Bitcoin, a renowned cryptocurrency, has established itself as a valuable asset with a solid use case and functions as a public good. However, its deliberately restricted features limit opportunities for further advancements. The question arises: can we expand Bitcoin's potential? While some Bitcoin enthusiasts argue that no specific actions are necessary, others propose exploring the integration of Bitcoin with other blockchains. This brings us to the concept of tokenized BTC on Ethereum.
Bitcoin, a dominant cryptocurrency, is often seen as a valuable "reserve asset." It boasts high adoption, liquidity, trading volume, and market capitalization, making it the top crypto. Some argue that Bitcoin alone can fulfill all the purposes of alternative cryptocurrencies.
However, blockchain technology is flourishing, particularly in Decentralized Finance (DeFi). DeFi aims to bring financial applications to the blockchain, predominantly on Ethereum. Despite Bitcoin's central role, it cannot leverage advancements in other parts of the ecosystem. Projects are addressing this issue.
Fortunately, a solution has emerged: tokenized bitcoin on Ethereum. This integration meets the increasing demand for expanding Bitcoin's utility while maintaining the Bitcoin network's integrity.
What Is Tokenized Bitcoin?
To avoid confusion, let's establish a clear distinction. Bitcoin, spelled with an uppercase "B," refers to the network, while bitcoin, spelled with a lowercase "b," represents the unit of account.
The concept of tokenizing bitcoin is straightforward. It involves locking BTC using a specific mechanism, minting tokens on a separate network, and utilizing the BTC as tokens within that network. Each token on the alternative network represents a distinct amount of bitcoin. It is essential to maintain a fixed relationship between the two and ensure the process is reversible. In simpler terms, destroying these tokens would unlock the original bitcoins on the Bitcoin blockchain once again.
In the case of Ethereum, this entails the creation of ERC-20 tokens that serve as representations of bitcoin. This enables users to conduct transactions on the Ethereum network using bitcoin as the denomination. Consequently, bitcoins gain programmability, similar to any other token on the Ethereum platform.
Currently, there are over 15,000 BTC tokenized on Ethereum. Although this may seem substantial, it is relatively insignificant compared to the circulating supply of approximately 18.5 million BTC. However, this could signify just the initial phase of development.
It is worth mentioning that sidechains and Layer 2 solutions, such as the Bitcoin Lightning Network or the Liquid Network, also address similar challenges. Interestingly, the amount of bitcoin on Ethereum surpasses the quantity held in the Bitcoin Lightning Network by more than tenfold.
However, the competition among these solutions is not a straightforward zero-sum game. In reality, many experts view them as complementary rather than competing with one another. Tokenized projects expand the options available to bitcoin holders, while projects without tokens enhance the overall infrastructure. This fosters increased integration within the industry, benefiting the entire ecosystem.
Why Would You Do That?
The intentional simplicity of Bitcoin's design allows it to excel in its designated functions. However, these characteristics also impose certain limitations. Despite Bitcoin's significant value, it cannot fully leverage the innovations occurring in other sectors of the digital currency industry. While smart contracts can technically run on Bitcoin, its capabilities are relatively restricted compared to platforms like Ethereum.
Tokenizing bitcoin on alternative chains offers the potential to enhance the network's utility. How? By enabling functionalities that are not inherently supported by Bitcoin. This expansion preserves the core functionality and security model of Bitcoin while potentially offering benefits such as faster transactions, enhanced fungibility, and improved privacy.
Another compelling factor is the concept of composability within DeFi. The ability for various applications to seamlessly interact on a shared, open-source, and permissionless foundation creates exciting possibilities. Integrating Bitcoin into this composable layer of financial building blocks is highly regarded as it opens doors to new applications utilizing bitcoin that would otherwise be unattainable.
How Does Tokenizing Bitcoin Work?
The process of tokenizing Bitcoin on Ethereum and other blockchains can be approached in various ways. These methods differ in terms of decentralization, trust assumptions, and risks, as well as the mechanisms used to maintain the peg.
There are primarily two main types: custodial and non-custodial.
- In the custodial approach, a centralized custodian is involved, who may also handle the minting of tokens. However, this introduces counterparty risk, as trust must be placed in the custodian to safeguard the bitcoins and remain operational. Despite this risk, some consider this implementation to be more secure than alternatives.
- The non-custodial solutions take a different approach. They rely on automated on-chain processes for the entire minting and burning process, without the need for a trusted entity. Collateral assets are locked, and tokens are minted on the target chain through on-chain mechanisms. The locked funds remain on-chain until the tokens are eventually destroyed and unlocked. While this eliminates counterparty risks, it does increase the potential for security risks. In this case, the user bears the entire burden of risk. If a user or contract error occurs, resulting in the loss of funds, they are likely lost permanently.
Tokenized Bitcoin Examples
Wrapped Bitcoin (WBTC) represents a substantial portion of the existing tokenized bitcoin supply. It operates by users sending their bitcoin to a centralized custodian responsible for maintaining a multi-signature cold storage wallet. In exchange for the deposited bitcoin, WBTC tokens are minted. It is important to note that this process involves verifying the users' identities to adhere to KYC/AML regulations. While trust in the token-minting entity is necessary, this method also provides certain security advantages.
Non-custodial solutions, like renBTC, operate on-chain without centralized custodians. Funds are secured and tokens are minted through smart contracts or virtual machines. Users deposit BTC in a trustless and permissionless manner. Some systems require overcollateralization for stability. Examples include sBTC and iBTC, which use SNX as collateral. iBTC inversely tracks Bitcoin's price, allowing for non-custodial shorting. These technologies are experimental and carry higher risks. Centralized solutions are currently more popular due to their security. Advanced users can utilize non-custodial options governed by automated processes. Alternatively, tokens can be purchased and traded on exchanges to avoid minting concerns.
Is It Worth It?
Tokenizing Bitcoin on Ethereum can increase the utility of both cryptocurrencies. While some argue that Bitcoin doesn't require additional functionality, there are potential benefits such as faster transactions, improved fungibility, enhanced privacy, and reduced costs. The launch of ETH 2.0 may contribute to faster and cheaper transactions on Ethereum, further supporting tokenized Bitcoin. However, there are concerns about the security risks associated with tokenization, as the strong security features of Bitcoin may be compromised if the tokenized bitcoins are stolen or lost due to smart contract bugs.
Another consideration is transaction fees. If a significant number of users start transacting tokenized BTC on Ethereum, it could potentially lower transaction fees on the Bitcoin network. Since Bitcoin's long-term sustainability relies on transaction fees, diverting fees to the Ethereum ecosystem could impact the security of the Bitcoin network. However, this is a distant concern and not an immediate issue.
From Ethereum's perspective, capturing a substantial portion of Bitcoin's value would enhance Ethereum's utility as a global value transfer network. A significant amount of BTC is already locked in the Ethereum DeFi ecosystem, according to research by Etherscan. Tokenized Bitcoin can greatly expand the DeFi offerings on Ethereum, allowing for decentralized financial services denominated in BTC. The success of tokenized Bitcoin may also pave the way for other assets to migrate to the Ethereum network. While these projects are still in the early stages, there is anticipation for exciting developments in the future as the technology progresses.
Tokenized bitcoin, implemented as ERC-20 tokens on Ethereum, aims to enhance the utility of Bitcoin. The implications of Ethereum capturing a substantial share of Bitcoin transactions are significant for the future of the blockchain industry. The possibility of a "flippening" and the exact proportion of Bitcoin supply that will be transacted on Ethereum remains uncertain. Nonetheless, building bridges between these two major cryptocurrency networks can bring benefits to the entire industry.