Bitcoin DeFi: RSK and SOV
Background
Last month, I wrote up the basics of DeFi and why it’s coming to Bitcoin.
Building DeFi on top of Bitcoin makes sense as the base layer is the most unchanging, trustworthy, and decentralized blockchain to build upon.
"To build DeFi on a centralized protocol, or one that is a protocol managed by rulers, is inherently broken from the start" - Alyse Killeen (Long time Bitcoin VC)
Based on a Twitter poll I ran, my followers were most interested in Stacks, which I wrote about last month.
In this newsletter, I’m covering the 2nd most popular request: Rootstock (RSK) and Sovryn (SOV).
DISCLAIMER: I do not recommend owning another token other than Bitcoin. The SOV I’ve been given to play around (via screenshots below) with the protocol I am donating to HRF at the end of my research (to fund resilient communication systems for Bitcoin). SOV is not needed to use SOV/RSK smart contracts.
Rootstock (RSK)
Rootstock is a smart contract platform that gets its security from Bitcoin via merge mining which helps prevent double-spending and increases settlement finality.
It is one of the oldest Bitcoin DeFi projects, with the first iteration being built under a different name in 2013.
There was no premine, all rBTC is created through locking up BTC on the main chain.
Security/Merge Mining
Rootstock believes that PoW is the best consensus system to provide proper finality, so it decided to append itself to Bitcoin’s security.
47% of Bitcoin miners opt-in to merge mine with the Rootstock blockchain because they get an additional mining fee (from Rootstock transaction fees paid in rBTC).
There are more complexities and theoretical security risks to merge mining but for the sake of brevity, I can’t cover all the nuances of that debate.
The Bridge
It’s connected to the Bitcoin blockchain via 2-way peg (acting as a bridge), which allows for BTC to be swapped for rBTC (native Bitcoin represented on the Rootstock blockchain) and vice versa. In order to interact with the Rootstock chain, users have to lock up some of their Bitcoin in the bridge.
In order to create this bridge, Rootstock requires a semi-trusted setup called a “federation.” The role of the federation is to determine when the user’s coins are locked up and released. The Federation and the locked Bitcoin become part of a multi-sig wallet. Members of the federation are chosen through a variety of quality/trust factors.
The multi-sig wallet is a simple m-for-n multisig. Basically, if “n” is the total number of participants in the multi-sig wallet, then “m” is the least number of signees required to release the funds.
All the other things
There is much more depth with merge mining, 2-way bridge, and governance. But for the sake of brevity, I’ll save that for another newsletter.
Sovryn (SOV)
Sovryn is a non-custodial and permissionless smart contract-based system for Bitcoin lending, borrowing, yield farming, and margin trading. It primarily resides on the Rootstock blockchain (there is connectivity to other chains including L2 Bitcoin and Ethereum).
SOV, the native currency of Sovryn, is a governance token that allows individuals to vote on various proposals. It’s like quasi-equity (but not equity) with voting rights.
rBTC, the native Bitcoin equivalent token of the Rootstock protocol, is what SOV uses to power smart contract activity. So there is no additional token other than rBTC (which is BTC) you need to use when interacting with SOV.
You can use a variety of wallets to connect to the Sovryn protocol via this website. They even work with hardware wallets which is really cool (vs browser-based like metamask).
What can you do with it?
Below are the primary functions you can do with SOV protocol:
Spot-Exchange (“Swap”)
A low-cost, low-slippage, AMM allowing instant trades between tokens.
Margin Trading
Creates up to 5X long/short trades, allowing users to borrow leverage from the lending pool.
Borrowing
Allows users and smart contracts to borrow tokens from the lending pool. All lending is over-collateralized.
Lending Pool
Allows HODLers to earn interest by lending tokens to margin traders and borrowers. As you can see the yield is super low on Bitcoin (more supply than demand). Rates fluctuate based on supply/demand. This low yield is similar to the rates we see in wrapped Bitcoin on Ethereum.
Interest payments made by borrowers are distributed to lenders. The Sovryn Protocol collects 10% of interest for the insurance fund, which exists to protect lenders in the possible case of loan default.
Governance
With the SOV token, you can vote on various proposals. There’s also a staking function, but I’m not sure what the purpose of that is.
Yield Farming/Automated Market Makers (AMM)
I chose to deep dive on yield farming versus the other functions because it’s one of the least understood DeFi functions in Bitcoin.
Traders can interact with this pool by getting a quoted price for any asset pair. For example, if they wanted to buy $10,000 worth of Bitcoin, the protocol spits out 0.15 BTC for $10,000 as the cost. Slippage is baked in.
With yield farming, liquidity providers deposit assets into a liquidity pool. Some types of pools require that you deposit both assets (ex: both BTC and USD in a BTC/USD pool), and some allow single asset deposits.
Liquidity providers earn a fee for providing tokens to the pool which is paid for by traders who interact with the liquidity pool. Also, they earn incentive yield from the protocol to provide liquidity. For example, below in the 4 boxes with $15k SOV value, you can see the incentive SOV is offering per liquidity pool.
There is a term called “Impermanent loss” which is a watered-down term for you fucking lost money (this exists for most, if not all liquidity pools/AMMs on any protocol). What happens here is that the price of one asset moves in one direction over an extended period of time. This leaves the liquidity providers with more of the other assets. For example, in a BTC/USD pool, the liquidity provider would be left with more USD if Bitcoin went on a bull run.
So when you see crazy high yields, this is typically a combination of incentive yield from the protocol (and speculative on the native token) + harvesting volatility at the expense of the performance of the asset.
Risks
With any “DeFi” protocol, risks inherently exist with the underlying smart contracts. SOV has undergone a series of audits, which are available to view here. In no way am I vouching for the quality of these audits, nor am I saying that SOV or RSK are “safe.” Exploits are found semi-often in Ethereum DeFi, so its wise to think that it could happen over in Bitcoin DeFi.
Conclusion
Bitcoin DeFi is a fascinating topic that I’ve been having fun diving into recently. First with a basic overview, then with Stacks, and now with RSK/SOV.
SOV is super interesting because it’s one of the most well-polished “Bitcoin DeFi” interfaces I’ve interacted with.
Of course, there is some controversy between the risks/implementations of protocols, so I recommend folks read some criticisms of each one.
Next up in the series will be DLCs (Discrete log contracts) and Lightning!
HODL,
Dan
If you’re a paid subscriber, check the top of this e-mail for the link to your voting form, and feel free to comment below in Substack (restricted only to paid subscribers).
Loved this newsletter? Subscribe now to the free tier to get:
Paid newsletter every week
Vote on the next topic
Q&A
we should build a community chat where we can talk about these things more.