January 31, 2024
Introducing dlcBTC and the dlcBTC Merchant Network
we introduce dlcBTC, a novel 'self-wrapping' Bitcoin solution on Ethereum, and the Merchant Network, which collectively enhance liquidity and security in DeFi.
With over $800 billion worth of Bitcoin currently in existence, less than 5% is actively engaged in various forms of wrapped Bitcoin. A significant barrier to the broader adoption of wrapped Bitcoin is the inherent risks associated with centralization. Traditional methods require depositors to transfer their Bitcoin to a centralized custodian or bridge, exposing them to risks of custodian failures, bridge hacks, and fraud. This undermines Bitcoin's fundamental principles of decentralization and self-sovereignty. As highlighted by a DeFi lead at a Tier 1 exchange: “Earning a 3% yield on Bitcoin isn't appealing if it means risking the total loss of my assets. I’d rather avoid using wBTC.”
Addressing these concerns, dlcBTC emerges as an innovative solution, offering a 'self-wrapping' mechanism. This article delves into dlcBTC and its merchant network—a system granting exclusive minting and unminting privileges to a group of verified, whitelisted depositors.
The Genesis of dlcBTC
dlcBTC introduces a novel approach by implementing Discreet Log Contracts (DLCs) at its core, enabling a unique 'self-wrapped' representation of Bitcoin on the Ethereum blockchain. This innovative mechanism allows Bitcoin holders to engage in DeFi activities while retaining ownership and a greater degree of control over their assets. For a more comprehensive overview about dlcBTC, refer to our dlcBTC Overview page.
Security Features of dlcBTC
dlcBTC's security framework is meticulously designed to shield depositors from prevalent risks in the cryptocurrency domain.
- Innovative DLC Deposit Structure: Each dlcBTC transaction is secured via physical Bitcoin locked in a 2-of-2 multisig. The DLC must be funded by physical Bitcoin, ensuring Proof of Reserves.
- Depositor-Focused Outputs: The design mandates that all output addresses in the DLC point back to the depositor. This architecture makes it impossible for the deposited BTC to be misappropriated. Only the depositor can redeem funds.
- Unparalleled Control and Custody: In the dlcBTC ecosystem, depositors cannot transfer their Bitcoin to DLC.Link or to any external parties. This model ensures that the underlying Bitcoin cannot be stolen in a hack or lost through fraud.
The Role and Responsibility of dlcBTC Merchants
At the core of the dlcBTC system is the dlcBTC Merchant Network, an assembly of carefully chosen institutional entities. These merchants play a pivotal role in bridging the gap between the retail sector and the dlcBTC framework, ensuring the smooth functioning and reliability of the network.
- KYC Compliance: The dlcBTC Merchant Network adheres to stringent Know Your Customer (KYC) protocols. Each merchant undergoes a comprehensive KYC process, aligning with global financial regulations and cementing user trust in the system.
- Minting and Redemption Duties: dlcBTC Merchants can access the dlcBTC bridge, enabling them to mint dlcBTC and to process redemptions for BTC.
- Swap Fee Generation: dlcBTC Merchants play a key role in facilitating redemptions for retail users, earning swap fees in the process. This not only provides a financial incentive but also contributes to the overall liquidity and efficiency of the dlcBTC ecosystem.
- Arbitrage Opportunities: Merchants have the exclusive right to mint or redeem dlcBTC, allowing them to capitalize on price discrepancies between dlcBTC and BTC. This unique position enables them to contribute to the price stability of dlcBTC while generating profits.
Introducing the dlcBTC Merchant Network
The establishment of the dlcBTC Merchant Network marks a significant step forward, enhancing the security and operational efficiency of the dlcBTC ecosystem:
- Risk Mitigation for Retail Users: By allowing only qualified merchants to mint and redeem dlcBTC, the network significantly reduces credit risk for retail participants. This fosters a more secure and reliable environment for all stakeholders involved.
- Incentivizing Network Integrity: dlcBTC merchants, benefiting from financial incentives such as swap fees and arbitrage profits, are motivated to maintain the network's integrity and liquidity. This not only serves as a revenue stream but also reinforces their commitment to the stability of the dlcBTC ecosystem.
