The co-founder of Bitcoin infrastructure company Babylon Labs claims to have built a system that allows native Bitcoin to be used as trustless collateral for lending on the Ethereum blockchain.
In a post on X on Wednesday, Babylon Labs co-founder and Stanford University professor David Tse claimed that Babylon has constructed a proof of concept that allows native Bitcoin to be "used as collateral for lending on Ethereum for the first time in a trustless manner."
These comments were made following the release of a white paper by Babylon in early August, which outlined its so-called trustless Bitcoin vault system. The system utilizes the Bitcoin smart contract verification system BitVM3 to lock BTC in each user's vault, where withdrawals (redemptions or liquidations) are controlled by cryptographic proofs of the state of an externally verified smart contract on Bitcoin.
This allows users to lock Bitcoin and bridge it to Ethereum without relying on federated custodians or bridges. On the Ethereum side, smart contracts verify the BTC vault through a Bitcoin light client and then calculate the collateral.
An experimental version of the resulting token is available on the on-chain lending protocol Morpho. However, it is still in the testing phase, with a total market liquidity of $14 USDC. Tse described VaultBTC as "a middle non-fungible asset that connects the vault with Morpho and allows depositors and liquidators to withdraw BTC in a trustless manner."
As of the time of publication, Babylon Labs and Tse had not responded to Cointelegraph's request for comment.
While the system explained above is partially trustless, certain aspects still require trust. According to the white paper, Babylon's Bitcoin vault liquidation utilizes whitelisted liquidators to monitor prices and vault status, resulting in a liquidation system that is not permissionless and introduces trust assumptions.
Even with co-signatures to mitigate censorship, the model still assumes that a sufficient number of liquidators (sometimes large lenders) will act correctly. Even if they cannot steal Bitcoin due to system design, this still introduces trust assumptions into the system.
Liquidation relies on price oracles, so they inherit the accuracy, timeliness, and censorship resistance risks of the oracles. If the oracles are incorrect or delayed, the system will make erroneous decisions. As of the time of publication, oracle providers Band Protocol and Pyth Network, which have existing relationships with Babylon Labs, had not responded to Cointelegraph's request for comment.
The white paper provides a simple example: "Bob holds 1 BTC and wants to borrow $50,000 stablecoins from Larry through a lending protocol on Ethereum." This would require that if the Bitcoin price falls below $50,000, Larry can liquidate the collateral, and if Bob repays the loan on time, he can reclaim his BTC.
Babylon Labs explains that the current system requires a significant number of trust assumptions. Bob can hand over his Bitcoin to Larry for safekeeping, trusting that he will return it.
Alternatively, Bob can keep the Bitcoin and promise to allow Larry to liquidate it if the price drops—but Larry must trust that Bob will keep his promise. Finally, Bob can bridge the Bitcoin as Wrapped Bitcoin (WBTC) to Ethereum and use it as collateral in a smart contract. However, he must trust the wrapping mechanism itself.
WBTC requires trust because the Bitcoin backing it is held by centralized custodians, and one must trust that they will not lose, freeze, or misuse the funds. Users rely on the honesty and solvency of this custodian rather than cryptographic guarantees. This is the main issue that Babylon's trustless implementation aims to solve.
"The trustless vault eliminates all such trust assumptions. Bob and Larry jointly pre-sign a set of Bitcoin transactions that define the conditions for spending rights," the white paper states.
Related: BlackRock enters the booming stablecoin market by redesigning funds
Original: “Native Bitcoin (BTC) as DeFi collateral? Babylon claims to have cracked this problem”
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