Institutional adoption sparks excitement as new launches storm DeFi
Bitcoin on Ethereum: Is tokenizing your BTC worth the risks?
OKX Insights takes a deep dive into the emerging appetite for tokenized BTC, as well as the inherent risks.
One of the fastest-growing niches in the cryptocurrency industry this year is that of tokenized BTC. Investors are increasingly finding value in utilizing billions of dollars’ worth of BTC’s unrivaled liquidity on different blockchains. Solutions like Wrapped Bitcoin (WBTC), renBTC, sBTC, tBTC and others allow holders to maintain exposure to the dominant digital asset’s price while benefiting from faster transaction times and the passive-income generating potential of decentralized finance.
Home to the most developed DeFi ecosystem, Ethereum has become the blockchain of choice for both tokenized BTC projects and their users. At the beginning of 2020, there were around 1,110 BTC tokenized on the network. Today, Ethereum is host to nearly 153,000 ERC-20 tokens representing BTC. Their combined value, at current BTC prices, is over $2.3 billion.
Driving much of this growth is the explosion of interest in DeFi. This year has seen the total value locked across decentralized finance protocols expand dramatically. Having recovered from the industry-wide crash this March, TVL in DeFi passed the $1 billion mark for the second time in late May. By Oct. 26, the figure stood at almost $12.5 billion.
In this article, OKX Insights considers the growth of BTC on the Ethereum blockchain by explaining exactly what tokenized BTC is and exploring the reasons why a user might want to bring the value of their BTC to another blockchain. Next, we look at some of the biggest projects that are tokenizing BTC and the trade-offs between them. Finally, we conclude with a discussion of the general risk associated with tokenizing BTC and integrating it with decentralized finance applications.
What is tokenized Bitcoin?
In the parlance of the cryptocurrency industry, a “coin” refers to a digital currency that is native to a blockchain. BTC is native to the Bitcoin network. Ether (ETH) is native to the Ethereum network.
Meanwhile, a “token” is a cryptocurrency that is not native to the blockchain network on which it operates. The Ethereum network, for example, hosts many tokens. These include Compound’s COMP token, Uniswap’s UNI token, and even OKX’s OKB token.
“Tokenization” refers to the process of representing an asset not native to a particular blockchain on said blockchain as a token. Assets such as fiat currencies, precious metals and even artwork have all been tokenized on different blockchain networks. So, too, has BTC.
Generally, the process of tokenization involves a custodian of sorts holding the non-native asset and minting the required number of tokens on the relevant blockchain. Each token representing an asset is supposed to be backed by at least the same value of said asset. Therefore, users can redeem the tokenized asset for the actual asset it represents by burning it. With a backing at a ratio of at least 1:1, the value of each token stays at least equal to the real asset’s current market value.
Protocols providing BTC tokenization services typically hold BTC or other collateral with either a centralized custodian, virtual machine or smart contract. The nature of the custodian itself dictates the process by which new BTC-backed tokens are minted. Different solutions also present users with their own set of risks, as well as advantages and disadvantages.
Once minted, holders can use their tokenized BTC to interact with various DeFi protocols. They can also trade them on secondary markets — providing an additional way to gain exposure to the price of BTC for those not already holding it.
Why tokenize Bitcoin?
BTC is, by far, the most established digital currency. Nearly 12 years after its inception, it leads the industry by almost all measures. Its $240 billion market capitalization accounts for over 60% of the entire cryptocurrency market. Meanwhile, the network’s hash rash, a measure of its overall security, continues to dwarf those of all other digital currencies combined.
Bitcoin’s historical record, its robust security model and its relatively large market capitalization all make BTC a comparatively stable hold for many investors. Additionally, the network’s simple functionality reduces the technical risks it faces. These factors, coupled with its vehemently defended supply cap of 21 million BTC, make it the strongest candidate for a store of value in the cryptocurrency industry today. The recent inclusion of BTC on the balance sheets of publicly listed companies like MicroStrategy, Square and others is a testament to this.
However, the network does have its limitations. Transactions are slow when compared to other blockchain networks. While Bitcoin’s 10-minute block time and relative lack of technical complexity actually strengthen the network’s overall security, these factors limit the appeal of using BTC for some kinds of applications, such as DeFi apps, which draw users to other blockchain networks.