- Transparency and Reduced Risk for Retail Users: The dlcBTC system, with its self-wrapping feature, offers a transparent and lower-risk alternative for retail users. While retail users don't retain direct control over their wrapped Bitcoin, the system's design ensures a safer environment for their assets, aligning with the principles of decentralization and trust in the cryptocurrency domain. This transparency is key to building user confidence and promoting long-term adoption in the DeFi space.
Credit Risk in the dlcBTC Ecosystem
The question of credit risk in the dlcBTC ecosystem, particularly concerning the scenario where a merchant goes under and refuses to redeem users' dlcBTC, is a valid concern. The primary credit risk arises if a merchant faces insolvency or operational issues and is unable or unwilling to redeem dlcBTC for BTC. In such a case, users holding dlcBTC associated with that merchant could face losses due to a loss of confidence leading to a de-peg.
To address and mitigate these risks, several strategies and mechanisms can be put in place. The Merchant approach borrows from wBTC’s Merchant network, which are the sole entities that can mint or burn wBTC.
- Diversification of Merchants: Having a diverse range of merchants in the network reduces the risk of a single merchant's failure impacting the entire system. This diversification ensures that the failure of one merchant doesn't jeopardize the entire network's integrity.
- Strict Vetting and Continuous Monitoring: Rigorous vetting procedures for merchants before their induction into the network and continuous monitoring of their financial health can preemptively identify risks.
- Insurance: Implementing insurance schemes or creating a guarantee fund pooled from merchants can offer additional protection to users. This fund could be used to cover losses in the event of a merchant's default.
- Surety Bond: dlcBTC merchants may be required to post a surety bond to participate in the network. If a merchant fails, the bond value compensates affected parties (up to the bond amount).
- Guarantee Funds: A guarantee fund in the dlcBTC ecosystem is a pooled financial reserve, contributed to by participating merchants, designed to compensate users in case of a merchant's default or failure to fulfill redemption obligations. This fund serves as a safety net, distributing risk among all participants and enhancing the overall security and trustworthiness of the system.
- Legal and Contractual Safeguards: Clear legal frameworks and contractual agreements bind merchants to their obligations, offering legal recourse in case of defaults. If a dlcBTC merchant becomes insolvent, their BTC locked in DLCs may be subject to takeover by a bankruptcy court, ensuring asset distribution in line with the jurisdiction's legal provisions.
- Decentralized Reserve: Exploring decentralized mechanisms where redemption doesn't solely rely on individual merchants could further reduce credit risk. For instance, a decentralized pool of BTC serves as a backup redemption mechanism.
Consequences of a dlcBTC Merchant Failure
Let’s now describe a scenario where a merchant refuses to redeem dlcBTC:
First, consider a situation where a dlcBTC merchant becomes insolvent. In the dlcBTC system, Bitcoin deposits are securely minted and only accessible when redeemed, ruling out risks of fraud or commingling as seen in cases like FTX. However, merchant insolvency could lead to a pause in dlcBTC redemption and potentially result in the DLC's ownership shifting to a bankruptcy court or another party.
Under these circumstances, dlcBTC may experience a drop in value (echoing the USDC depegging event earlier this year). This devaluation could attract investors to purchase dlcBTC at reduced prices, either to seek redemption from other solvent merchants or to hold the asset, betting on a future resolution and normalization of the peg.
An additional risk scenario involves the theft of a merchant's private keys, constituting a serious financial crime. In such events, arbitrageurs might speculate on the possibility of the stolen wallets being recovered.
How to design dlcBTC Merchant Network to Enable Sufficient Redemptions
While there is an inherent credit risk in the dlcBTC system due to the reliance on merchants for redemption, this risk can be effectively managed and mitigated through a combination of diversification, financial safeguards, strict vetting, legal frameworks, and user education. The robust design of the dlcBTC ecosystem aims to minimize such risks and ensure the stability and reliability of the system.
- Quality and Quantity of Merchants: A higher number of merchants can reduce the risk of any single merchant's failure impacting the system significantly. Also, seeing multiple reputable institutions as part of the network can significantly boost confidence.
- Merchant Capacity: Each merchant should have enough liquidity to handle a significant portion of redemption requests, ensuring no single merchant is a bottleneck.
- Geographic Distribution: Merchants will cover different geographic regions to cater to a global user base and mitigate region-specific risks.
