What Is Tokenized Bitcoin? A Complete Beginner's Guide
August 7, 2023
Despite its dominance in the market, Bitcoin’s base layer has limitations that prevent BTC from taking advantage of developments happening in decentralized finance (DeFi). Solutions like tokenization have popped up as demand for bitcoin on DeFi has risen over the last few years.
Let’s look at tokenized bitcoin, how it works, examples of tokenized bitcoin, and risks associated with the tokens.
What Is Tokenized Bitcoin?
Tokenized bitcoin assets are digital representations of BTC that mimic the value of bitcoin and have utility in other blockchains. Tokenized bitcoin allows users to use BTC on other blockchains, usually at a 1:1 ratio.
Tokenized bitcoin can be used on DeFi applications and converted back to BTC.
How Does the Tokenization of Bitcoin Work?
In tokenization, each tokenized bitcoin represents a certain number of native bitcoin. There are two main mechanisms to tokenize bitcoin: custodial and non-custodial. The mechanisms differ in degree of decentralization, trust, and risk.
In custodial tokenization, a centralized authority holds your BTC in a vault and gives you an equivalent value of tokenized BTC. The authority may also be in charge of minting the tokens. You must comply with KYC/AML regulations to participate in this process.
Conversely, non-custodial tokenization requires no centralized authority and works in a completely trustless manner. You deposit your BTC funds, and a smart contract or a virtual machine mints the equivalent value in tokenized bitcoin on the desired blockchain.
Bitcoin tokenization happens in relatively similar steps in both mechanisms:
- Deposit your BTC funds and request for equivalent tokenized BTC
- The collateral BTC is locked away, and tokenized BTC is minted on the other network
- You receive your tokenized bitcoin that you can use on the other network
The process is reversible, and you can convert the tokens back to BTC. The tokenization protocol burns the tokenized bitcoin once the native BTC is unlocked and transferred back to your account.
The Benefits of Tokenizing Bitcoin
Tokenizing bitcoin adds a new layer of utility for the world’s leading digital currency, providing a range of benefits for bitcoin holders.
- It allows for increased liquidity and accessibility. By representing Bitcoin as a token on other blockchain networks, it becomes tradable on decentralized exchanges and can be seamlessly integrated into various decentralized finance (DeFi) platforms.
- It enhances the interoperability of Bitcoin. Through tokenization, Bitcoin can be used as a medium of exchange within smart contracts and dApps, opening up new possibilities for decentralized applications and cross-chain transactions.
- It facilitates faster and cheaper transactions, especially when utilizing blockchains with higher scalability. This efficiency paves the way for a more practical and attractive alternative to traditional payment systems.
By leveraging Bitcoin bridges, tokenized bitcoin can improve the utility, interoperability, and accessibility of bitcoin across the wide crypto ecosystem.
Tokenized Bitcoin Use Cases in DeFi
Tokenized bitcoin in DeFi allows BTC to have more functionality beyond conventional roles. A few standout uses include:
- Bitcoin holders can leverage tokenized bitcoin to earn a yield in the DeFi lending markets.
- Bitcoin investors can use tokenized bitcoin as collateral on borrowing and lending platforms to borrow other digital assets, such as stablecoins. Tokenized bitcoin assets are pegged equal to BTC, which leverages the native coin's liquidity.
- You can use tokenized bitcoin in smart contract-powered decentralized applications. The tokens seamlessly integrate with DeFi platforms (or any other kind of dApp) on networks other than native BTC.
- Tokenized bitcoin improves network interoperability, which allows Bitcoin holders to leverage the security of Bitcoin and reduce the blockchain’s transaction load.
Examples of Tokenized Bitcoin
Developers have come up with a variety of tokenized bitcoin for different networks. Let’s look at the most popular assets.
Wrapped Bitcoin (WBTC)
Wrapped Bitcoin is an ERC-20 token on the Ethereum network that is pegged to BTC 1:1. Wrapped BTC gives native BTC access to decentralized applications and exchanges while giving Ethereum more liquidity. WBTC allows users to create Bitcoin smart contracts on Ethereum.
