To the surprise of many, bitcoin (BTC) has been a breakout star in Ethereum’s decentralized finance (DeFi) moment. Taking the form of wrapped or tokenized bitcoin, the digital asset takes the best of both blockchains – bitcoin’s price value and brand along with Ethereum’s programmability – into one highly in-demand token.
Last week alone, the supply of BitGo’s wrapped bitcoins (WBTC) topped 76,000 after setting an all-time record of nearly 21,000 wrapped bitcoins minted within one week.
The week before held the previous record of over 12,200 tokens minted in a single week, according to Dune Analytics.
Why use tokenized bitcoin?
What bitcoin on Ethereum does is simple: It provides liquidity for growing decentralized exchanges (DEX), such as Uniswap. Bitcoin’s current market cap is five times larger than the second largest cryptocurrency, ether (ETH), according to The CoinDesk 20. That money can be put to use making more money.
Tokenized bitcoin allows investors to bring large amounts of value over to the Ethereum network and its young DEX market in a few clicks.
DeFi is considered vastly immature when compared to traditional or centralized exchange (CEX) markets. This can be seen in the large price spreads between orders on exchange books between different DeFi markets.
Price differences on markets can be exploited by traders in what is called arbitrage opportunities.
Wrapped bitcoin is often the asset of choice for investors seeking arbitrage. Bitcoin packs a large punch in terms of price value. More money on DeFi trading platforms makes the markets themselves stronger as additional buying and selling options are presented.
But tokenizing bitcoin isn’t without risks, particularly software risk. Investors who want exposure to bitcoin’s liquidity pay higher interest rates to cover the risk of losing an asset in addition to getting exposure to the first cryptocurrencies liquidity.
How this works in practice has taken on a few different forms.
Security of bitcoin investments
Different tokenizing models represent different security assumptions for investor funds.
For tokenized bitcoin, security boils down to the type of custodianship and if the investment is collateralized. Three major models exist: a centralized firm like BitGo; a smart contract system with collateral, such as tBTC; or a complete, synthetic-asset backing employed by sBTC.
It’s centralized, meaning deposited bitcoin is held by BitGo. Parties wanting WBTC give BTC to BitGo and then receive an ERC-20 token-equivalent of BTC in return. That ERC-20 can then be sold on secondary markets or plugged into a DeFi application to earn yield.
Keep Network’s tBTC, which launched Tuesday, is similar to WBTC but replaces the centralized BitGo model with a network of nodes, wallets and smart contracts. This network aims at bringing more decentralization to BitGo’s process by allowing both parties – the bitcoin depositor and custodian – to interact trustlessly through software.
A few features make this possible, such as the bitcoin depositors being able to choose who holds their bitcoin and a 150% security bond (held in ETH) pledged by the custodians on the off-chance they run to the hills with the deposits.
Lastly, sBTC is an ERC-20 version of bitcoin. But this time it's backed by another token, the Synthetix Network Token (SNX). Each sBTC is not backed by BTC, but 800% of a BTC’s value in SNX, the token for minting synthetic assets (Syns) on the Synthetix DEX.
An example of how wrapped bitcoin works
Take a recent transaction from Alameda Research (sister firm of the trading platform FTX).
FTX allows users to swap between BTC and WBTC. When users swap bitcoin for wrapped bitcoin, FTX pulls from Alameda’s pool of BTC/WBTC. Users may send BTC to FTX (Alameda) and receive WBTC. When Alameda's pool of WBTC is exhausted, they replenish it directly with BitGo.
Alameda is a merchant and part of the WBTC decentralized autonomous organization (DAO), meaning it can initiate mints for new WBTC using BTC. They send BTC to BitGo and create a minting request on the Ethereum chain as a merchant.
BitGo validates the BTC has been deposited to a preminted address and approves a mint of the number of WBTC equal to Alameda’s request. The WBTC can then be used on FTX or swapped with another token atomically (meaning via a peer-to-peer exchange) or even within a DeFi market.
To redeem, the process is reversed: The buyer will send the WBTC back to the merchant who will then provably burn the tokens.
The future of tokenized assets
The wild success of BitGo’s WBTC and WETH (wrapped ether) may lead to more constructions of other coin holdings. Ben Chan, CTO at WBTC co-creator BitGo, told Coindesk in August that the firm was looking at wrapping other cryptocurrencies.
WBTC’s 2020 success has largely been thanks to DeFi, he said.
“What we’ve seen this year is that WBTC traction has been largely thanks to the highly composable DeFi industry,” Chan said.
Zack Voell contributed reporting.
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