Explanation in Simple Language (ELI5)

Tokenized Bitcoin is a way to use Bitcoin on another blockchain.

But wait, isn't Bitcoin already good? Indeed it has! Bitcoin has a solid use case, and has also been recognized as a kind of public good. However, at the same time, its deliberately limited features require further innovation.

What are the other benefits of Bitcoin? Some Bitcoiners say that we don't need to do anything, and that's fine. While others believe that we must find a way to use Bitcoin on other blockchains. And this is where we meet BTC tokenized on Ethereum.

Why is Bitcoin tokenized? Does this make sense? How are tokenized Bitcoins created? How do you acquire BTC tokens? Read more below if this topic interests you.


Content

  • Introduction

  • What is tokenized Bitcoin?

  • Why tokenize Bitcoin on Ethereum?

  • How to tokenize Bitcoin?

  • Example of tokenized Bitcoin

    • Custodian

    • Non-custodial

  • Is this good for Bitcoin or Ethereum?

  • Conclusion

Introduction

Bitcoin is usually viewed as a “reserve asset” or store of value in the cryptocurrency world. As a result, this asset has the highest adoption, best liquidity, highest average trading volume, and remains the top cryptocurrency by market capitalization. In fact, some people believe that there is no need for cryptocurrencies other than Bitcoin. Their argument is that Bitcoin can fulfill all the use cases that altcoins try to offer.

However, blockchain technology is growing in many segments. The Decentralized Finance (DeFi) movement aims to bring financial applications to the blockchain. This decentralized application (DApp) runs on a permissionless public network and allows trustless financial transactions without the need for a central controlling party. Although the idea of ​​DeFi is blockchain-agnostic, meaning that it can be operated on any smart contract platform, most of this activity occurs on Ethereum. 

Bitcoin is the backbone of the cryptocurrency market, however, this asset cannot take advantage of developments from other networks in the crypto ecosystem. Several projects have worked to solve this problem. 

Is there a way to use bitcoin more than we can currently see, while keeping the Bitcoin network intact? Well, the growth of bitcoin tokenized on Ethereum shows so.


What is tokenized Bitcoin?

Before we start, there is something that must be explained to avoid confusion. If you have read the article What is Bitcoin?, you must already know that Bitcoin with an uppercase b is a network, and bitcoin with a lowercase b is a unit of account.

The idea behind bitcoin tokenization is relatively simple. You lock BTC through some mechanism, create a token on another network, and use BTC as a token on that network. Each token on another network represents a certain amount of bitcoin. The amount pegged between the two must be maintained, and the process must be reversible. In other words, you can destroy these tokens, resulting in “real” bitcoins being unlocked again on the Bitcoin blockchain.

In Ethereum's case, this means an ERC-20 token that represents bitcoin. Allows users to make transactions on the Ethereum network denominated in bitcoin. Also makes bitcoin programmable – like other tokens on Ethereum.

You can check the current total number of bitcoins tokenized on Ethereum via btconethereum.com.


Pertumbuhan BTC yang ditokenkan di Ethereum. Sumber: btconethereum.com

Growth of BTC tokenized on Ethereum. Source: btconethereum.com


In July 2020, there were approximately 15,000 BTC tokenized on Ethereum. It may sound like a lot, but this amount is negligible when compared to the ~18.5 million circulating supply. However, these numbers are still preliminary.

It is worth noting that sidechain and Layer 2 solutions such as the Bitcoin Lightning Network or Liquid Network also aim to address similar challenges. Interestingly, there are ten times more bitcoins on Ethereum than on the Bitcoin Lightning Network. 

However, the competition between these different solutions is not that simple – it is not a zero-sum game. In fact, many people believe that these two solutions actually complement each other. Tokenization projects can add options for bitcoin owners. This could lead to more integration, which would benefit all parties.

So, this all sounds interesting, but what's the point? Let's discuss why we want to tokenize Bitcoin.


Why tokenize Bitcoin on Ethereum?

Bitcoin's design is intentionally simple. It has been designed to do several things, and do them very well. However, these traits have inherent limitations.

Even though it is the most valuable asset, Bitcoin cannot take advantage of the innovation of other networks in the digital currency environment. While you can technically run smart contracts on Bitcoin, the scope is very limited compared to Ethereum or other smart contract platforms. 

Bitcoin tokenization on other chains can increase the utility of the network. How could that be? Well, this process can enable functionality that is not supported in Bitcoin. At the same time, Bitcoin's core functionality and security model remain intact. Additional benefits can include increased transaction speed, fungibility, and privacy.

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

Bringing Bitcoin to the composite layer of financial blocks is considered an attractive prospect by many. It could lead to many new types of applications that use bitcoin, which would not be possible if this were not done.


How to tokenize Bitcoin?

There are many ways to tokenize Bitcoin on Ethereum and other blockchains. Each has different levels of decentralization, different assumptions regarding trust and risk, and may treat tokenized coins differently.

Two main types can be distinguished as custodial and non-custodial. The custodial type involves centralized custodianship, and tokens can also be minted by that party. This can create counterparty risk, because the entity holding the bitcoins must be trustworthy (and must remain in business). On the other hand, this implementation may be considered safer than other alternatives.