The tokenization of BTC to wBTC goes through three key players: custodians, merchants, and Decentralized Autonomous Organizations (DAOs). Custodians mint and secure the wBTC, while merchants initiate the minting of new wBTC and oversee wrapped token burning. DAO is responsible for adding or removing custodians and merchants and making smart contract changes.
Stacks Bitcoin (sBTC)
Stacks Bitcoin is a BTC token on the Stacks network with a two-way peg mechanism with BTC at 1:1. sBTC differs from other peg systems because it doesn't use custodians or federations. Instead, it uses smart contracts on Stacks and an open membership group to sign peg-out transactions.
Another difference is sBTC doesn't have peg in or out fees like other tokenization mechanisms which use their fees to pay custodians. The token utilizes BTC rewards from Stack consensus to incentivize signers.
Rootstock Smart Bitcoin (rBTC)
Rootstock smart bitcoin is a tokenized bitcoin that executes smart contracts on the Rootstock network. Its value is pegged one-to-one with bitcoin and acts as a link between Bitcoin and DeFi. Rootstock network’s built-in 2-way peg is the native way of acquiring rBTC. The process of tokenizing BTC to rBTC is reversible.
Liquid Bitcoin (L-BTC)
Liquid bitcoin is a tokenized bitcoin on the Liquid network pegged one-to-one with BTC. The Liquid ledger and custody are controlled by a federation, which consists of signers that approve new blocks and manage the token supply.
It utilizes peg in and peg out to convert BTC to L-BTC and vice versa. BTC is held in a multi-signature contract during the 2-way peg in process. L-BTC allows atomic exchanges on the network.
Risks of Using Tokenized Bitcoin
Tokenized bitcoin assets are still relatively new in the crypto market and undoubtedly come with many challenges and risks.
In custodial tokenization, acquiring tokens depends heavily on a central authority. Not only does this system undermine the basic tenet of Bitcoin, which is decentralization, but you must also trust a third party with your assets. You can easily lose your assets if the third party is hacked or mismanages funds.
On the other hand, non-custodial tokenization mechanisms are highly experimental and depend on smart contracts that are vulnerable to coding errors and bugs. Hackers may exploit contract loopholes to manipulate the tokens and steal user funds. The responsibility of asset security lies solely with the user, with almost zero chance of regaining funds once stolen or lost, which is why custodial tokens are more popular.
Tokenized bitcoin assets are unregulated and introduce technical complexities that may discourage adoption. Moreover, cross-chain interactions open up new avenues of vulnerability that hackers can exploit. There is also a risk of interoperability between platforms which may limit token utility.
The Bottom Line
Tokenizing bitcoin is an exciting development for bitcoin holders who want to utilize their assets beyond conventional constraints. However, most tokenization projects are still fairly young and are yet to stand the test of time. You should do your due diligence and research on any tokenization project before deciding to deploy capital.
Are tokenized bitcoin assets safe to use?
Tokenized bitcoin offer the security of the Bitcoin mainchain while leveraging the benefit of the other network. However, there are risks associated with either trusting your assets with a custodian or using a smart contract when tokenizing your bitcoin.
How do I buy tokenized bitcoin?
You can buy tokenized bitcoin from centralized and decentralized exchanges. You can also use a cross-chain bridge to convert your BTC to tokenized bitcoin directly.
What are the risks of tokenizing my bitcoin?
Tokenized bitcoin assets experience price volatility like native bitcoin and may not offer the same level of privacy as Bitcoin.
Can I convert my tokenized bitcoin back to BTC?
Yes, you can reverse the tokenization process and get back your BTC. Networks provide a reversal process for their tokenized bitcoin, but they can have fees attached.
Why do people convert BTC to tokenized bitcoin?
The utility of native bitcoin is limited on the Bitcoin mainchain. Users tokenize their bitcoin to take advantage of features from other networks, e.g., smart contract execution on Ethereum, while retaining the liquidity of bitcoin.