What is Tokenized Bitcoin on Ethereum

Introduction

In the conventional understanding of the cryptocurrency space, Bitcoin is often categorized as a "reserve asset" or a means of preserving wealth. This is reflected in its high popularity, liquidity, and market circulation, maintaining its position as the leading cryptocurrency by market capitalization. Some argue that Bitcoin already encompasses all possible use cases, something that alternative cryptocurrencies struggle to achieve.

Blockchain technology has spurred active development in various sectors. Decentralized Finance (DeFi) aims to integrate financial applications into the blockchain. These applications (DApps), operating on public networks and devoid of centralized intermediaries, enable financial transactions without the need for trust in third parties. Although DeFi is blockchain-agnostic and can function across different smart contract platforms, the primary activity is concentrated within Ethereum.

While Bitcoin serves as the cornerstone of the cryptocurrency market, it falls short in fully harnessing innovations available in other parts of the ecosystem. Some projects are actively seeking solutions to address this issue.

Are there ways to expand Bitcoin's utility while preserving its immutability? The increasing number of tokenized bitcoins on the Ethereum platform indicates a substantial demand for them.

What is Tokenized Bitcoin?

Tokenized Bitcoin is the concept where a specific amount of BTC is locked in one network, tokens are issued on another network, and these tokens represent the equivalent amount of Bitcoin. Each token corresponds reversibly to a certain amount of Bitcoin: upon token destruction, the Bitcoins are unlocked back in the Bitcoin blockchain.

On Ethereum, Bitcoins can be represented as ERC-20 tokens, allowing their use for transactions within the Ethereum network. This also extends the programmability of Bitcoins, making them similar to any other tokens on Ethereum.

You can check the total amount of tokenized Bitcoins on Ethereum at btconethereum.com, which has reached 15,000 BTC since July 2020. This amount is relatively small compared to the total circulating supply (~18.5 million BTC), but it's just the beginning.

It's also worth mentioning that sidechains and second-layer solutions like Bitcoin Lightning Network or Liquid Network are also working on similar tasks. Despite Ethereum having more than ten times the number of tokenized Bitcoins compared to the Bitcoin Lightning Network, these projects complement each other rather than compete.

Tokenized projects can expand the capabilities of Bitcoin owners, while projects without tokens help improve the overall infrastructure. This contributes to a tighter integration within the cryptocurrency space, benefiting the entire industry.

But what are the benefits of tokenizing Bitcoin, and why is it important? Let's explore the advantages that can be derived from this process.

Why tokenize Bitcoin on Ethereum

Tokenizing Bitcoin on Ethereum serves specific purposes. Bitcoin was intentionally designed for simplicity and performs a limited set of functions, while innovations in other cryptocurrency areas remain outside its scope.

One of Bitcoin's key values lies in its functional limitations compared to Ethereum or other smart contract platforms. Tokenizing Bitcoin on alternative blockchains can enhance network efficiency by introducing features not initially supported by Bitcoin. This doesn't compromise Bitcoin's core principles or security. It can result in faster transaction speeds, enhanced interchangeability, and increased confidentiality.

Interoperability stands as a critical aspect of DeFi. As these applications operate on a shared, open-source foundational level, they can seamlessly interact with each other. Integrating Bitcoin into this financial infrastructure might attract new users and lead to the emergence of new types of applications utilizing Bitcoin.

How does Bitcoin tokenization work?

Tokenization of Bitcoin across Ethereum and other blockchains involves various methods and degrees of decentralization, linked to different trust levels and associated risks. They differ in their ability to maintain a connection with the original asset.

The main types of tokenization include custodial and non-custodial approaches. The custodial method implies a centralized custodian that issues tokens, carrying risks associated with trusting a third party storing the Bitcoins. Simultaneously, it might be considered a safer option.

Other tokenization methods don't require trust in a third party since the issuance and destruction processes of tokens are automated within the blockchain. Bitcoins get locked, and tokens are minted using specific network manipulations. They remain locked until the tokens are destroyed. This reduces risks related to third parties, but potential security risks increase as responsibility falls entirely on the user. User or contract errors could lead to fund losses without a chance of recovery.

