Let's explain it in our fingers.
Tokenized Bitcoin is a way to use Bitcoin on other blockchains.
But isn't Bitcoin good enough on its own? Bitcoin is fine! It has a robust use case and has already become something of a public domain. However, its deliberately limited capabilities hinder innovation.
What else can you do with bitcoins? Some owners of this coin believe that there is no need to look for new ways to use it. On the other hand, we often need to use Bitcoin in other blockchains. This is where the idea of tokenized BTC on Ethereum comes from.
Why tokenize Bitcoin? What's the use of this? How is tokenized Bitcoin created? Is it possible to get tokenized BTC? Below you will find answers to these questions.
Introduction
Bitcoin is generally viewed as a “reserve asset” or store of value in the cryptocurrency space. As a result, it has the highest adoption rate, the best liquidity, the highest average trading volume, and remains the top cryptocurrency by market capitalization. Some people believe that no cryptocurrencies are needed at all, since Bitcoin already offers all the possible use cases that altcoins are just trying to implement.
Blockchain technology is thriving in various segments. The decentralized finance (DeFi) movement aims to bring financial applications to the blockchain. These decentralized applications (DApps) run on public networks and, by being trustless, allow financial transactions to be carried out without the need for a central coordinating entity. While DeFi is blockchain agnostic and can run on any smart contract platform, most of its activity occurs on Ethereum.
Bitcoin is the backbone of the cryptocurrency market, yet it fails to take advantage of the innovations of other parts of the ecosystem. Some projects are already working to solve this problem.
Are there ways to expand Bitcoin's uses while keeping the Bitcoin network intact? The increase in the number of tokenized Bitcoins on Ethereum demonstrates the high demand for them.
What is tokenized Bitcoin?
To avoid confusion, we first need to clarify a few things. If you read our article What is Bitcoin?, then you know that Bitcoin with a capital letter is a network, and Bitcoin with a small letter is a unit of account.
The idea of tokenizing Bitcoin is relatively simple. You lock BTC using a specific mechanism, issue tokens on another network, and use BTC as a token on that network. Each token on this network represents a certain number of Bitcoins. The connection between them must be maintained, and the process must be reversible. That is, you should be able to destroy these tokens, causing the “original” bitcoins to be unlocked again on the Bitcoin blockchain.
In the case of Ethereum, Bitcoins are represented by ERC-20 tokens. This allows users to make transactions on the Ethereum network denominated in Bitcoin. The programmability of bitcoins, like any other token on Ethereum, is also increasing.
You can check the current total amount of Bitcoin tokenized on Ethereum at btconethereum.com.
Since July 2020, 15,000 BTC have been tokenized on Ethereum. This figure may seem very large, but it is negligible compared to the ~18.5 million coins in circulation. However, this may just be the beginning.
It is worth noting that sidechains and layer 2 solutions such as Bitcoin Lightning Network or Liquid Network also aim to solve similar problems. Surprisingly, Ethereum has more than ten times more bitcoins than the Bitcoin Lightning Network.
But even so, the competition between different solutions is not so clear-cut - it is not a zero-sum game. Many believe that they complement each other rather than compete. Tokenized projects can empower Bitcoin holders, while non-tokenized projects help improve the overall infrastructure. This will encourage greater integration across the space, which will benefit the entire industry.
This all sounds interesting, but what good is it? Let's figure out why we need to tokenize Bitcoin.
Why tokenize Bitcoin on Ethereum
Bitcoin is intentionally made very simple. It was designed to perform multiple tasks, but it also has certain limitations.
While Bitcoin holds the most value, it does not benefit from innovation in other segments of the digital currency industry. While you can run smart contracts on Bitcoin, they will be limited in scope compared to Ethereum or other smart contract platforms.
Tokenizing Bitcoins on other chains can improve the efficiency of the network. How exactly? This will enable features that are not natively supported by Bitcoin. At the same time, Bitcoin's core features and security model remain intact. Additional benefits include increased transaction speed, fungibility, and privacy.
In this section we will look at several possible reasons. One of the main aspects of DeFi is interoperability. Because all of these applications run on the same public, open-source base layer, they can interact seamlessly with each other.
Using Bitcoin in this composite layer of financial building blocks has the potential to interest potential customers. This could lead to new types of applications using Bitcoin.
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 may support anchoring in different ways.
The two main types are custodial and non-custodial. The first type involves the presence of a centralized custodian that can issue tokens. This method involves certain risks associated with the participation of a third party, since you will have to trust the organization that stores the bitcoins. However, this implementation can be considered more secure than the alternatives.
