Explain like a 5 year old

Tokenized Bitcoin is a way to use Bitcoin on other blockchains.

But wait, isn’t Bitcoin already awesome? Of course yes ! It has a robust use case, and it already acts as a sort of public good. At the same time, its deliberately limited features leave little room for innovation.

What else could we do with Bitcoin? Some Bitcoin supporters say we shouldn't do anything special, and that's reasonable. Tokenized Bitcoin is a way to use Bitcoin on other blockchains. And this is where we come to tokenized BTC on Ethereum.

Why tokenize bitcoins? Does that make sense? How is tokenized Bitcoin created? Can you get tokenized BTC? If you're interested in the answer, read on.


Introduction

Bitcoin is generally considered a “reserve asset” or store of value in the cryptocurrency space. Therefore, it has the highest adoption, best liquidity, largest average trading volume and remains the best cryptocurrency by market capitalization. In fact, some people believe that there is no need for cryptocurrencies other than Bitcoin. Their argument is that Bitcoin could meet all the use cases that altcoins are trying to address.

However, blockchain technology is flourishing in many different segments. The decentralized finance (DeFi) movement aims to bring financial applications to the blockchain. These decentralized applications (DApps) run on permissionless public networks and enable trustless financial transactions without the need for a coordinating central party. Although the idea of ​​DeFi is blockchain independent, meaning it can be developed on any smart contract platform, most of this activity takes place on Ethereum.

Bitcoin is the backbone of the cryptocurrency market. Yet it cannot benefit from developments occurring in other parts of the ecosystem. Some projects have attempted to address this issue.

Is there a way to use Bitcoin for more than it can do while still keeping the Bitcoin network intact? Well, the increase in the number of bitcoins tokenized on Ethereum suggests that there is demand for it.


What is tokenized Bitcoin?

Before we begin, there is one thing we need to clarify to avoid confusion. If you have read our article What is Bitcoin?, you know that Bitcoin with a capital B is the network and that bitcoin with a lowercase b is the unit of account.

The idea behind bitcoin tokenization is relatively simple. You lock the BTC using one mechanism, issue tokens on another network, and use the BTC as a token on that network. Each token on the other network represents a specific amount of bitcoins. The link between the two must be preserved and the process must be reversible. In other words, you can destroy these tokens, thereby unlocking the original bitcoins on the Bitcoin blockchain again.

In the case of Ethereum, this means having ERC-20 tokens that represent bitcoins. This allows users to transact on the bitcoin-denominated Ethereum network. This also makes bitcoins programmable, like any other token on Ethereum.

You can view the current total amount of bitcoins tokenized on Ethereum at btconethereum.com.


As of July 2020, approximately $15 trillion was converted into tokens on Ethereum. This may seem like a lot, but it is negligible compared to the ~18.5 million that constitutes the circulating supply. However, this may just be the beginning.

Importantly, sidechains and second-layer solutions such as the Bitcoin Lightning Network or Liquid Network also aim to address similar challenges. There are more than ten times more bitcoins on Ethereum than on the Bitcoin Lightning Network.

Despite everything, the competition between these different solutions is not so simple, it is not a zero-sum game. In fact, many believe they complement each other rather than compete with each other. Tokenized projects can increase the options available to bitcoin holders, while non-tokenized projects improve the overall infrastructure. This could result in greater integration in the space, which would benefit the entire sector.

This all sounds interesting, but what is the point of all this? Let's first look at the reasons why we would want to tokenize bitcoin.


Why tokenize Bitcoin on Ethereum?

The design of Bitcoin is deliberately simple. It was designed to do a few things, and it does them very well. However, these properties have inherent limitations.

Although Bitcoin accounts for most of the value, it cannot benefit as much from the innovation occurring in other segments of the digital currency industry. Although you can technically run smart contracts on the Bitcoin network, their scope is quite limited compared to Ethereum or other smart contract platforms.

Tokenizing bitcoins on other chains can increase the utility of the network. How ? Well, it could enable features that are not natively supported on Bitcoin. At the same time, the core functionality and security model of Bitcoin remains intact. Additional benefits can be increased transaction speeds, fungibility and privacy.

Here's another potential reason. One of the greatest aspects of DeFi is the idea of ​​composability. This means that since all of these applications run on the same public, open-source, permissionless base layer, they can work seamlessly with each other.

Integrating Bitcoin into this composable layer of financial blocks is seen by many as an interesting prospect. It could introduce many new types of applications that use bitcoins that would not otherwise be possible.


How does Bitcoin tokenization work?

There are many ways to tokenize Bitcoin on Ethereum and other blockchains. They all have different degrees of decentralization, different assumptions about trust and risk, and can all maintain the connection differently.

The two main types can be defined as custodial and non-custodial. The first type involves a centralized custodian, and tokens can also be issued by this party. This presents a risk for counterparties, because the entity handling the bitcoins must be trusted (and must remain in business). On the other hand, this implementation can be considered more secure than other solutions.