To combat this, some developers are committed to bringing smart contract functionality to the Bitcoin network. However, most projects dependent on smart contracts favor other blockchains. With its faster transaction times, more diverse programming options and the largest developer community, Ethereum has become the go-to network for those building decentralized applications. As such, the network boasts the most expansive and vibrant DeFi sector. It is, therefore, no surprise to see Ethereum lead in terms of the number of tokenized BTC it supports, too.
Ilya Abugov, OpenData lead at DappRadar, a decentralized-application data aggregator, told OKX Insights:
“The Ethereum DeFi ecosystem enables users to put their capital to work, and there are not that many options for BTC holders that rival the returns available in DeFi.”
Developers behind tokenized BTC projects see the cryptocurrency’s massive liquidity as an opportunity to encourage the expansion of decentralized finance, without necessarily requiring fresh capital to enter the cryptocurrency industry. Without tapping BTC’s liquidity, growth in the sector is limited by the size of the market capitalizations of the much smaller networks on which DeFi apps are built.
With approximately $11.5 billion in total value locked today, decentralized finance still represents a tiny fraction of the traditional financial services industry, which is forecast to top $26.5 trillion by 2022. Given the size and age of the DeFi niche, absorbing BTC liquidity would certainly give the sector greater legitimacy to those in finance that aren’t yet paying attention to the cryptocurrency industry.
The number of tokenized BTC on Ethereum shows that there is already significant demand to bring BTC liquidity to other blockchains. The 2,700 tokenized coins on the network six months ago has now increased to over 150,000.
Attributing tokenized BTC’s rapid growth to DeFi’s own expansion, Ren Project’s chief operating officer, Michael Burgess, told OKX Insights:
“It’s the first time individuals can maintain exposure to BTC while simultaneously gaining attractive yield on the asset in a permissionless fashion. This combination of attributes, along with the yield farming frenzy over the summer, has led to the growth we’ve seen.”
Similarly, Carolyn Reckhow, the head of business development and strategy at Keep Network, sees the utilization of BTC on the Ethereum network as natural — particularly given the proliferation of passive-income generating opportunities in DeFi:
“Bitcoin will always be the original ‘decentralized finance.’ At the same time, 2020 has presented new opportunities to earn in Ethereum DeFi, as that ecosystem grows. It makes sense that BTC holders want to participate in a way that is consistent with their values and priorities.”
Bitcoin on Ethereum: The biggest projects
Wrapped Bitcoin (WBTC)
Launched in early 2019 by existing projects Kyber, Ren and BitGo, Wrapped Bitcoin (WBTC) is by far the most established project tokenizing BTC today. There are currently over 123,000 WBTC on Ethereum. In fiat terms, the total value is close to $1.9 billion, at the time of writing.
WBTC relies on a centralized custodian to oversee the storage of the BTC coins, as well as the subsequent minting and burning of WBTC. When users want to mint WBTC, they do so through one of the project’s merchants. The merchant relays the request to the custodian, which mints the WBTC in accordance with the number of BTC taken into custody. Individual merchants and custodians are approved by the project’s decentralized autonomous organization, commonly referred to as a DAO.
Although clearly a centralized implementation, WBTC strives to maintain as much transparency as possible. Users can view the custody addresses in which funds are held and compare them to the number of WBTC minted on the Ethereum network. Thanks to the public nature of both the Bitcoin and Ethereum blockchains, proving full reserves of circulating WBTC is very easy.
According to the WBTC website, there are currently 26 merchants. These include major DeFi projects like Maker, Ren, Set Protocol and Aave. Meanwhile, there are 17 members of the platform’s DAO. Those familiar with decentralized finance will recognize names like Gnosis, OmiseGO, bZx and Kyber, which are all among the DAO members.
Protecting the users’ BTC as the project’s sole custodian is BitGo. While reliance on a single custodian may ring alarm bells to some readers, the company is one of the most prominent custodians in the industry. It’s regulated by the Division of Banking in South Dakota and boasts a $100 million insurance policy from Lloyd’s of London.
Despite its credentials, BitGo still represents a trusted third party. For many in the industry, this sits at odds with the very ethos of cryptocurrency. So, too, does the obligation to conform with anti-money laundering regulations, such as Know Your Customer checks, which require disclosing one’s identity prior to minting WBTC. For these reasons, other projects have attempted to bring BTC to the Ethereum network in a more trust-minimized fashion.