Examples of tokenized bitcoins

Custodial

Some of the tokenized bitcoins are represented by custodial solutions, where a significant portion of assets exists within Wrapped Bitcoin (WBTC). Users transfer their bitcoins to a centralized custodian, which stores them in a multi-signature cold wallet and issues WBTC tokens. This process requires identity verification in compliance with KYC/AML rules and involves trust in the custodian for token creation with certain security assurances.

Non-custodial

Non-custodial methods of handling Bitcoin tokens operate within the blockchain without involving a centralized custodian. These tokens, similar to Wrapped BTC, utilize smart contracts or virtual machines for storage and issuance. Users can deposit BTC and create their own Bitcoin tokens without the need for trust or permission.

Some of these systems require additional collateral, where users need to deposit more funds than they intend to issue. This is done to prepare the system for emergencies or market disruptions, although even with reduced collateral, these systems might encounter issues.

The most prominent non-custodial approach is renBTC. Bitcoins are sent to the Ren virtual machine (RenVM), which holds them via a network of decentralized nodes and issues ERC-20 tokens corresponding to the sent amount of bitcoins.

Other examples include sBTC and iBTC - synthetic tokens backed by Synthetix Network Token (SNX) instead of bitcoins. iBTC tracks the price of Bitcoin inversely and is used for short positions. These technologies are still in an experimental stage and, despite their potential, carry risks. Centralized custodial methods are more popular due to security, but non-custodial solutions have the potential for future developments in tokenization.

Using non-custodial solutions is recommended for experienced users due to their automated nature. If you prefer not to create tokens yourself, they can be purchased on cryptocurrency exchanges.

Is all this benefiting Bitcoin or Ethereum?

How might this be beneficial for Bitcoin? Expanding its functionality opens up new avenues for use. While some argue that Bitcoin already has sufficient functionality, these new capabilities could be significant. Increased transaction speed, enhanced privacy, and reduced fees are the key advantages to expect. However, with the launch of ETH 2.0, improvements in transaction speed and fee reductions are expected within Ethereum itself. This is likely to also benefit tokenized Bitcoin on Ethereum. However, some express concerns regarding the security of holding tokenized Bitcoins. Tokenizing BTC involves relinquishing the level of security that Bitcoin provides—one of its key advantages.

For instance, what if tokenized bitcoins are stolen or lost due to a smart contract error? In such a scenario, owners would no longer be able to unlock the locked bitcoins in the Bitcoin blockchain.

Consideration should also be given to fees. If many users begin transacting with tokenized BTC on the Ethereum blockchain, this could significantly reduce transaction fees on the Bitcoin network. Moreover, it is anticipated that in the long term, Bitcoin will be supported solely by transaction fees. If the majority of these fees shift to the Ethereum ecosystem, it could potentially pose a security threat to the network. However, this is still quite a way off.

Regarding benefits for Ethereum, if a substantial amount of Bitcoin funds moves onto Ethereum, it could significantly enhance Ethereum's efficiency as a global fund transfer network. In Ethereum's DeFi ecosystem, a substantial amount of 15,000 BTC is already locked, according to Etherscan data. Tokenized Bitcoin could significantly enhance DeFi functionality on Ethereum. Tokenized bitcoins could serve as the foundation for decentralized financial services like DEXs, lending markets, and liquidity pools. The success of tokenized Bitcoin could also encourage the migration of other asset types onto the Ethereum network. Most of these projects are in early development stages, and their technologies will continue to evolve. Exciting events lie ahead.

Summary

We've delved into the concept of tokenized Bitcoin and its various implementations. The fundamental idea behind tokenizing BTC as an ERC-20 token revolves around enhancing the efficiency of Bitcoin's utilization. If Ethereum starts attracting more Bitcoin transactions, it could have significant implications in the future. Could Ethereum surpass Bitcoin? What portion of Bitcoin's inventory might transition to Ethereum later on? Answers to these questions are yet to be determined. However, the convergence of the two largest cryptocurrency networks could bring benefits to the entire blockchain industry.