BitVM earlier this year came under fire due to the large liquidity requirements needed for the pool (or other system operator) to be able to process withdrawals for two-way peg mechanisms that are built using BitVM’s design. Galaxy, an investor in Citrea, conducted an economic analysis looking at its assumptions regarding the economic conditions needed to make BitVM-based two-way pegging a sustainable operation.
For those unfamiliar, linking to the BitVM system requires operators to hold user funds in n-of-n multisig, creating a set of pre-signed transactions allowing the operator to facilitate withdrawals to claim refunds after the challenge period. Backed tokens are then issued to the user on the pooling system or other layer 2 system.
Pegouts are a bit more complicated. The user must burn their funds on the layer 2 system, then formulate a Partially Signed Bitcoin Transaction (PSBT) that pays them the funds on the mainnet, minus withdrawal processing operator fees. They can continue to formulate new PSBTs that pay the operator higher fees until the operator accepts. At this point, the operator will take their liquidity and pay the withdrawal amount to the user.
The operator can then, after processing the withdrawals and adding up to the deposited UTXO, start withdrawing from the BitVM system to make itself whole. This includes the fraud protection challenge and response period, which Galaxy has designed as a 14-day window. During this time period, anyone who can generate fraud evidence showing that the operator did not faithfully honor the withdrawals of all users in that era can initiate a challenge. If an operator cannot provide proof that they have processed all withdrawals correctly, the connector inputs (a special transaction entry required to use pre-signed transactions) that the operator uses to claim their funds back can be burned, locking them out of the ability to get their funds back.
Now that we’ve finished revamping the mechanism, let’s take a look at the Galaxy model: the economic feasibility of operating such an interconnection.
There are a number of variables that must be taken into account when considering whether this system can be operated profitably. Transaction fees, the amount of liquidity available, but most importantly the opportunity cost of allocating capital to process withdrawals from a BitVM link. The latter is of critical importance in being able to provide liquidity to manage the connection in the first place. If Liquidity Providers (LPs) can make more money doing something else with their money, then they are essentially losing money using their capital to run the BitVM system.
All of these factors must be covered, profitably, by the total fees users will pay for connecting the system to the system for it to make sense in business. That is, to generate profit. The two competing interest rate references Galaxy considered were Aave, a DeFi protocol running on Ethereum, and OTC markets in Bitcoin.
Aave at the time of its report earned lenders interest of around 1% on WBTC (wrapped bitcoin tied to Ethereum). On the other hand, OTC lending rates reached 7.6% compared to Aave. This shows a stark difference between the expected return on capital between DeFi users and institutional investors. Users of the BitVM system must generate revenues in excess of these interest rates in order to attract capital to interconnect from these other systems.
According to Galaxy’s forecast, as long as limited partners target a 10% annual percentage yield (APY), this would cost individual users -0.38% in a linking transaction. The only wildcard variable, for example, is the transaction fees that the operator must pay during high-fee environments. Users’ funds are actually recovered using the operator’s liquidity immediately after the installation process starts, while the operator has to wait for the two-week challenge period in order to recover the provided liquidity.
If fees rise in the meantime, this would erode operators’ profit margins when they eventually demand their money back from BitVM pegging. However, in theory, operators could simply wait until the fees subside to initiate the challenge period and claim their money back.
In general, the viability of linking BitVM comes down to the ability to generate a high enough return on the liquidity used to process withdrawals to attract the required capital. To attract more institutional capital, these returns must be higher in order to compete with over-the-counter markets.
You can read the full Galaxy report here.
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