A comprehensive guide to tokenized bitcoin on Ethereum, its need, and the inception of service providers like Wrapped Bitcoin (WBTC).

The launch of Bitcoin in 2008 propelled a movement of cryptocurrencies and decentralized applications. Today, more than 7,000 digital currencies exist in the cryptocurrency markets. These tokens are generally a part of an application, leveraging blockchain technology, that facilitates an application/use-case in a specific industry. The market thus encompasses multiple coins including utility tokens, security tokens, DeFi tokens, etc.

While Bitcoin is compared to Gold and is considered to be a ‘store of value’, it is limited in its functionality. As per its whitepaper, Bitcoin was described as a ‘peer-to-peer electronic cash system’ - an ecosystem enabling financial transactions on a decentralized network without the need for intermediaries to process or govern. Although the Bitcoin blockchain contributes more than 60% of the entire cryptocurrency ecosystem, it lacks the capacity to offer a broader system of tools in the blockchain ecosystem.

The search for additional uses of Bitcoin in the DeFi industry led to the concept of Bitcoin’s tokenization. In this article, we explore what tokenized Bitcoin is, as well as its benefits, drawbacks, and the concept of Wrapped Bitcoin (WBTC).

What is Tokenized Bitcoin on Ethereum?

The purpose of tokenized Bitcoin is to leverage the benefits of Bitcoin for decentralized applications, mainly in the DeFi landscape, similar to how any other asset can be tokenized on blockchain. Tokenized Bitcoin refers to the tokenization of Bitcoin on other blockchain networks, like Ethereum, so that it is backed by the underlying asset - actual Bitcoin. Its properties are similar to that of a security token attained by tokenizing an asset on the blockchain. With this purview, the value of tokenized Bitcoin is always pegged to the value of Bitcoin in real time.

Tokenized Bitcoin becomes an ERC-20 token as it is raised on the Ethereum blockchain network. The idea behind Bitcoin tokenization is to lock BTC in a smart contract mechanism, mint an equivalent amount of the ERC-20 (tokenized Bitcoin) token, and use it for applications demanding programmability within its infrastructure. The process of Bitcoin tokenization allows traders to capture both the benefits of Bitcoin’s liquidity and Ethereum’s programmability into one token.

Benefits of Tokenization of Bitcoin

Facilitating the extension of Bitcoin’s properties into the Ethereum blockchain further stretches the functionality of Bitcoin. Some of the advantages of Bitcoin tokenization are as follows:

  • Liquidity - The process of Bitcoin tokenization enables investors to use their BTC for various purposes apart from its property of ‘store of value’. It allows BTC holders to use their Bitcoins in decentralized applications.
  • DeFi Ecosystem - The concept of Bitcoin tokenization is a catalyst to the DeFi ecosystem. It facilitates using Bitcoin’s liquidity and market capitalization into DeFi protocols.
  • Scalability - Currently, the Bitcoin blockchain holds limited scalability with greater block times and higher transaction processing times. However, as tokenized Bitcoin is an ERC-20 token, it eliminates transactional congestion, reduces block times, and thereby enables greater scalability.
  • Smart Contract Functionality - As it is developed on the Ethereum blockchain, developers can increase its inherent functionality by capturing the factor of programmability.
  • Interoperability - DeFi apps are built on open-source networks and are highly interoperable with each other. Capturing the essence of Bitcoin’s liquidity adds another layer to the DeFi innovation.

Tokenized Bitcoin Examples

The concept of Bitcoin tokenization has gathered substantial interest in the last year, mainly with the onset of DeFi and yield farming opportunities. There are custodial and non-custodial solutions focussed on providing a tokenized version of the leading digital currency.

Wrapped Bitcoin: Custodial

Launched in 2019, Wrapped Bitcoin (WBTC) is a centralized custodian solution developed by the BitGo trust. The Decentralized Autonomous Organization (DAO) is responsible for the management and governance of the WBTC ecosystem.

It facilitates a system for users to convert their BTC into the wrapped token WBTC. Custodians hold a user’s BTC in a multi-sig wallet and mints an equivalent proportion of WBTC, an ERC-20 token. A user can retrieve their original BTC by handling the WBTC back to the network. The WBTC is burned and the original BTC is handed back to its owner.

As per its website, Wrapped Bitcoin ensures trust and transparency in its system by complying with audits as well as through smart contracts. However, unlike Bitcoin, WBTC is not managed through codes. It is run by a centralized organization and does not guarantee the same security level of Bitcoin.

Smart Contracts: Non-Custodial

Non-custodial solutions are not run by a centralized organization. Instead, smart contracts manage the process of converting BTC into ERC-20 tokens and vice versa. User’s BTC funds are held in a smart contract virtual machine which essentially mints an ERC-20 token. It is an open-source and permissionless protocol, thereby enabling transparency in the system.

However, the smart contracts also do not guarantee the same level of security as that of the Bitcoin blockchain. Any vulnerability in the smart contract code may result in the loss of the user’s Bitcoins through a hack or attack. Moreover, these solutions may also require users to deposit more than minted to protect against large market crashes.

Tokenized Bitcoin Security Risks

As of November 2020, the value of tokenized Bitcoin on Ethereum is more than $2.5 billion, with more than 150,000 Bitcoins tokenized. Whilst the concept does facilitate multiple advantages and enables greater functionality, it also carries security risks.

In the case of a custodian solution, a user needs to hand their Bitcoins to a centralized entity. The custodian is responsible for storing a user’s BTC into a wallet. Any attack on the wallet may result in the loss of the user’s BTC. Also, the smart contracts developed for minting and burning WBTC may carry code vulnerabilities.

In the case of a non-custodial solution, it still poses a risk. Smart contracts may be vulnerable as tokenized Bitcoin could face a threat from a bug in the future. It may entirely be possible that there is no way to unlock the original Bitcoins from the smart contract.

Closing Thoughts

It is true that Bitcoin tokenization can largely increase its functionality and add advantages to the entire blockchain ecosystem. Tokenized Bitcoin enables the development of DEXs, liquidity pools, and even lending/borrowing using Bitcoin as collateral. It also facilitates increased scalability, reduction of transaction times, and fungibility in Bitcoin.

At the same time, the concept is relatively new. The threats and vulnerabilities to the entire ecosystem may not even be comprehended at this stage. But the concept has already taken off. In the next few years, we are likely to recognize the advantages or disadvantages of tokenization of Bitcoin at a much larger scale.