Other solutions are different in that they do not force you to trust a third party, as the on-chain mining and burning processes are performed by automated processes. Collateral assets are locked and tokens are released on another chain using certain network manipulations. Funds are blocked on the chain until the tokens are destroyed. While this eliminates third party risks, the potential security risks increase. Why? In this case, the burden of responsibility falls entirely on your shoulders. In case of user or contract error, funds will be lost forever.
Examples of tokenized bitcoins
Custodial
They make up a significant portion of the current tokenized Bitcoin circulation. Most of the funds are locked in Wrapped Bitcoin (WBTC). How it works? Users transfer their bitcoins to a centralized custodian, who stores them in a multi-signature cold wallet and issues WBTC tokens. It is worth noting that this process requires identity verification in accordance with KYC/AML rules. This method involves trusting the custodian who creates the token, but also provides some guarantees in terms of security.
Binance also has a tokenized version of BTC called BTCB. This is a BEP-2 token issued on Binance Chain and can be purchased independently on Binance DEX.
Non-custodial
Non-custodial solutions operate on the blockchain without the participation of a centralized custodian. That is, these tokens can be thought of as Wrapped BTC. However, instead of a centralized custodian, the storage and issuance function is performed by a smart contract or virtual machine. Users can deposit BTC and issue their own tokenized Bitcoins without the need for trust or permission.
Some of these systems also require overcollateralization, meaning users must deposit more funds (collateral) than they intend to issue. This is done to prepare the system for black swan events and major market failures. But even in this case, with a decrease in supply, these systems may not be able to cope.
The most popular non-custodial implementation is renBTC. 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 number of Bitcoins sent.
Other notable examples are sBTC and iBTC – synthetic tokens backed by Synthetix Network Token (SNX) instead of Bitcoin. iBTC is especially interesting because it tracks the price of Bitcoin inverted. This makes it one of the few non-custodial ways to short Bitcoin.
It is worth noting that these are experimental technologies. It is not surprising that centralized custody solutions are more popular due to their security. Of course, there is a risk of user errors, potentially leading to loss of funds. But ultimately, as technology advances, this could be the future of tokenization.
Since non-custodial solutions are governed by automated processes, we recommend that they only be used by experienced users. But if you don't want to worry about mining tokens, you can buy and exchange them on cryptocurrency exchanges.
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Does all this benefit Bitcoin or Ethereum?
This is not an easy question. Let's try to figure it out.
So, how will this benefit Bitcoin? First of all, the possibilities of its application are expanding. Although many argue that Bitcoin does not need additional functionality, many of these methods can be very useful. As we said earlier, the main benefit is increased transaction speed, fungibility, privacy and reduced transaction fees. With the launch of ETH 2.0, we can expect faster transactions and lower fees on Ethereum. This will also be useful for tokenized Bitcoin on Ethereum.
However, some argue that this poses potential dangers for owners of tokenized Bitcoins. Tokenizing BTC also implies abandoning the security benefits of Bitcoin, one of its main properties.
For example, what if tokenized Bitcoins are stolen or lost due to a smart contract error? In this case, you will no longer be able to unlock locked bitcoins on the Bitcoin blockchain.
Commissions should also be taken into account. If more users transact with tokenized BTC on the Ethereum blockchain, transaction fees on the Bitcoin network could drop significantly. It is assumed that in the (very) long term Bitcoin will be supported only by transaction fees. If most of them end up in the Ethereum ecosystem, the security of the network could be at risk. However, this is still a long way off.
How will this be useful for Ethereum? If Ethereum captures a majority of Bitcoin's funds, it could increase the effectiveness of Ethereum as a global network for transferring money. According to Etherscan research, a significant portion of the previously mentioned 15,000 BTC amount is locked in the Ethereum DeFi ecosystem.
Tokenized Bitcoin could significantly improve the efficiency of DeFi on Ethereum. How exactly? Decentralized financial services can operate based on tokenized bitcoins. BTC-based DEXs, lending markets, liquidity pools, and everything in DeFi can be denominated in BTC. The success of tokenized Bitcoin may also encourage other types of assets to move to the Ethereum network.
Most of these projects are still in very early stages, and the technology behind them still has room for improvement. Nevertheless, there are definitely many interesting events ahead of us.
Summary
We discussed what tokenized Bitcoin is and what implementations there are. The main driving force behind tokenizing Bitcoin as an ERC-20 token is to improve the efficiency of Bitcoin.
If Ethereum is able to intercept a significant portion of Bitcoin transactions, this could have serious consequences in the future. So flipping is a realistic scenario? How much of Bitcoin's supply will move to Ethereum in the future? This remains to be seen. However, the blockchain industry could ultimately benefit from the merger of the two largest cryptocurrency networks.