The second-largest project tokenizing BTC on Ethereum is powered by the Ren Virtual Machine (RenVM). The BTC-backed tokens it creates are known as renBTC tokens. There are currently more than 25,000 renBTC, or around $320 million worth, on Ethereum.
The RenVM is a network of machines known as Darknodes. The virtual machine acts as the custodian for users by creating a one-time BTC deposit address to which users must send BTC. The private key to this address is kept completely secret, even from the nodes. Once the transaction has been confirmed, the RenVM mints the appropriate number of renBTC for use with supported DeFi applications.
As a permissionless network, anyone can run a RenVM Darknode. However, registration does require that operators stake 100,000 REN tokens. This ensures that one user cannot overrun the network with Darknodes they control in order to game the virtual machine’s operation in their favor. Darknode operators are incentivized to participate honestly by a share of the transaction fees charged to those using the RenVM.
Unlike WBTC, which requires users to fall in with AML and KYC regulatory requirements, renBTC — and the virtual machine that powers it — focuses on privacy. It uses various cryptographic techniques to ensure that all processes — inputs, outputs and state — are kept secret from all participants, including Darknode operators. As outlined in the project’s documentation, RenVM incorporates Shamir’s Secret Sharing, zkSNARKs, and a secure multiparty computation protocol to achieve this privacy-focused functionality.
As well as reportedly being a more trust-minimized and private way to bring BTC liquidity to other blockchains, RenVM offers additional advantages. Firstly, its composability allows DeFi projects to add inter-blockchain-operability into their own applications — making for a smoother user experience. The chief operating officer of Ren, Michael Burgess, told OKX Insights how this might impact the cryptocurrency industry’s wider growth:
“As RenVM expands to other blockchains, users will be able to interact with native assets (such as BTC) and not know which underlying L1 the dApps are on — which, in our view, will move interoperability into the mainstream and have a profound impact on the ecosystem’s user experience and subsequent adoption.”
Additionally, being entirely protocol-based, minting assets using RenVM requires little more time than it takes to confirm transactions on the blockchains it bridges. This makes it much faster than systems requiring central authorization.
“No other wrapped asset mechanism can move to and from Ethereum as quickly and in a capital-efficient manner. All other variants have UX hurdles that prevent this level of fluidity and capital efficiency.”
Keep Network’s tBTC
WBTC and renBTC aren’t the only efforts to bring BTC’s liquidity to the expanding decentralized finance sector. While Huobi’s HBTC and Tokenlon’s imBTC both rely on centralized custodian services — akin to that of WBTC — others strive to represent BTC on Ethereum in a way that is more fitting with the ethos of the wider cryptocurrency industry.
Among them is tBTC by the Keep Network. This tokenization of BTC utilizes overcollateralized, randomly selected signing nodes to take custody of users’ BTC. These signers receive a share of fees paid by the platform’s users and are kept honest by a bond of ETH worth 150% of the BTC in their custody. At present, there are around 1,000 tBTC (~$15 million) in circulation, making it one of the smaller implementations of tokenized BTC.
Despite representing a smaller share of the tokenized BTC on Ethereum, those behind tBTC believe it currently represents the implementation that’s most ideologically aligned with Bitcoin. In Reckhow’s own words:
“tBTC is built to be consistent with the values and priorities of Bitcoin holders. That means prioritizing decentralization and safety. tBTC is completely trustless, which means that no intermediary needs to sign off in order to redeem tBTC for BTC at any time.”
The developers behind the decentralized derivatives trading platform Synthetix have come up with another approach to representing the value of Bitcoin on the Ethereum network. Its sBTC token is actually a synthetic representation of BTC’s value. Unlike WBTC, renBTC and tBTC, sBTC is not backed by BTC. Instead, Synthetix’s SNX token provides the necessary collateral to mint sBTC tokens. Users wishing to mint sBTC must lock up SNX worth around 700% of the value of the BTC. This over-collateralization is needed to protect the system against a sudden drop in the price of SNX versus that of BTC.
