Babylon Labs has fleshed out a plan that would allow users of DeFi lending protocol Aave to borrow stablecoins using bitcoin as collateral.

Defiant reported on Oct. 14 that Babylon Labs released a governance proposal describing a way to use bitcoin as loan collateral on Ethereum while keeping it on the Bitcoin network.

The proposal calls for adding 2 modules to Aave V4. One is a "Babylon Spoke" that accepts only bitcoin as collateral, and the other is a "BTC Vault Swap Spoke" that handles liquidations. Funding for loans would be supplied by the Aave V4 hub. The first use would be stablecoin loans.

The plan first emerged in May. Defiant said the document is for discussion and does not mean a market listing has been approved.

Babylon Labs' proposal does not involve depositors swapping bitcoin for another token. Depositors would not need to move it to another blockchain or entrust it to a company. The approach would lock bitcoin on the Bitcoin network in a vault that can be opened only if specified conditions are met.

Aave V4 recognises only Ethereum standard tokens (ERC-20) as collateral. Babylon would issue 1 internal token for each 1 bitcoin locked. The token would be used only within the lending system, and users would not be able to trade or transfer it.

Time could be a problem, Defiant said. It can take several days to retrieve the original bitcoin, and only pre-designated participants can process it.

The next steps after this proposal are gathering community feedback and conducting a risk analysis. If consensus is reached, it would go through a Snapshot vote. If the result is positive, an Aave Improvement Proposal setting out detailed risk parameters would go to an on-chain vote.