Tokenized Bitcoin is a way to use bitcoins on other blockchains.
But wait, isn’t Bitcoin great yet? Indeed it is! It has a solid use case, and it’s already acting as a public good. At the same time, its purposefully restricted features leave little room for further innovation.
So what else can be done with Bitcoin? Some Bitcoiners say that we shouldn’t do anything specific, and that makes sense.Then others once again believed that we should find a way to use Bitcoin on other blockchains And this is where we come in with BTC tokenized on Ethereum.
Why Encrypt Bitcoin? Does this even make sense? How Are tokenized bitcoin Generated? Can you use encrypted BTC?
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Introduction
Bitcoin is often seen as a “reserve asset” or store of value in the cryptocurrency space. As a result, it has the highest adoption, the best liquidity, the highest average trading volume and remains the top cryptocurrency by market capitalization. In fact, some believe that there is not even a need for any other cryptocurrency than Bitcoin. Their argument is that Bitcoin can cater to all the use cases that altcoins are trying to fulfill.
However, in many different segments, blockchain technology is flourishing. The Decentralized Finance (Defi) movement aims to bring financial applications to blockchain. Decentralized Applications (DApps) run on public, permissionless networks and allow trustless financial transactions without the need for a central coordinator. While the idea of DeFi is blockchain agnostic, meaning it can happen on any smart contract platform, most of this activity is happening on Ethereum.
Bitcoin is the backbone of the cryptocurrency market, however, it cannot take advantage of developments that occur in other parts of the ecosystem. Several projects have been working on solving this problem.
Is there a way to use bitcoin more than it can do while keeping the Bitcoin network intact? Well, the growth of tokenized bitcoin on Ethereum shows that there is a need for it.
What is Tokenized Bitcoin?
Before we begin, we should clarify something to avoid confusion. If you have read What is Bitcoin? you know that Bitcoin with uppercase b is the network and bitcoin with lowercase b is the unit of account.
The idea behind bitcoin encryption is relatively simple. You lock BTC through some mechanism, mint tokens on another network, and use BTC as a token on that network. Each token on the other network will represent a specific amount of bitcoin The latch between these two should be held and the process should be reversed. In other words, you can destroy these tokens, resulting in the “original” bitcoin being unlocked back on the Bitcoin blockchain.
In the case of Ethereum, this means that an ERC-20 token represents bitcoin. This allows users to make transactions on the Ethereum network using bitcoins. This also makes bitcoin programmable – just like any other token on Ethereum.
You can check the current total number of bitcoins encrypted on Ethereum on btconethereum.com.
As of July 2020, there are approximately 15,000 BTC encrypted on Ethereum. That sounds like a lot, but it’s insignificant compared to the ~18.5 million that make up the circulating supply. However, this may be just the beginning.
It should be noted that sidechains and layer 2 solutions like Bitcoin Lightning Network or Liquid Network aim to solve similar challenges. Fascinatingly, there are ten times more bitcoins on Ethereum than there are bitcoins in Bitcoin’s Lightning Network.
The competition between these different solutions isn’t straightforward, though – it’s not a zero-sum game. In fact, many people believe that they complement each other rather than compete with each other. Crypto projects can increase the options bitcoin holders have, while tokenless projects improve the overall infrastructure. This could lead to more integration in the space, which would benefit the entire industry.
So all this sounds interesting, but what’s the point of it? Let’s explore why we wanted to tokenize Bitcoin in the first place.
Why tokenizing Bitcoin on Ethereum?
Bitcoin design is simple on purpose. It’s designed to do a few things and does them very well. However, these attributes come with inherent limitations.
While most of the value is in Bitcoin, it cannot benefit much from the innovation taking place in other segments of the digital currency industry. While you can technically run smart contracts on Bitcoin, its scope is quite limited compared to Ethereum or other smart contract platforms.
Encrypting bitcoins on other chains can increase the utility of the network. How? Well, it can enable functionality that is not supported on Bitcoin. At the same time, Bitcoin’s core functionality and security model remains intact. Additional advantages can be increased transaction speed, interchangeability, and privacy.
This is another reason. One of the best aspects of DeFi is the idea of composability. Which means since all these applications are running on the same public, open source, permissionless base class, they can work seamlessly with each other.
Putting Bitcoin on this class of composable financial building blocks is seen by many as an exciting prospect. It could bring many new types of applications using bitcoin and would not be possible.
So how does Tokenized Bitcoin work?
There are many ways to tokenize Bitcoin on Ethereum and other blockchains They all have different levels of decentralization, different assumptions about trust and risk, and can maintain different pegs.
Two main categories can be defined as custodial and non-custodial. The first one involves a centralized custodian and the tokens can also be minted by that party. This leads to counterparty risk, as the bitcoin custody entity must be trusted (and it must continue to function). On the other hand, this implementation can be considered more secure than the alternatives.
