Bitcoin embodies decentralization, security, and self-sovereignty. But today, financial transactions with Bitcoin require the use of custodians or bridges – a reliance on intermediaries that has led to disastrous losses numbering in the billions of dollars. Discreet Log Contracts (DLCs) are poised to change that by allowing users in the space, for the first time, to deliver on the core ideals of building on Bitcoin.
The following opinion editorial was written by Aki Balogh, Co-founder and CEO of DLC.Link.
Discreet Log Contracts
Originally proposed in 2018 by Tadge Dryja, the co-inventor of the Lightning Network, DLCs enable new decentralized financial applications while keeping Bitcoin deposits safely held in safe custody. DLCs allow two parties to make conditional payments based on predefined conditions. The parties identify possible outcomes, sign them beforehand, and use these pre-signatures to execute the payout when the outcome is known. By offering decentralized security directly on-chain, DLCs also ensure the base-level security of the full computational power of the Bitcoin network.
The Mechanics of DLCs
Let’s walk through a general example of a DLC to illustrate the mechanics. Alice and Bob wish to enter into a DLC and they select a third party (“Olivia the Oracle”) to referee their transaction. They agree on two potential outcomes; either all of the BTC moves to Alice or all moves to Bob. Both Alice and Bob pre-sign transactions for these outcomes, securing their commitments.
When the loan term ends, Olivia publishes an “attestation” that activates the corresponding pre-signature. Either party can then execute the contract to transfer Bitcoin to the winning party. Most importantly, Olivia is not a party to the transaction. She does not know who the participants are, the amount of Bitcoin locked, or any other transaction details.
Take this one step further. What if Olivia was not a single reporting entity, but a blockchain? What if the source of the oracle data was the Ethereum blockchain itself? The triggering event could be delivered by examining on-chain events published by validators on the Ethereum network. In this sense, Olivia would not be an oracle but would rather be a DLC Attestor: an off-chain service that verifies on-chain signals and publishes the DLC’s “attestation”, to relay signals between Bitcoin and Ethereum.
Enabling DeFi on Bitcoin
At present, Bitcoin Layer 2 networks are early-stage compared to those on other blockchains. Still, interest in L2s is quickly growing, according to the “Bitcoin Layers” report produced by the Singapore-based Web3 investment firm, Spartan Group. According to the report, Bitcoin is well-placed to unlock its potential with layered architecture to mirror that of Ethereum.
However, enabling interoperability through L2 protocols also comes with its fair share of risks. Since L2 protocols operate on other networks, they are only as secure as the leading networks they are on, and share their vulnerabilities. A network failure on an L1, for example, could lead to users losing assets locked on an L2 bridge. DLCs however, safeguard security by eliminating these L2 vulnerabilities and overhauling DeFi on a larger scale.
While there are current limitations to building on Bitcoin, these mechanics open up safer possibilities. For instance, using the system outlined above, DLCs can be used to secure Bitcoin collateral to generate a yield in DeFi. The pre-signed logic within the DLC enforces redemptions and liquidations using smart contract logic that can be verified on-chain. Most importantly, this eliminates the need for a third-party entity or bridge to hold custody of the Bitcoin.
Using a DLC-enabled DeFi protocol does involve smart contract risk. If there is a bug in smart contract code, or if hackers are able to manipulate the signals seemingly sent from Ethereum validators, then a DLC could unlock prematurely or fail to unlock at all. In such a case, a depositor would have locked BTC but be unable to unlock it, even in the case of a published on-chain signal.
Nevertheless, for those looking to invest their funds while HODLing, or those looking to purchase covered calls or other derivatives to generate investment yield, DLCs offer a more secure option. Billions of dollars in Bitcoin collateral have been lost due to centralized custodians who went bankrupt or bridges that were compromised. By locking using technology already available in Bitcoin L1, DLCs are secured by the full hashrate of the Bitcoin network.
So What’s Next?
This year’s Bitcoin halving, while impacting supply dynamics in the short term, will have far-reaching consequences for the entire crypto market. It’s a crucial test for DeFi protocols, demanding agility and innovation to remain relevant in a fluctuating market. DLCs emerge as a powerful solution, not just for Bitcoin deposits in DeFi, but for the entire cryptocurrency ecosystem. By enabling new financial instruments and applications, DLCs have the potential to propel DeFi adoption to new heights, fulfilling the promise of a truly decentralized financial future
What do you think about DLCs and the emergence of Bitcoin DeFi? Share your thoughts and opinions about this subject in the comments section below.
