Bitcoin tokenization allows them to be used in any other blockchain. Why is this necessary if the world's first cryptocurrency is already good enough? And then, the BTC protocol itself limits its ability to use many of the innovations regarding convenience. And one of the best ways to maintain the reliability and increase the efficiency of BTC is tokenization. And now we will tell you about this in more details.
Introduction
At the moment, bitcoin is the most efficient store of value or "reserve underlying asset" in the cryptocurrency space. Simply put, it is in "cue ball" that most people prefer to keep their money. This is logical - the largest distribution, high liquidity, good average trading volume and the highest capitalization among cryptocurrencies. Therefore, many believe that "altcoins" are not needed at all, because in bitcoin, you can easily implement almost all of their use cases and the associated benefits. But this is not entirely true.
Blockchain technology is not only Bitcoin, it is also, for example, the rapidly developing sector of decentralized finance. It is directly related to decentralized applications and is able to operate in distributed networks without the need for trust and control from the coordinating centre. It is based on a variety of smart contracts that can be launched on almost any blockchain platform. However, the most popular for this business is Ethereum.
Yes, bitcoin is the backbone of the cryptocurrency market, but this does not mean that it cannot and should not take advantage of other blockchain projects. And the rapid growth in the number of tokenized coins only confirms this.
What is "tokenized bitcoin"?
First, a little clarification. Bitcoin with a capital "B" is a distributed network, and with a small "b" - the unit of account of this network.
The meaning of tokenization is simple. You block BTC in the system using special mechanisms, and then mint into another equivalent amount of tokens. The connection between the two units of account is complete, so when the token is destroyed, you again get the opportunity to freely use the cryptocurrency tied to it.
Since we are talking about Ethereum, we are creating ERC-20, which are programmable and perfectly compatible with the entire blockchain ecosystem.
As of the end of summer 2020, about 15 thousand bitcoins were tokenized. This is a large amount, but compared to the total number of them in circulation - 18.5 billion (in fact, less, since some are permanently blocked or lost), this is very small. However, this is just the beginning.
Interestingly. So-called “sidechains” or “second-tier solutions” like the Bitcoin Lightning Network or Liquid Network work in a similar way. But in Ethereum, tens of times more coins are already blocked than in them, although the process began much later.
However, experts argue that these two ways to optimize work with BTC do not compete with each other, but rather complement each other. And they benefit not only the owners, but the entire ecosystem.
What is the reason behind doing this at all?
Bitcoin's protocol is pretty simple. The world's first cryptocurrency can only do a few things, but it does them well.
However, this means that bitcoin will hardly benefit from improving blockchains as such and introducing various innovations in them. Yes, you can run Bitcoin smart contracts, but they are very limited in functionality. Especially when compared to their Ethereum counterparts.
Tokenizing bitcoins on other blockchains improves the overall efficiency of the entire network. At the same time, the coins will receive new functions, but they will retain their basic ones, as well as a high level of security. But what do they get for it? Higher transaction speed, privacy, and complete fungibility.
And one more important point. The main idea of DeFi is the ability to directly interact with each other for any projects created on the same public base level. Simply put, remove the "disconnection" of blockchains, turning them into a global network in which assets move between owners without any problems. And attracting bitcoins with their enormous liquidity to this process is an exciting prospect.
How does tokenization work?
There are many ways to tokenize bitcoins. They differ in varying degrees of centralization, the need for trust and the potential risks.
The two main types of methods are custodial and non-custodial. The first implies a central custodian who issues new coins. On the one hand, this significantly increases the counterparty's risk, since the custodian must be trusted and must remain in the system. On the other hand, experience shows that this is a more reliable method of work.
It is more difficult with non-custodial methods. There is no need for a central authority as all processes are automated. Assets are blocked as collateral, and new tokens are minted automatically, taking into account the current rate or other parameters specified when creating smart contracts. Destroying the token also automatically starts the unlock process. Alas, all of this comes with a high security risk. Because if something goes wrong (and a smart contract may contain an error from the moment of creation), then the funds will be lost without the possibility of a refund.
Examples of services that provide tokenization
Custodial
They are responsible for most of the tokenized bitcoins. Perhaps the main role is played by Wrapped Bitcoin (WBTC). Users send their BTC to a centralized custodian who keeps them in cold multisig wallets and who issues WBTC tokens in return. This process requires proof of identity, according to the KYC / AML rules. And trust in the custodian.
Non-custodial
There is no centralized storage in them. In fact, these are the same BTC, only more automated. All the main work is done by smart contracts or virtual machines, which allows minting new tokens without trust and permission from regulators.
However, in a number of situations, users need to deposit more funds than will be minted. This is the so-called "provision" that is needed to make the system more resilient to market crashes and other problems. However, alas, this does not give a 100% guarantee.
The most popular method at the moment is using renBTC. Users send their bitcoins to the Ren virtual machine (RenVM), which stores them in the nodes of the decentralized network and automatically mints ERC-20 tokens in an amount equivalent to the amount deposited.
Other systems are also actively used - sBTC and iBTC. Only they are backed not by bitcoins, but by Synthetix Network Token (SNX). Therefore, users may need to take an extra step - exchange BTC for SNX.
The problem is that these technologies are all experimental. Therefore, they are prone to errors and failures. Against their background, custody systems seem much more reliable, since they provide the opportunity to return funds even in the event of a serious error on the part of the user.
Why is it good for Ethereum and Bitcoin?
Benefits for Bitcoin. The usefulness of coins is significantly increased. They cease to be a means of accumulating capital and turn into a working tool. It also increases transaction speed, introduces fungibility, improves privacy, and reduces transaction costs. And with the launch of ETH 2.0, all of this will improve even more. But on the other hand, tokenization means a slight decrease in the level of security - the main advantage of bitcoins over other cryptocurrencies. If a smart contract fails, you can lose not only the token, but also the underlying asset associated with it.
And one more controversial point is the commission. On the one hand, if all processes take place in Ethereum, then in Bitcoin itself, transaction costs will decrease, which is extremely beneficial for users. On the other hand, after all possible bitcoins have been mined, miners will receive a reward solely from the commission. And if it is small, then they will have no reason to participate in the process. However, this is a problem for the future, since bitcoins will be mined for a long time.
Benefits for Ethereum. The more assets will be attracted to Ethereum, the higher the usefulness of this blockchain as a global network for money transfers will be. Plus, it is known that according to Etherscan data, the vast majority of the previously mentioned 15 thousand bitcoins are blocked in the Ethereum DeFi ecosystem.
Yes, tokenized bitcoins significantly increase the value, stability, and reliability of decentralized finance. These are credit markets, liquidity pools, and stock exchanges. And if the inflow of bitcoins continues, then other assets will begin to more actively flow into Ethereum. However, most DeFi projects are at an early stage of their development, so it is not known what will come of them and whether someone will invest real assets in them. But there are prospects, and quite decent ones.
Conclusion
So, the main point of bitcoin tokenization is to increase its utility and functionality due to ERC-20 tokens. In addition, attracting large volumes of cryptocurrency to the Ethereum blockchain makes it more stable and increases the potential for further growth. In any case, the entire blockchain industry will benefit from this kind of bridge-building. But how events will develop further is not known exactly.