge requires operators (“Vaults”) to lock up collateral in different assets, including L1 PoS tokens. In a recent upgrade, the collateral can now also be supplied into selected lending protocols, enabling operators to earn both BTC bridge and collateral lending fees. The deployed collateral can in turn be utilized by users who bridge BTC to participate in the staking product, creating a (nearly) closed loop for liquidity.

Conclusion

In this post we reviewed way to create Bitcoin staking, unlocking the same opportunities for BTC as already exist for PoS assets like ETH. The most promising approach that does not require institutional trust or changes to Bitcoin is synthetic BTC staking: a combination of bridging, lending and swaps. If the risks are carefully mitigated by users, synthetic BTC staking represents a significant leap forward in the world of decentralized Bitcoin finance.

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