Given that both SNX and sBTC operate on the Ethereum blockchain, the assets represented by Synthetix do not really bridge blockchains in the same way that other solutions do. The system involves no actual BTC. Therefore, sBTC cannot be redeemed for BTC. Therefore, sBTC allows traders to take exposure to the price of BTC only and does not bring any of the BTC market’s vast liquidity to the Ethereum network.
Issues raised by different tokenized Bitcoin implementations
None of the efforts to bring Bitcoin to Ethereum are currently without drawbacks. The major one — for now, at least — is the requirement of trusting a central entity. Ultimately, external pressure on those exercising central control of such systems could result in transaction censorship and even the seizure of BTC in custody.
With WBTC, HBTC and imBTC, such central control is made fairly explicit. The BTC in custody is held in wallets controlled by a central entity. Users trust that this central entity does indeed hold one coin for each tokenized BTC in circulation and that it will not suddenly disappear with the contents of its custodial wallet. What’s not as clear, however, is the level of central control commanded by those behind solutions claiming to offer tokenization of BTC in a more trust-minimized fashion.
Both tBTC and renBTC have previously attracted criticism over their own decentralization claims. On Aug. 26, 2020, the Wanchain Foundation published a Medium post in which it identified discrepancies between renBTC’s claims and its actual implementation. It stated that all of the BTC in the custody of RenVM remained in a single BTC address. Control of that private key would allow an attacker to transfer all BTC the project has in custody to any address on the network.
The Ren Project responded with a post of its own, reasoning that full decentralization from the start invites its own issues. Software bugs — particularly when dealing with complex, cutting-edge software — are common. Therefore, the Ren Project is following a roadmap toward what it describes as full decentralization.
The post revealed that those behind the project could indeed collude internally to access those funds in the custody of RenVM. However, it claimed that there are “strong incentives not to do so.” These include “throwing away years of hard work and reputation,” as well as potential legal ramifications and the blacklisting of stolen assets, limiting the efficacy of such an exit scam. Ultimately, users have to trust that there will be no collusion.
An earlier issue — this time, with tBTC — highlighted both centralization concerns and how full decentralization from the start can present their own risks. Just a couple of days after tBTC’s May 2020 launch, the Keep Network team was forced to trigger a deposit pause function written into the project’s code. By triggering what it called the “red lever,” the team was able to prevent the loss of user funds while it addressed issues with its signer bonding system. Without such central control, vulnerabilities identified may have been exploited.
Like the Ren Project, the Keep Network is reportedly progressing towards full decentralization for tBTC. It outlines a staggered process to remove central points of trust. This is intended to allow for the resolution of teething issues while still retaining control over certain aspects of the system in order to protect network participants from unforeseen vulnerabilities. Evidently, however, there is still some requirement of user trust in these apparently trust-minimized solutions.
Efforts to replace centralized custodians when bridging different blockchains may be a better fit with the decentralized nature of cryptocurrency, itself, but their relative complexity invites new potential attack vectors, too. As is the case with many cryptocurrency protocols, flaws in their code, if exploited, could result in a loss of user funds. This is an important consideration for anyone considering tokenizing their own BTC holdings.
Speaking with OKX Insights, Abugov commented on the trade-off between centralized custodian services and those attempting to provide BTC tokenization in a trust-minimized manner:
“Some may say that retail users do not understand the technology behind their centralized financial products — they just need them to work. That may be true but, with centralized products, there is an identified responsible party. There are procedures for what happens if things go wrong. In DeFi, there is a lot less of that.”
General risks and shortcomings of tokenized BTC on Ethereum
Smart contract risk
Given the growth of BTC on Ethereum this year, it’s clear that there is a lot of demand from BTC holders to put the value of their investments to work in Ethereum’s booming DeFi sector. However, it’s important to consider the inherent risks of DeFi before attempting to interact with decentralized financial applications.
As OKX Insights has explored previously, the composability of DeFi applications creates a potentially vast attack surface for those looking to exploit vulnerabilities in code. On numerous occasions during 2020, smart contracts have been drained by opportunists and malicious actors, alike. Naturally, many attacks have targeted completely unaudited projects, which may also offer passive-income generating opportunities using tokenized BTC.