The other solutions are a little different. No trusted entity is needed, as automated on-chain processes perform the entire issuance and destruction process. The collateral assets are locked and tokens are issued to the other chain through on-chain mechanisms. The funds are locked on-chain until released again when the tokens are destroyed. While this eliminates counterparty risk, it increases potential security risks. For what ? Well, in this case, the burden of risk lies entirely on the shoulders of the user. In the event of a user or contract error resulting in the loss of funds, it is likely that they will be lost forever.


Examples of Bitcoin tokenization

Custodial

The latter represent a significant part of the current tokenized bitcoin supply. The largest amount of value blocked is in wrapped bitcoin (WBTC). How does it work ? Users send their bitcoins to a centralized custodian who holds them in a multi-signature offline wallet that issues WBTC tokens in return. It is important to note that this process requires proof of identity to comply with KYC/AML regulations. This method requires the trust of the entity issuing the token, but also provides some security advantages.

Binance also has a tokenized version of BTC called BTCB. This is a BEP-2 token issued on Binance Chain. If you want to try it, you can trade it on Binance DEX.


Non-custodial

Non-custodial solutions operate entirely on-chain, without any intervention from a centralized custodian. In simple terms, you can think of them as wrapped BTC. However, instead of a centralized custodian, it is a smart contract or virtual machine that protects the funds and issues the tokens. Users can deposit their BTC and issue their tokenized bitcoins in a trustless and permissionless manner.

Some of these systems will also require over-collateralization, meaning users must post more value (collateral) than they will issue. This requirement is intended to prepare the system for black swan events and crashes. However, if the value of the guarantee decreases significantly, these systems may not be able to maintain their operation.

The most popular non-custodial implementation is renBTC. The bitcoins are sent to the Ren Virtual Machine (RenVM), which stores them using a network of decentralized nodes. It then issues ERC-20 tokens based on the quantity of bitcoins sent.

Other notable examples are sBTC and iBTC, which are synthetic tokens collateralized by Synthetix Network Token (SNX) instead of bitcoins. What makes iBTC particularly interesting is that it inversely follows the price of Bitcoin. It therefore constitutes one of the rare non-custodial ways to sell Bitcoin short.

It is important to note that these are highly experimental technologies. It's no wonder that centralized and custodial solutions are more popular, given that they tend to be more secure. Naturally, there is also a higher risk of bugs and user errors, which can lead to loss of funds. Even so, they could be the future of tokenization once the technology improves.

As these non-custodial solutions are governed by automated processes, their use is only recommended for advanced users. But if you want to play with these tokens without worrying about the issuance process, you can buy and trade them on cryptocurrency exchanges.


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Is this a good thing for Bitcoin or Ethereum?

It is not easy to answer this question. Let's try to take into account the pros and cons.

So how can this be good for Bitcoin? Well, that arguably increases its usefulness. While many will argue that Bitcoin doesn't necessarily need more features, it could benefit from them. As we have already discussed, the advantages can be speed, fungibility, confidentiality and reduced transaction costs. With the launch of ETH 2.0, we can expect transactions on Ethereum to be faster and cheaper. This may also help the case for tokenized bitcoins on Ethereum.

On the other hand, some argue that this is potentially dangerous for holders of tokenized bitcoins. Tokenizing BTC also involves giving up Bitcoin's strong security advantages, one of its most sought-after properties.

For example, what happens if tokenized bitcoins are stolen or lost due to a smart contract bug? There would potentially be no way to unlock bitcoins locked on the Bitcoin blockchain.

Another thing to consider: fees. Some argue that if large numbers of users start transacting tokenized BTC on the Ethereum blockchain, transaction fees on the Bitcoin network could plummet. In the (very) long term, Bitcoin is expected to be supported solely by transaction fees. If most of them flock to the Ethereum ecosystem, the security of the network could be compromised. However, this is a long-term issue and will not be an urgent problem for many years.

How can this be good for the Ethereum network? Well, if Ethereum captures a lot of value from the Bitcoin network, it could increase Ethereum's usefulness as a global network for transferring value. According to a study conducted by Etherscan, a considerable portion of the previously mentioned 15,000 BTC is locked in the DeFi ecosystem.

Tokenized bitcoins could significantly increase the utility of DeFi on Ethereum. How ? There could be decentralized financial services based on tokenized bitcoins. BTC-based DEXs, lending marketplaces, liquidity pools, and anything else DeFi offers could be denominated in BTC. The success of tokenized bitcoin could also encourage other types of assets to migrate to the Ethereum network.

Most projects are still in their early stages, and the technology behind them can still be improved. Nonetheless, there are certainly some exciting developments to come on this front.


To conclude

We discussed what tokenized bitcoin is and its different implementations. The main driver behind tokenizing bitcoin as an ERC-20 token is to increase the utility of the Bitcoin network.

If Ethereum can capture a significant portion of Bitcoin transactions, it can have major consequences in the future. Is overthrow a realistic scenario? How much of Bitcoin's supply will be transferred to Ethereum in the future? That remains to be seen. However, the entire blockchain industry could benefit from building bridges between the two largest cryptocurrency networks.