Easy Popular Science for Newbies (ELI5)

By tokenizing Bitcoin, you can use Bitcoin in other blockchains.

But wait a minute, isn’t Bitcoin already powerful? Indeed! Bitcoin’s use cases are robust and reliable, and it has become a public good. But at the same time, Bitcoin deliberately sets limits on functionality, leaving little room for further innovation.

What else can we do with Bitcoin? Some Bitcoin users believe that there is nothing special to do, which sounds reasonable. However, some users believe that we should find ways to use Bitcoin on other blockchains. That’s why we explore why Bitcoin should be tokenized in Ethereum.

Why tokenize Bitcoin? Does this make sense? How to Create Tokenized Bitcoin? How to get tokenized Bitcoin? If you are interested, please continue reading below.

Introduction

Bitcoin is generally regarded as the "reserve asset" or value in the cryptocurrency field Savings has become the most widely used, most liquid, highest average cryptocurrency, and its market capitalization remains at the top of the list. In fact, some argue that there is no need for any other cryptocurrency at all besides Bitcoin. Their view is that all the use cases that altcoins want to achieve, Bitcoin can do.

However, blockchain technology is being widely used in various fields. The development of decentralized finance (DeFi) 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 central coordinating authority. Although DeFi was originally designed to have nothing to do with the blockchain and can run on any smart contract platform, most still run on Ethereum.  

Bitcoin is the "backbone" of the cryptocurrency market, but it is unable to take advantage of other developments in the cryptocurrency ecosystem. Some projects have been working hard to solve this problem.  

Is there a way to keep the Bitcoin network intact while making Bitcoin useful beyond its originally intended scope? The rise of tokenized Bitcoin on Ethereum is evidence of this need in the market.

What is tokenized Bitcoin?

Before the introduction, we should clarify some concepts to avoid confusion. If you have read our What is Bitcoin? ” article, you will understand that the capital letter B (Bitcoin) refers to the Bitcoin network, and the lowercase letter B (bitcoin) is the unit of account of Bitcoin.

The logic of tokenizing Bitcoin is relatively simple. Lock Bitcoins through some mechanism, mint corresponding tokens on other networks, and then use Bitcoins as the tokens of that network. Each token of other networks can represent a specific number of Bitcoins. The linkage between the two should remain unchanged and the process should be reversible. In other words, destroying the tokens unlocks the "original" Bitcoin and returns it to the Bitcoin blockchain.

In the Ethereum network, ERC-20 tokens represent Bitcoin. Users can conduct Bitcoin-denominated transactions on the Ethereum network. Similar to other tokens of Ethereum, Bitcoin is also programmable.

The current total number of tokenized Bitcoins in Ethereum can be viewed at btconethereum.com.

As of July 2020, there are approximately 15,000 tokenized Bitcoins in Ethereum. This number may sound like a lot, but compared to Bitcoin’s circulating supply of approximately 18.5 million coins, it is completely negligible. But this is just the beginning.

It is worth noting that sidechains and Layer 2 solutions (such as the Bitcoin Lightning Network or Liquid Network) are also designed to address similar challenges. Interestingly, there are more than a dozen times as many Bitcoins in Ethereum as there are in Bitcoin’s Lightning Network.  

Even so, there is no direct competition between these different solutions, which means it is not an either/or game. In fact, many believe that they complement each other rather than compete with each other. Tokenized projects enrich Bitcoin holders’ options, while tokenless projects improve overall infrastructure. This brings more opportunities for consolidation in this area, benefiting the entire industry.

This all sounds interesting, but what’s the point? Let’s explore why Bitcoin should be tokenized in the first place.

Why tokenize Bitcoin in Ethereum?

The design of Bitcoin is very simple. This is to focus on specific functions, and the effect is indeed significant. However, these features themselves have limitations.

Although Bitcoin is the most valuable currency in the digital currency industry, it is unable to benefit from innovative developments in other areas of the industry. Technically, smart contracts can be run in Bitcoin, but their scope is quite limited compared to Ethereum or other smart contract platforms.  

Tokenizing Bitcoin on other blockchains increases the utility of the network. How is this achieved? This is because this approach enables functionality that Bitcoin itself does not support. At the same time, Bitcoin’s core functionality and security model remain unchanged. Further benefits include increased transaction speed, fungibility and privacy.

There is another potential reason. The biggest advantage of DeFi is its "composability". This means that all applications run on the same open source, permissionless common base layer and work seamlessly with each other.  

Many believe that the prospect of bringing Bitcoin into the composable financial building block is exciting. This will lead to many new applications using Bitcoin that would otherwise not be possible.

How does tokenized Bitcoin work?

There are many ways to tokenize Bitcoin in Ethereum and other blockchains. They have different degrees of decentralization, different expectations of trust and risk, and different ways of linking value.

The two main types are managed and unmanaged. The first type has a centralized custodian, which is also responsible for minting tokens. There is counterparty risk, as the entity hosting Bitcoin must be trustworthy and operating properly. On the other hand, this implementation should be safer than the alternative.