Granted, growing numbers of DeFi projects are now opting into smart contract auditing services. Yet, even audited projects can present risks. The open, permissionless nature of the sector and interoperability of different protocols can create vulnerabilities that are difficult to perceive until systems are live — and with real capital at stake. In a niche as new and complex as DeFi, which involves increasingly large sums of money, it’s a stretch to believe that auditors can account for every conceivable exploit.
Burgess told OKX Insights about the compounding risk involved with the tokenization of Bitcoin:
“By bringing an asset to Ethereum (via tokenization) and depositing it into a DeFi app, you are compounding Bitcoin blockchain risk, Ethereum blockchain risk, the tokenized model risk and the DeFi app’s (smart contract) risk. For tokenized assets in DeFi, this is unavoidable and should be conveyed to users, so they can make educated decisions on which model and risk profile fit their needs best.”
Similarly, projects may change their code after receiving a positive appraisal from an audit firm. Such changes may introduce new attack vectors. Those interacting with such protocols with tokenized BTC (or any digital asset, for that matter) may be at risk, despite prior audits of the project.
Abugov commented on the risks associated with both tokenized Bitcoin protocols and the DeFi sector more generally:
“I think there is added risk. We have seen over the past few months a number of projects suffer from various attacks. BTC tokens create an added level of, at least, technological risk. It’s been said before that, at the moment, the space resembles a big ‘beta test.’ So, it would help if those using the applications understand what it is they are using.”
Gas prices drive Bitcoin to other networks
An additional shortcoming of interacting with Ethereum DeFi via tokenized BTC relates to scalability. Not only has the amount of BTC and TVL in DeFi applications on the network grown rapidly this year, so too have transaction fees.
Every interaction with Ethereum-based applications requires updating the blockchain. With DeFi driving demand for block space, gas prices have increased to levels that price all-but-the-wealthiest out of even using these supposedly open and accessible financial services.
The shortcomings of the Ethereum blockchain, in its current implementation, are encouraging proponents of other smart contract-compatible platforms to pursue DeFi development more seriously. The TRON network, for example, has been attempting to position itself as a much cheaper platform for decentralized finance. Efforts like the Justswap DEX, pearl.finance, salmon.finance and others all borrow not only from the functionality of their Ethereum-based counterparts but their irreverent branding, too. Other Ethereum competitors seeing increasing DeFi development include Polkadot, EOS and Cosmos.
With options for DeFi users growing, it’s little surprise to see tokenized BTC solutions now providing bridges between the Bitcoin blockchain and non-Ethereum networks. BitGo announced at the end of September that it was working with TRON to bring WBTC to the network. Meanwhile, TRON’s own home-baked solution is JUST BTC. Similarly, Interlay is working on Polkadot’s first tokenized BTC implementation, PolkaBTC, which is expected to go live in early 2021.
Should you tokenize your BTC?
If security is your chief concern, the answer to this may be “no.” All existing methods of tokenizing BTC on Ethereum present some additional security risk. Burgess sums it up neatly:
“The safest place for BTC and other assets is on their native chain. No exception. All tokenized models (renBTC, WBTC, tBTC, etc) compound risk, and stating otherwise is disingenuous. Users need to be aware of this.”
Yet, holders totaling around $2 billion worth of BTC have taken that risk. Most of them favor the centralized custodian model of WBTC in place of more complex systems like those the Ren Project and Keep Network are moving toward.
Commenting that she anticipates a continuing demand for such centralized solutions in the institutional market, Reckhow spoke to OKX Insights about the trade-offs between centralized and trust-minimized BTC tokenization projects, in terms of risk:
“Users should understand and qualify for themselves the technologies they select, and use them if they accept the risks. There is a lot of variance among DeFi and crypto projects and protocols. With centralized projects, risks lie in the need to trust a third-party around security or rehypothecation risk (i.e., the Bitfinex’d risk) and, with more decentralized projects, you’re looking at technical/smart contract risks.”
The fact that WBTC, with its industry-leading insured-but-centralized custody, continues to account for more than three-quarters of all BTC on Ethereum is telling of the market’s appetite for risk. While users are happy to take on smart contract risk for the potential reward of interacting with DeFi protocols, there is little to gain and a lot to lose from opting to use one of the trust-minimized solutions. After all, we are talking about trusting brand new, complex and scantly tested systems with the crypto world’s most valuable asset.
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.
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