Decentralized Finance (DeFi) has brought many innovations into the space, bridging the gap between traditional finance and the decentralized economy. Many financial services like lending, borrowing, escrow, etc. have been merged with non-custodial solutions of blockchain technology in order to provide secure, trustless, and peer-to-peer financial activities. Eliminating the middleman but also increasing incentives to participate, has resulted in higher APYs than those offered by the banks and traditional institutions.
With low barriers for entry, the DeFi sector has grown from 798M to over 25B in about a year. In the spirit of lowering barriers to entering the market, another invasion has been brought to life and that is bringing Bitcoin on to the Ethereum blockchain. Bitcoin isn’t actually running on Ethereum’s network but is tokenized through a process called wrapping which we will explain further in the article.
What are the advantages of tokenized Bitcoin?
As the largest by market cap with its deflationary monetary model, Bitcoin is perceived as a store of value and digital gold. But it isn’t programmable and besides transacting it doesn’t provide further use cases. Ethereum on the other hand is designed to be the network for building decentralized applications and is why the vast majority of DeFi is run on the Ethereum blockchain.
Yield farming, liquidity mining, and lending are just a few services that DeFi brings. And while these are great what usually happens is that each platform has its native token which further divides the space. Like bridging the gap between traditional finance, with tokenized BTC the interoperability is increased between traditional crypto investors and the DeFi sector.
This means that those DeFi platforms can start integrating Bitcoin into their pools, increasing their liquidity and user base by offering a solution to maximize the profits of Bitcoin holders. Users can now use Bitcoin in the DeFi ecosystem, meaning they can stake it into liquidity pools, trade on decentralized exchanges, participate in ICOs, and so on. One of the biggest obstacles when it comes to decentralized exchanges was not being able to support Bitcoin trading pairs. Now, with tokenized BTC, that isn’t the issue anymore. It should help to bring further adoption to DEXes. Another advantage in migrating BTC to Ethereum is shorter transaction waiting time as Ethereum has a higher network throughput and block confirmation time.
Tokenizing Bitcoin opens up new investment opportunities to its holders and participating in Decentralized Finance products without having to sell them for Ethereum or other crypto tokens. Also, it maintains a higher level of security with the smart contract controlling the process of swapping Bitcoin for its equivalent token counterpart.
How does Bitcoin tokenization work?
Tokenizing Bitcoin means that there is an ERC20 token running on the Ethereum network that represents BTC in a 1:1 ratio. This is done by a process called wrapping which boils down to having BTC staked as collateral in exchange for its equivalent token minted upon the process completion.
The first projects to do this and the largest one by the market cap is called wBTC or Wrapped Bitcoin. Bringing new wBTC to the market is done by a process called minting. A merchant initiates the minting process by requesting the custodian to mint wBTC.
They send Bitcoin to the custodian, wait for 6 confirmations and after the custodian receives BTC, they release the newly minted ERC20 token to the merchant’s address on the Ethereum wallet.
Burning is the opposite process of minting and is redeeming Bitcoin for wBTC tokens. It’s done strictly with the merchant’s addresses after the burn transaction is initiated. Custodian waits for 25 block confirmations on the Ethereum network upon releasing Bitcoin back to the merchant and the wBTC tokens are deducted or burned from the merchants Ethereum wallet.
Regular users are to be distinguished between merchants and custodians. They are the market participants that want to receive wBTC and their point of contact is the merchant. The transaction is done by simply requesting wBTC from the merchant, and upon the completion of the KYC procedure the user can send BTC in exchange for Wrapped Bitcoin, most commonly through an atomic swap which is trustless exchange between two coins.
Trust and transparency
Since there are multiple parties involved in the process and Bitcoin is staked for a token in a 1:1 ratio, the issue of having the token really backed by its collateral comes up as significant.
The most significant entity in this process to be audited is the custodian who holds real Bitcoin but also merchants that perform the requests. wBTC operates a DAO which holds the keys to the multi-signature wallet and can make changes to the smart contracts that perform the action. Decisions are made in a decentralized way through its governance model and this ensures that no one party can control the decision making – which increases the reliability of the process. Proof of reserves is shown publicly and minting and burning is verifiable on the Ethereum blockchain.
Also another key component that serves as a guarantee of trust is that only merchants can initiate the process of creating wBTC.
What tokenized Bitcoin projects are out there?
There are currently 153,529.545 BTC tokenized on the ethereum blockchain. The majority of them are minted in wBTC with a total volume of 112,222.16 wBTC.
While wBTC was the first and the biggest one, there are other projects that offer to tokenize BTC. The organizational structure of the customer-merchant-custodian triangle, how these transactions work, what is their governance model etc., brought some variations to solving this equation in a different way.
Second largest Bitcoin token is hBTC which is done by the Huobi exchange with currently around 19,906 Bitcoin staked. Third largest is renBTC with over 14,627 BTC done by the Ren protocol and unlike wBTC, renBTC is not a synthetic token, meaning it doesn’t rely on any liquidation mechanisms to ensure it remains pegged to the value of BTC.
Which DeFi projects are working with tokenized BTC?
We have mentioned that the sole purpose of tokenizing Bitcoin is to bring it on to the Ethereum blockchain for participating in DeFi applications. Taking a closer look we can make a distinction between its particular use cases.
One of its primary use cases is being staked into the liquidity pools and decentralized exchange trading pairs. Most notable ones are in the Uniswap DEX which is a decentralized protocol for automated liquidity provision on Ethereum with currently around 2.9B in total value in USD locked. It offers various trading pairs and staking options. So does its forked version Sushiswap.
These are just some of the examples but tokenized Bitcoin is used all across the DeFi ecosystem for incentives, trading, collateralized borrowing etc. Some of the other platforms that use tokenized BTC in their products and operations are Compound, Kyber Network, OmiseGO and many others.
Badger is another interesting project that brings tokenized Bitcoin to the forefront. It is a Decentralized Autonomous Organization (DAO) that is dedicated to accelerate Bitcoin in decentralized finance. It aims to be the all encompassing app tokenized Bitcoin operations in DeFi such as minting, borrowing, yield farming, liquidity mining and so on. Its flagship product the “Sett vault” is used to deposit different types of tokenized Bitcoin to generate automated yield similarly like yearn.finance does for its farmers. Setts automatically execute yield producing strategies to optimize returns and reduce costs. It is on the 9th place according to its TVL with around 689.3M.
While variations in the process of minting, burning, governance and others have brought various tokenized representations of Bitcoin onto the Ethereum blockchain their purpose is the same. That is bringing further use case to Bitcoin and opening the doors for Bitcoin holders to participate in Decentralized Finance.
With new investment opportunities ahead, Bitcoin holders can maximize their holdings by for example lending Bitcoin in exchange for an yearly percentage interest and in that way drive further legitimacy to the DeFi sector, with Bitcoin being the most reputable crypto on the market. This increases the playing field for DeFi to rival traditional services even more as having “digital gold” as collateral for financial operations stands unrivaled to the banking sector.
While using tokenized Bitcoin in DeFi is straightforward, tracking its investment performance isn’t. Crypkit can track ethereum addresses natively (via a public address or xPub). All you need to do is paste the address and hit Connect. Crypkit will start tracking your crypto assets automatically. We will be adding support for the tokenized Bitcoin projects in the upcoming weeks.
Recently we have added DeFi support for 0x, Aave, Compound, Nexus Mutual, Synthetix, ygov.finance. You can read about it in our latest product development update: What’s new? DeFi support, Crypto Accounting and improved UI/UX