It was a surprise for many that Bitcoin liquidity through Wrapped Bitcoin caused Ethereum’s DeFi industry to gain a lot of momentum. You may wonder "why?"
Many Bitcoin holders got frustrated that they couldn’t access a piece of the recent DeFi hype. Many people want to hold on to their Bitcoin while simultaneously accessing the crazy DeFi gains on the Ethereum network.
Therefore, multiple Ethereum DeFi products joined forces to create a solution - Wrapped Bitcoin. Wrapped Bitcoin allows Bitcoin holders to deposit Bitcoins with a custodial party who mints new ERC20 WBTC tokens on the Ethereum blockchain. This token allows Bitcoin holders to access the benefits of DeFi projects without losing their underlying exposure to Bitcoin.
This article explores how Wrapped Bitcoin works, the benefits, and the future of the project. Besides that, we take a brief look at a decentralized alternative called tBTC, created by Keep Network.
The WBTC project has been a collaborative effort between different prominent DeFi players, such as BitGo, Compound, Ren, MakerDAO, Dharma, Set Protocol, and Kyber. Their overarching goal is to add more liquidity to the Ethereum blockchain, especially to DeFi projects.
The above projects decided to collaborate because many of them require you to lock up Ethereum tokens to use their protocols. For instance, MakerDAO and Compound enable borrowing and lending services through Ethereum staking. As most users actively use all their Ethereum assets, it limits how much these protocols can grow.
On top of that, as we are dealing with many individual entities which all have to manage a single token, they decided to manage the project via a Decentralized Autonomous Organization (DAO). This DAO can decide upon protocol changes or adding new members as entities to the organization.
However, BitGo is the most prominent player in this initiative. The WBTC project uses BitGo’s centralized custodian solution to hold Bitcoins in custody.
So, how does Wrapped Bitcoin work?
WBTC is an ERC20 token that lives on the Ethereum blockchain. BTC holders can lend their Bitcoin in the form of WBTC. Every WBTC token represents one Bitcoin on the Bitcoin blockchain.
In more detail, WBTC tokens are minted by accredited merchants by the WBTC DAO. Merchants can mint new Wrapped Bitcoins by verifying the buyer’s identity and holding their BTC in custody.
Moreover, these merchants can burn WBTC tokens to convert your WBTC back into BTC, releasing our Bitcoin from BitGo’s custodial storage. It’s a simple but effective mechanism to bring Bitcoin liquidity to the Ethereum network.
As most Bitcoin users don’t want to sell their Bitcoin position, Wrapped Bitcoin provides them with a brilliant solution to access Ethereum functionality without losing their exposure to Bitcoin. Therefore, they can enjoy interest gains through borrowing and lending services while still being exposed to the underlying Bitcoin value.
The WBTCs white paper describes the benefits as follows: “Global liquidity, increased fractional ownership, smart contract programmability, and reduction in transaction fees are some of the key benefits of tokenization.”
Here, fractional ownership is an interesting benefit to explore. Fractional ownership refers to users from different networks having a stake in one particular network, which is Ethereum. In other words, we allow Bitcoin users to own part of the Ethereum network. It’s good to have people with different opinions or interests represented in your network. This mixture often leads to innovative ideas.
Fun fact, it’s faster to transfer Bitcoin using WBTC on the Ethereum blockchain and convert it back to a Bitcoin instead of using the Bitcoin blockchain.
It’s important to mention that Keep Network has launched its tBTC token. The concept is similar to WBTC but replaces the centralized custodial provider BitGo with a network of signing nodes which take care of minting new tokens.
Keep Network aims to bring more decentralization to the concept of wrapped tokens where you don’t have to rely on a centralized custodian.
A snippet from their blog describes how they reduce counterparty risk through signers groups. “Another key way tBTC ensures safety and transparency is by addressing counterparty risk. It uses a system of signers’ groups that allows tBTC to process transactions safely and transparently without a trusted middleman. This decentralization further reduces counterparty risk, since there is no longer a possibility of the middleman collapsing, as happened in many of the high-profile thefts of recent years.”
In other words, this model removes the need for a single point of trust, such as BitGo’s custodian solution.
Currently, the WBTC token lives on the Ethereum network. Although the Ethereum mainchain is easily accessible, it’s often a point of congestion with higher transaction costs.
To keep WBTC attractive, it’s essential to keep the transactional cost as low as possible. We don’t want users to pay hefty transaction fees to convert their Bitcoin into Wrapped Bitcoin tokens.
To solve this problem, the Wrapped Bitcoin whitepaper suggests migrating to a sidechain.
“The collaboration of multiple institutions in the wrapped framework enables the ability to deploy a practical, scalable solution to increase transactional throughput. This can be done through the use of a pegged sidechain, using existing software (parity-bridge)
run among DAO members.”
"The chain will run on its proof of authority network. Wrapped tokens will be pegged between the main and sidechain by creating a 2-way multi-sig wallet on mainnet and the sidechain. Sidechains provide much-needed scalability on Ethereum for the creation of fast, low-cost wrapped tokens.”
To conclude, wrapped tokens have been a big hit among the Bitcoin and Ethereum community. Currently, the market cap for WBTC has been proliferating since its launch to the point of just above $2 billion in value, with an average daily trading volume of $90 million.