Other solutions take a different approach. They do not require a trusted entity and can be automatically wound up to complete the entire process of minting and destruction. Collateral assets are locked and tokens are minted on another chain through various on-chain means. Funds are locked on-chain and cannot be unlocked until the token is destroyed. This eliminates counterparty risk but increases potential security risks. Why do you say that? Because in this case, the risk lies entirely with the user. User error or contract errors can result in the loss of funds, even permanently.

Tokenized Bitcoin Example

Custodial

Custody dominates the current supply of tokenized Bitcoin. The one with the most value locked is Wrapped Bitcoin (WBTC). How does it work? Users send Bitcoin to a centralized custodian, which deposits it into a multi-signature cold storage wallet and mints WBTC tokens in return. It’s worth noting that this process requires proof of user identity in compliance with identity authentication or anti-money laundering regulations. This method requires trust in the entity that mints the tokens, but also has certain security advantages.

Binance also has a tokenized Bitcoin called "BTCB". This is a BEP-2 token issued by Binance Chain. If you want to try it out, you can trade through Binance DEX.

Non-custodial

Non-custodial solutions run entirely on the chain without the intervention of any centralized custodian . Simply put, they are similar to wrapped Bitcoin, but without the need for a centralized custodian, funds can be secured and tokens minted through smart contracts or virtual machines. Users can deposit Bitcoin and mint tokenized Bitcoin in a trustless and permissionless manner.

Some systems require over-collateralization, meaning users must deposit more value (i.e. collateral) than is actually minted. Doing so makes the system resistant to black swan events and large market crashes. Even then, if the value of the collateral drops significantly, the system will be helpless.

renBTC is the most popular non-custodial method. Bitcoins are sent to the Ren Virtual Machine (RenVM) and stored in the decentralized node network. The virtual machine then mints ERC-20 tokens based on the amount of Bitcoin sent.  

Other typical examples are sBTC and iBTC, which are synthetic tokens collateralized by the Synthetix Network Token (SNX) rather than by Bitcoin. iBTC is particularly eye-catching because it can reversely track the price of Bitcoin, making it one of the few non-custodial ways to short Bitcoin.

It is worth noting that these technologies have a strong experimental nature. It’s no wonder that centralized hosting solutions are more popular as they are more secure. But there is also a greater risk of vulnerabilities and user error, which can also lead to the loss of funds. Even so, as long as there is a breakthrough in technology, this may also become the future direction of tokenization.

These unmanaged solutions are controlled by automated processes and are therefore only recommended for advanced users. However, if you also want to try these tokens but don’t want to worry about the minting process, you can buy and trade them through cryptocurrency exchanges.

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Is tokenizing Bitcoin good for Bitcoin or Ethereum?

This question is difficult to answer. Let's think about this problem from two aspects.

First of all, what are its advantages for Bitcoin? It can increase the utility of Bitcoin. Although many people believe that Bitcoin does not need more features, it is still better than nothing. As mentioned in the previous discussion, it has the potential to bring many benefits such as transaction speed, fungibility and privacy improvements, as well as reduced transaction costs. With the release of Ethereum 2.0, Ethereum transactions are expected to be faster and cheaper. Tokenized Bitcoin in Ethereum would also benefit.  

On the other hand, some believe that holders of tokenized Bitcoins face potential dangers. Tokenizing Bitcoin would give up its strong security advantages, which are its most sought-after features.  

For example, what happens if a smart contract vulnerability causes tokenized Bitcoins to be stolen or lost? This may result in Bitcoins locked on the Bitcoin blockchain being unable to be unlocked.

Another consideration is cost. Some believe that if a large number of users start trading tokenized Bitcoin on the Ethereum blockchain, transaction fees on the Bitcoin network will drop. In the long run, Bitcoin runs solely on transaction fees. If most transactions flow into the Ethereum ecosystem, network security will be compromised. But this problem is still far away from breaking out, and it will not be something that needs to be solved urgently for a long time.

What are its benefits to Ethereum? If Ethereum captures a significant amount of Bitcoin's value, Ethereum's utility as a global value transfer network will be enhanced. According to research from Etherscan, a significant portion of the previously mentioned total of 15,000 Bitcoins is locked in the Ethereum DeFi ecosystem.  

Tokenized Bitcoin will greatly enhance the effectiveness of DeFi in Ethereum. How is this achieved? Some decentralized financial services can be launched based on tokenized Bitcoin. Bitcoin-based decentralized exchanges (DEX), lending markets, liquidity pools, and various other forms that exist in DeFi can all be denominated in Bitcoin. The success of tokenized Bitcoin will also incentivize other types of assets to migrate to the Ethereum network.

Most projects are still in their early stages, and the technologies they rely on still have a lot of room for improvement. Despite this, the prospects for development in this frontier are still exciting.

Summary

We discussed what tokenized Bitcoin is and the different ways it can be implemented . The main motivation behind converting Bitcoin into ERC-20 tokens is to increase the utility of Bitcoin.  

If Ethereum can capture a large number of Bitcoin transactions, it will have a significant impact in the future. So will this disrupt the status quo? How much of Bitcoin’s supply will flow into Ethereum transactions in the future? let us wait and see. Regardless, building a bridge between the two major cryptocurrency networks will benefit the entire blockchain industry.