- Market Representation: Having merchants from diverse market segments (like exchanges, institutional investors, Bitcoin miners) can ensure broader market representation and stability.
- Transparent Operations: The way the network operates – including merchant activities, audit processes, and redemption mechanisms – should be transparent to users.
- Regulatory Compliance: At launch, dlcBTC merchants will be required to complete KYC and other requirements (e.g. KYT) to ensure compliance with international trade laws as well as any jurisdiction-specific regulations.
Advantages of dlcBTC over other Wrapped Bitcoin
Due to the fact that DLCs can only be redeemed by depositors, there are clearly risks of the dlcBTC ecosystem that are not reflected in other wrapped tokens which allow redemptions to any party at any time. In turn, dlcBTC offers a significant advantage over traditional wrapped Bitcoin assets like wBTC or tBTC through its unique approach to handling Bitcoin deposits.
In the dlcBTC system, Bitcoin deposits remain under the control of the merchants, rather than being held in a centralized custodial setup. This decentralization fundamentally reduces the risk of loss due to theft, hacks, or fraud. Since the Bitcoin is not pooled or stored in a single repository, it's less vulnerable to the kinds of large-scale security breaches that have historically affected centralized crypto platforms.
Additionally, the dlcBTC model aligns closely with Bitcoin's principles of decentralization and self-sovereignty. Depositors engage in special multisig transactions, ensuring a higher level of security and control over their assets. This setup not only enhances the safety of the assets but also provides transparency and auditability, as all transactions are verifiable on the blockchain. By avoiding the need to transfer Bitcoin to a third party, dlcBTC maintains the integrity and ownership of the user's assets, offering a more secure and trust-aligned option in the world of wrapped Bitcoin assets.
Further Enhancements for dlcBTC
Looking ahead, the dlcBTC system could evolve to include new features that enhance its security and functionality:
Reserve System: To enhance the reliability of the dlcBTC system, particularly for redemptions, the introduction of a reserve system can be considered. This reserve would act similarly to how FDIC insurance functions in traditional banking. It would represent a pool of dlcBTC locked in Discreet Log Contracts (DLCs), set aside specifically to facilitate redemptions in scenarios where individual merchants are unable to fulfill redemption requests. This reserve could provide an additional layer of security and stability, ensuring users have a fallback mechanism for redeeming their dlcBTC.
Insurance Coverage: Another significant enhancement involves implementing insurance coverage for deposits within the dlcBTC system. This insurance would serve to protect users against potential losses, adding an extra layer of trust and safety to the system. By covering deposits, users can feel more secure in the knowledge that their assets have some protection against unforeseen circumstances, further aligning dlcBTC with traditional financial systems' safety nets.
Liquidation to a Counterparty (Reserve): Developing mechanisms for liquidations to a designated counterparty, such as the reserve, would allow for more flexibility and security in managing the dlcBTC assets.
Partial Liquidations: Implementing partial liquidation options could provide users with more granular control over their assets, allowing them to redeem a portion of their holdings as needed.
Other DLC Core Features: The introduction of additional DLC core features could be explored. These features would be selectively enabled, especially when they contribute to the overall enhancement of the system's security and user experience.
These potential enhancements represent a forward-thinking approach, aiming to bolster the robustness and appeal of the dlcBTC system in the dynamic world of DeFi and cryptocurrency.
Launch Plans
Building trust and understanding in a new system takes time. The dlcBTC network addresses this through education and transparent operations. DLCs represent new technology that must be stress-tested and evaluated in various long-tail scenarios. As such, dlcBTC will be launched with a phased rollout, initially with low deposit limits in place. Ongoing security and risk audits will take place to ensure technical and economic performance.
Conclusion
dlcBTC represents a significant step forward in the integration of Bitcoin with Ethereum's DeFi capabilities. By offering a secure, self-wrapped version of Bitcoin and establishing a reliable merchant network, dlcBTC addresses critical issues that have hindered the wider adoption of wrapped Bitcoin. As the network grows and evolves, it is set to pave the way for a more inclusive, transparent, and secure DeFi ecosystem, demonstrating the transformative power of blockchain technology.
Appendix
Resources:
https://www.gauntlet.xyz/resources/reassessing-usdc-risk
https://www.gauntlet.xyz/resources/improved-var-methodology
https://www.gauntlet.xyz/resources/uniswap-incentive-design-analysis
