BitVM earlier this year came under fire due to the large liquidity requirements needed for a rollup (or other system operator) to process withdrawals for the two-way pegging mechanisms being built using BitVM’s design. Galaxy, an investor in Citrea, has performed an economic analysis analyzing its assumptions regarding the economic conditions necessary to make a BitVM-based two-way peg a sustainable operation.
For those unfamiliar, linking to a BitVM system requires operators to take custody of users’ funds on a multisign, creating a set of pre-signed transactions that allow the operator facilitating withdrawals to claim funds after a period of challenge. The user then receives tokens backed in the rollup or other second layer system.
Pegouts are a little more complicated. The user must burn their funds into the second layer system and then create a Partially Signed Bitcoin Transaction (PSBT) that returns the funds to them on the main chain, minus a fee for the operator who processes the withdrawals. They can continue to create new PSBTs by paying the operator higher fees until the operator agrees. At this point, the trader will take his own liquidity and pay the user’s withdrawal.
The trader can then, after having processed withdrawals that add up to a deposited UTXO, initiate the withdrawal outside of the BitVM system to complete. This includes a challenge-response period to protect against fraud, which Galaxy models as a 14-day window. During this period, anyone who can build proof of fraud proving that the operator did not honestly honor all users’ withdrawals at that time can initiate the challenge. If the trader cannot provide proof that they successfully processed all withdrawals, then the connector input (a special transaction input that is required to use their pre-signed transactions) that the trader uses to claim their funds may be burned, blocking them from access. . ability to recover your funds.
Now that we’ve gone over the mechanism, let’s look at what Galaxy modeled: the economic viability of operating such a linkage.
There are a number of variables that must be considered when analyzing whether this system can work profitably. Transaction fees, amount of liquidity available, but most importantly the opportunity cost of dedicating capital to processing withdrawals from a BitVM peg. The latter is critically important to be able to obtain liquidity to manage the bond in the first place. If liquidity providers (LPs) can make 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 set of fees that users will pay to exit the system and for its operation to make sense. That is, to generate profits. The two competitive interest rate benchmarks Galaxy analyzed were Aave, a DeFi protocol operating on Ethereum, and OTC markets on Bitcoin.
At the time of its report, Aave was earning lenders approximately 1% interest on lent WBTC (Wrapped Bitcoin Pegged to Ethereum). On the other hand, OTC loans 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 income in excess of these interest rates to attract capital into bonding from these other systems.
According to Galaxy’s projections, as long as LPs aim for a 10% annual percentage yield (APY), that should cost individual users -0.38% on a link transaction. The only wild card variable, so to speak, is the transaction fees that the operator has to pay in high fee environments. User funds are already recovered using the trader’s liquidity immediately after initiating the pegout, while the trader has to wait for the two-week challenge period to claim the early liquidity.
If fees were to increase in the meantime, this would affect traders’ profit margins when they finally claim their funds from BitVM pegging. However, in theory, traders could simply wait until fees decrease to start the challenge period and claim their funds back.
Generally, the viability of a BitVM peg comes down to being able to generate a sufficiently high return on the liquidity used to process withdrawals and attract the necessary capital. To attract more institutional capital, these yields must be higher to compete with OTC markets.
The full Galaxy report can be read here.