The other solutions are a little different There is no need for a trusted entity, as automated on-line processes do the entire casting and burning process. The collaterals are locked and the token is minted on another chain through some on-chain operation. The funds are locked on-chain until they are unlocked again when the tokens are destroyed. While this eliminates counterparty risk, it increases potential security risks. Why? Well, in this case, the burden of risk is entirely on the user’s shoulders. If a user or contract error occurs resulting in the loss of funds, they may be lost forever.
Tokenized Bitcoin Examples
Custodial
These make up a significant portion of the current tokenized bitcoin supply. The most number of locked values is Wrapped Bitcoin (WBTC). How it works? Users deposit their Bitcoins to a centralized custodian who keeps them in a cold multisignature storage wallet and mints WBTC tokens back. It should be noted that this process requires proof of their identity to comply with KYC/AML regulations. This method requires trust in the entity that is minting the token but also offers some security benefits.
Binance also has a crypto version of BTC called BTCB. It is a BEP-2 token issued on Binance Chain. If you want to try it out, you can trade on Binance DEX.
Non-custodial
Unattended solutions work completely on-chain without any involvement from a centralized manager. In a word, you can think of them similar to Wrapped BTC. However, instead of a centralized custodian, it is a smart contract or a virtual machine that keeps coins safe and mints the tokens. Users can deposit their BTC and mint their tokenized bitcoin in a trustless and permissionless manner.
Some of these systems will also require overpayment, which means users have to deposit more value (collateral) than they want to target. They do this to prepare the system for black swan events and major market crashes. Even so, if collateral values drop significantly, these systems may not be able to handle it.
The most common non-custodial implementation is the yuan. Bitcoins are sent to the Ren Virtual Machine (RenVM), which stores them using a decentralized network of nodes. It then mines ERC-20 tokens according to the amount of bitcoins sent.
Other notable examples are sBTC and iBTC, which are synthetic tokens collateralized with the Synthetix Network Token (SNX) instead of bitcoin. What makes iBTC particularly interesting is that it tracks back the price of Bitcoin. This makes it one of the few unattended ways to sell Bitcoin.
It should be noted that these are highly experimental technologies. It’s no surprise that centralized, monitoring solutions are more popular – they tend to be more secure. Naturally, there is also a higher risk of user error and failure, potentially resulting in loss of funds. Even so, this could eventually be the future of encryption once the technology improves.
Since these unattended solutions are governed by automated processes, their use is recommended only for advanced users. However, if you want to play with these tokens without worrying about the mining process, you can buy and trade them on cryptocurrency exchanges.
Is this good for Ethereum or Bitcoin?
It’s hard to answer. Let’s try to consider both sides of the argument.
So how can this be good for Bitcoin? Well, it is supposed to increase the utility of Bitcoin. While many would argue that Bitcoin doesn’t necessarily need more functionality, it could use some. As we discussed earlier, the possible benefits are increased transaction speed, interchangeability, privacy, and reduced transaction costs. With the launch of ETH 2.0, we can expect transactions on Ethereum to be faster and cheaper. This can also help in the case of tokenized bitcoin on Ethereum.
On the other hand, some argue that this is potentially dangerous for holders of tokenized bitcoin. Encrypting BTC also results in giving up Bitcoin’s strong security benefits – some of its most sought-after attributes.
For example, what if the tokenized bitcoins are stolen or lost due to a smart contract failure? There will likely be no way to unlock bitcoins locked on the Bitcoin blockchain.
Another thing to keep in mind is the fee. Some argue that if a large number of users start trading BTC encrypted on the Ethereum blockchain, transaction fees on the Bitcoin network could drop. In the (very) long term, Bitcoin is supposed to be backed only by transaction fees. If most of them flow into the Ethereum ecosystem, the security of the network could be compromised. However, this is a long way off and not an urgent matter for a long time.
How can it be good for Ethereum? Well, if Ethereum captures much of the value of Bitcoin, that could increase Ethereum’s utility as a global network for value transfer. According to research by Etherscan, a significant portion of the total 15,000 BTC mentioned previously is locked in the Ethereum DeFi ecosystem.
Tokenized bitcoin can significantly increase the utility of DeFi on Ethereum. How? Based on tokenized bitcoin, decentralized financial services are possible. BTC-based DEXs, lending markets, liquidity pools, and anything else that exists in DeFi can all be denominated in BTC. The success of tokenized bitcoin could also incentivize other asset classes to migrate to the Ethereum network.
Most projects are still in the early stages and the technology behind them has a lot of room for improvement. However, there are bound to be interesting developments on this front.
Closing thoughts
We discussed what tokenized bitcoin is and what different implementations exist. The main motivation behind tokenizing bitcoin as an ERC-20 token is to increase Bitcoin’s utility.
If Ethereum is able to capture a significant portion of Bitcoin transactions, there could be major impacts in the future. Is flippening a realistic scenario? What part of the Bitcoin supply will be traded on Ethereum in the future? This is still to be seen. However, the entire blockchain industry could benefit from building a bridge between the two largest cryptocurrency networks.
Still want to learn more about tokenized bitcoin and other digital assets? Check out our Q&A platform, Ask Academy, where you can have your questions answered by the Binance community.