BitVM came under fire earlier this year for the large liquidity requirements required to allow a rollup (or other system operator) to process withdrawals for the two-way peg mechanisms being built using the BitVM design. Galaxy, an investor in Citrea, has conducted an economic analysis looking at their assumptions regarding the economic conditions needed to make a BitVM-based two-way link a sustainable operation.
For those unfamiliar, linking to a BitVM system requires the operators to hold user funds in an n-of-n multisig, creating a series of pre-signed transactions through which the operator can facilitate withdrawals to recover funds after a challenge period. The user is then issued supported tokens on the rollup or other second tier system.
Pegouts are a little more complicated. The user must burn their funds on the second tier system and then make a partially signed Bitcoin transaction (PSBT), refunding the funds on the main chain, minus a fee for the operator processing the withdrawals. They can keep making new PSBTs and paying the operator higher fees until the operator agrees. At this point the operator will use its own liquidity and cash out the user’s withdrawal.
The operator can then, after processing withdrawals that make up a deposited UTXO, initiate the withdrawal from the BitVM system to restore themselves to health. This includes a challenge response period to protect against fraud, which Galaxy models as a 14-day period. During this period, anyone who can construct a fraud proof showing that the operator did not fairly honor the withdrawals of all users during that era can start the challenge. If the operator cannot prove that he has processed all withdrawals correctly, the connector entry (a special transaction entry required to use his pre-signed transactions) that the operator uses to recover his funds may be burned, causing him to whether she is no longer eligible for the transaction. ability to get their money back.
Now that we’ve brushed up on the mechanics, let’s look at what Galaxy has modeled: the economic viability of exploiting such a link.
There are a number of variables to consider when considering whether this system can be operated profitably. Transaction costs, amount of available liquidity, but most importantly the opportunity cost of spending capital on processing withdrawals from a BitVM link. The latter is crucial to be able to obtain liquidity in the first place to manage the link. If liquidity providers (LPs) can make more money by doing something else with their money, they are essentially losing money by using their capital to operate a BitVM system.
All of these factors must be profitably covered by the set of fees that users will have to pay to opt out of the system for it to function meaningfully. That is, to generate profit. The two benchmarks for competitive interest rates that Galaxy looked at were Aave, a DeFi protocol running on Ethereum, and OTC markets in Bitcoin.
Aave was earning around 1% interest on the WBTC (wrapped Bitcoin linked to Ethereum) lent at the time of their report to lenders. OTC loans, on the other hand, had interest rates as high as 7.6% compared to Aave. This shows a big difference between the expected returns on capital between DeFi users and institutional investors. Users of a BitVM system must generate revenues in excess of these interest rates to raise capital to connect these other systems.
According to Galaxy’s forecasts, as long as LPs target an annualized rate of return (APY) of 10%, this should cost individual users -0.38% on a peg-out trade. The only wildcard variable, so to speak, is the transaction fees that the operator has to pay in high-fee environments. The user’s funds are already recovered using the operator’s liquidity immediately after initiating the pegout, while the operator has to wait the two-week challenge period to recover the fronted liquidity.
If fees were to increase in the meantime, it would eat into operators’ profit margins when they eventually claim their money back from the BitVM link. In theory, however, operators could simply wait until costs drop to start the challenge period and claim their money back.
In general, the viability of a BitVM link comes down to being able to generate a high enough return on the liquidity used to process withdrawals to raise the necessary capital. To attract more institutional capital, these returns need to be higher to compete with OTC markets.
The full Galaxy report can be read here.