The introduction of BitVM smart contracts has marked a significant milestone in the path for scalability and programmability of Bitcoin. Rooted in the original BitVM protocol, Bitlayer’s Finality Bridge introduces the first version of the protocol live on testnet, which is a good starting point for realizing the promises of the Bitcoin Renaissance or “Season 2”.

Unlike earlier BTC bridges that often required reliance on centralized entities or questionable trust assumptions, the Finality Bridge leverages a blend of BitVM smart contracts, fraud proofs, and zero-knowledge proofs. This combination not only enhances security but also significantly reduces the need for trust in third parties. We’re not at the trustless level that Lightning provides, but this is a million times better than current sidechains designs claiming to be Bitcoin Layers 2s (in addition to significantly increasing the design space for Bitcoin applications).

The system operates on a principle where funds are securely locked in addresses governed by a BitVM smart contract, functioning under the premise that at least one participant in the system will act honestly. This setup inherently reduces the trust requirements but has to introduce additional complexities that Bitlayer aims to manage with this version of the bridge.

The Mechanics of Trust

In practical terms, when Bitcoin is locked into the BitVM smart contract through the Finality Bridge, users are issued YBTC – a token that maintains a strict 1:1 peg with Bitcoin. This peg is not just a promise but is enforced by the underlying smart contract logic, ensuring that each YBTC represents a real, locked Bitcoin on the main chain (no fake “restacked” BTC metrics). This mechanism allows users to participate in DeFi activities like lending, borrowing, and yield farming within the Bitlayer ecosystem without compromising on the security and settlement assurances that Bitcoin provides.

While some in the community might find these activities objectionable, this type of architecture allows users to get some guarantees that they previously could not hope to get with traditional sidechain designs, with the added bonus that we do not need to “change” Bitcoin to make it happen (although covenants would make this bridge design completely “trust-minimized, which would effectively make it a “True” Bitcoin Layer 2). For more details about the different levels of risks associated with sidechains designs, take a look at Bitcoin Layers assessment of Bitlayer here.

However, until such advancements come to fruition, the Bitlayer Finality Bridge serves as the best realization of the BitVM 2 paradigm. It’s a testament to what’s possible after the dev “brain drain” from centralized chains back to Bitcoin. Despite all the challenges that BitVM chains will face, I remain exceptionally excited at the prospect of Bitcoin fulfilling its destiny as the Ultimate Settlement Chain for all economic activity.

This article is a Take. Opinions expressed are entirely the author’s and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

Guillaume’s articles in particular may discuss topics or companies that are part of his firm’s investment portfolio (UTXO Management). The views expressed are solely his own and do not represent the opinions of his employer or its affiliates. He’s receiving no financial compensation for these Takes. Readers should not consider this content as financial advice or an endorsement of any particular company or investment. Always do your own research before making financial decisions. 

BitVM earlier this year came under fire due to the large liquidity requirements necessary in order for a rollup (or other system operator) to process withdrawals for the two way peg mechanisms being built using the BitVM design. Galaxy, an investor in Citrea, has performed an economic analysis looking at their assumptions regarding economic conditions necessary to make a BitVM based two way peg a sustainable operation.

For those unfamiliar, pegging into a BitVM system requires the operators to take custody of user funds in an n-of-n multisig, creating a set of pre-signed transactions allowing the operator facilitating withdrawals to claim funds back after a challenge period. The user is then issued backed tokens on the rollup or other second layer system.

Pegouts are slightly more complicated. The user must burn their funds on the second layer system, and then craft a Partially Signed Bitcoin Transaction (PSBT) paying them funds back out on the mainchain, minus a fee to the operator processing withdrawals. They can keep crafting new PSBTs paying the operator higher fees until the operator accepts. At this point the operator will take their own liquidity and pay out the user’s withdrawal.

The operator can then, after having processed withdrawals adding up to a deposited UTXO, initiate the withdrawal out of the BitVM system to make themselves whole. This includes a challenge-response period to protect against fraud, which Galaxy models as a 14 day window. During this time period anyone who can construct a fraud proof showing that the operator did not honestly honor the withdrawals of all users in that epoch can initiate the challenge. If the operator cannot produce a proof they correctly processed all withdrawals, then the connector input (a special transaction input that is required to use their pre-signed transactions) the operator uses to claim their funds back can be burned, locking them out of the ability to recuperate their funds.

Now that we’ve gotten through a mechanism refresher, let’s look at what Galaxy modeled: the economic viability of operating such a peg.

There are a number of variables that must be considered when looking at whether this system can be operated profitably. Transaction fees, amount of liquidity available, but most importantly the opportunity cost of devoting capital to processing withdrawals from a BitVM peg. This last one is of critical importance in being able to source liquidity to manage the peg in the first place. If liquidity providers (LPs) can earn more money doing something else with their money, then they are essentially losing money by using their capital to operate a BitVM system.

All of these factors have to be covered, profitably, by the aggregate of fees users will pay to peg out of the system for it to make sense to operate. I.e. to generate a profit. The two references for competing interest rates Galaxy looked at were Aave, a DeFi protocol operating on Ethereum, and OTC markets in Bitcoin.

Aave at the time of their report earned lenders approximately 1% interest on WBTC (Wrapped Bitcoin pegged into Ethereum) lent out. OTC lending on the other hand had rates as high as 7.6% compared to Aave. This shows a stark difference between the expected return on capital between DeFi users and institutional investors. Users of a BitVM system must generate revenue in excess of these interest rates in order to attract capital to the peg from these other systems.

By Galaxy’s projections, as long as LPs are targeting a 10% Annual Percentage Yield (APY), that should cost individual users -0.38% in a peg out transaction. The only wildcard variable, so to say, is the transaction fees that the operator has to pay during high fee environments. The users funds are already reclaimed using the operators liquidity instantly after initiating the pegout, while the operator has to wait the two week challenge period in order to claim back the fronted liquidity.

If fees were to spike in the meanwhile, this would eat into the operators profit margins when they eventually claim their funds back from the BitVM peg. However, in theory operators could simply wait until fees subside to initiate the challenge period and claim their funds back.

Overall the viability of a BitVM peg comes down to being able to generate a high enough yield on liquidity used to process withdrawals to attract the needed capital. To attract more institutional capital, these yields must be higher in order to compete with OTC markets.

The full Galaxy report can be read here.