The other solution is slightly different. No trusted entity is required, as the on-chain process automatically performs the entire minting and burning process. Collateral assets are locked, and tokens are minted on another chain through some on-chain process. Funds are locked on-chain, reopened when the token is destroyed. While this eliminates counterparty risk, it can, however, increase potential security risks. Why? In this case, the burden of risk falls entirely on the shoulders of the user. If a user or contract error results in the loss of funds, they will likely be lost forever.


Example of tokenized Bitcoin

Custodian

This type of custodian accounts for the majority of the current supply of tokenized bitcoin. The most value locked is in Wrapped Bitcoin (WBTC). How does it work? Users send their bitcoins to a centralized custodian who stores them in multisignature cold storage wallets, and mints WBTC tokens in exchange. Please note that the process requires proof of identity to comply with KYC/AML regulations. This method requires trust in the entity minting the token, but also provides some security benefits.

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


Non-custodial

The non-custodial solution works completely on-chain, without the involvement of a centralized custodian. In simple terms, you can think of it as similar to Wrapped BTC. However, instead of a centralized custodian, the tools used are smart contracts or virtual machines that keep funds safe and mint tokens. Users can deposit BTC and print tokenized bitcoins in a trustless and permissionless manner.

Some of these systems will also require overcollateralization, meaning the user must deposit more value (collateral) than they wish to print. This is done to prepare the system for the possibility of a black swan event and a severe market crash. However, if the collateral value decreases significantly, the system may not be able to handle it either.

The most popular non-custodial implementation is renBTC. Bitcoins are sent to the Ren Virtual Machine (RenVM), which stores them using a decentralized network of nodes, which then mint ERC-20 tokens according to the number of bitcoins sent. 

Another important example is sBTC and iBTC, which are synthetic tokens collateralized with Synthetix Network (SNX) Tokens instead of bitcoin. What makes iBTC especially interesting is that the token tracks the price of Bitcoin inversely, making it one of the few non-custodial ways to open a short position against Bitcoin.

It should be noted that the non-custodial method is a highly experimental technology. It's no surprise that centralized custodial solutions are still more popular – because they tend to be more secure. Of course, there is also the risk of bugs and user error, which could potentially lead to loss of funds. Even so, ultimately these methods could be the future of tokenization once the technology is improved.

Because this non-custodial solution is governed by an automated process, its use is only recommended for advanced users. However, if you want to play around with these tokens without worrying about the minting process, you can buy and trade them on cryptocurrency exchanges.


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Is this good for Bitcoin or Ethereum?

This question is difficult to answer. Let's try to consider both sides of the argument.

So, how could this be good for Bitcoin? Well, tokenization can be said to increase Bitcoin's utility. Although many would argue that Bitcoin does not need more functionality, however, Bitcoin does need some. As we discussed previously, the benefits can include increased transaction speed, fungibility, privacy, and reduced transaction costs. With the launch of ETH 2.0, we expect transactions on Ethereum to become faster and cheaper. This could also help with bitcoin tokenized on Ethereum. 

On the other hand, some people argue that tokenization has the potential to harm tokenized Bitcoin holders. BTC tokenization also means sacrificing Bitcoin's strong security properties – its most sought after properties. 

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

One more thing to consider is cost. Some people argue that if a large number of users start transacting with BTC tokenized on the Ethereum blockchain, transaction fees on the Bitcoin network could decrease. In the (very) long term, Bitcoin should only be supported by transaction fees. If a large portion of those transaction fees flow into the Ethereum ecosystem, network security could be at risk. However, this is still a long way off, and is not a pressing issue for now.

How can tokenization be good for Ethereum? Well, if Ethereum captures much of Bitcoin's value, that means this process could increase Ethereum's usefulness as a global network for transferring value. According to Etherscan research, most of the previously mentioned amount of 15,000 BTC is locked in Ethereum's DeFi ecosystem. 

Tokenized Bitcoin could increase the utility of DeFi on Ethereum. How could that be? There may be decentralized financial services based on tokenized bitcoin. BTC-based DEXes, lending markets, liquidity pools, and any service found in DeFi can all be denominated in BTC. The success of tokenized bitcoin may also encourage other types of assets to migrate to the Ethereum network.

Most of these projects are still in a very early stage, and the drive technology still needs to be improved. However, there will definitely be interesting developments in the future.


Conclusion

We've discussed what tokenized bitcoin is and some of the existing implementations. The main goal behind tokenizing bitcoin as an ERC-20 token is to increase Bitcoin's utility. 

If Ethereum can capture a large portion of Bitcoin transactions, there could be huge implications in the future. Is flippening a realistic scenario? How much of the Bitcoin supply will be transacted on Ethereum in the future? This is still a question. However, all blockchain industry players can benefit from building a bridge between the two largest crypto networks.

Still want to learn more about tokenized bitcoin and other digital assets? Check out our question and answer platform, Ask Academy, where your questions are answered by the Binance community.