One of the biggest problems facing the world of blockchain is interoperability. Without this functionality, users wouldn't have the ability to interact with other blockchains. That means basic tasks like performing transactions would be out of the question. This is especially true for Bitcoin, which faces the challenge of interacting with the DeFi market.
Fortunately, developers discovered a creative way to circumvent this obstacle through the creation of wrapped tokens. For example, wrapped Bitcoin (wBTC) gives BTC holders a way to enter the decentralized finance market without selling their digital assets.
If you aren’t familiar with wrapped Bitcoin, don’t worry. This post will tell you what wrapped Bitcoin is, how it works, and ways it can be used in the DeFi marketplace.
What is Wrapped Bitcoin?
Wrapped Bitcoin is a digital asset that represents a tokenized version of Bitcoin. So, a cryptocurrency like wBTC is basically the ERC-20 token version of BTC, which is tied directly to Bitcoin's price. Is it the same as owning actual Bitcoin? No, but the price of your wBTC will always reflect the price of Bitcoin.
If you understand stablecoins, then you should have no trouble grasping wrapped tokens. Take a token like Tether (USDT). Tether is an on-chain representation of one U.S. dollar, which is tied to the actual USD price. The purpose is to provide a stable method of switching between fiat and cryptocurrency while eliminating much of the volatility associated with the crypto market.
The same idea is applicable with wrapped Bitcoin. Instead of selling their Bitcoin in exchange for Ethereum (ETH), investors choose to switch to an Ethereum-based version of their crypto assets.
History of wBTC
The idea of wrapped BTC came to light after a partnership between BitGo and Kyber Network was established in 2018. The two companies worked together to create a bridge that would allow ERC-20 tokens to be pegged to the real market price of Bitcoin.
Even though decentralized finance was relatively unknown at the time, wBTC launched in 2019. Nevertheless, Kyber and BitGo paved the way for wrapped tokens as wBTC realized more than $1 billion in collateralized assets by October of 2020.
Currently, the wBTC protocol is controlled by a decentralized autonomous organization, also known as a DAO. This organization includes exchanges, wallets, and merchants who are active in the crypto market.
How does tokenizing Bitcoin work?
When talking about tokenizing Bitcoin, the first step is to understand that there is an ERC-20 token on the Ethereum network that represents Bitcoin in a ratio of 1:1. This wrapping process stakes BTC as collateral in exchange for the equivalent minted token.
Bringing new wBTC to the market is done through a method called minting. A merchant kicks off the minting process by requesting a certain amount of wBTC from the custodian. The Bitcoin is sent to the custodian, who then sends the newly minted ERC-20 tokens to the merchant once they confirm receipt of the BTC.
Wrapped Bitcoin is sent to the end user from the merchant. In much the same way the merchant requests wBTC from the custodian, the end user makes a request to the merchant. Once the merchant receives the corresponding amount of Bitcoin, they release the wBTC to the end user.
On the other end of the spectrum is the burning of wrapped BTC. Burning occurs when wBTC is exchanged for Bitcoin. This is performed as a merchant and custodian transaction. Once the merchant sends the tokens to the custodian and the exchange is complete, the wBTC tokens are burned from the merchant's Ethereum wallet.
Governance and Trust Model
Wrapped Bitcoin uses a DAO governance model. That means if an entity is going to be added or removed, it has to have the signatures of members of the DAO. With a multi-signature contract in place, wBTC uses an M of N signature process. M is the required number of signatures, and N is the total number of DAO members. The values of these variables are dictated by members of the DAO.
Additionally, some level of trust is required with the wrapped BTC governance model. For instance, it is trusted that custodians will not steal stored assets. However, the wrapped Bitcoin model attempts to prevent this by not allowing custodians to mint their own wBTC and by performing a quarterly audit to ensure that all minted wBTC have an equivalent amount of BTC stored in wallets.
Benefits of wBTC
There are many within the world of crypto who argue that wrapped Bitcoin is a solid investment because of the inherent advantage of using ERC-20 tokens. Of course, there are disadvantages to wBTC as well, but here are a few examples of the benefits of wBTC.
Access to the Ethereum Network
Ethereum is one of, if not the largest ecosystem in the crypto world. By integrating Bitcoin with Ethereum and providing interoperability, investors have access to the Ethereum blockchain and all its features. This includes popular facilities like decentralized exchanges (DEXs), decentralized apps (dApps), and much more.
Liquidity
Wrapped Bitcoin brings liquidity to the decentralized finance market since the Ethereum ecosystem is spread out. That means there could come a point when a decentralized exchange or platform may not have the necessary liquidity to perform as it should. As a result, users could have trouble trading for the token they want. Fortunately, wrapped tokens like wBTC serve to close this gap.
Transaction Speed
Another benefit of a wrapped Bitcoin is transaction speed. The thinking here is that tokens like wrapped BTC don't reside on the Bitcoin network. Instead, they reside on the Ethereum blockchain. As a result, transactions that take place with wrapped Bitcoin on the Ethereum network are faster and typically result in lower fees.
Improved Functionality
By using wBTC, Bitcoin holders have access to all functionalities in the DeFi ecosystem they wouldn't have otherwise. They can use their wBTC tokens to make use of smart contracts and DeFi applications. By comparison, these types of features are simply something Bitcoin cannot offer its investors.
How to use Wrapped Bitcoin in DeFi?
Decentralized finance has experienced remarkable growth on the Ethereum blockchain with wrapped Bitcoin offering interoperability between Ethereum and Bitcoin. This gives Bitcoin investors a way to participate in the rapidly expanding Ethereum ecosystem. But how can you use wrapped Bitcoin in this ecosystem? Let's look at a few examples.
Governance
Some decentralized platforms incentivize borrowing and lending by offering a way to accrue the platform's governance token. Compound, for instance, has its COMP token that lets holders vote on the platform's borrowing and lending mechanisms and protocol upgrades. With wrapped Bitcoin, investors can participate in earning governance tokens by providing liquidity to the platform.
Collateral
Loans facilitated on DeFi platforms are secured through collateral. That means a certain amount of crypto is held on the site until the borrower repays the amount of the loan. Before wBTC, collateral for loans was paid in Ethereum's native cryptocurrency, Ether. The problem is that when only a single digital asset is used as collateral, the risk of price volatility increases.
With wrapped Bitcoin, other digital assets are able to provide collateral. Examples of protocols that allow for wBTC to be used as collateral for loans include MakerDAO, Compound, AAVE, Uniswap, and Kyber Network.
Yield Farming and Interest
DeFi platforms also allow users to earn interest on their wrapped Bitcoin. This is done through liquidity pools on the platform, many of which use an algorithm based on supply and demand that determine the interest rates offered.
Additionally, users can yield farm with their wBTC using platforms like Unagii. Yield farming is the process of moving from pool to pool or from platform to platform to find the best possible interest rate. The beauty of Unagii is that it harvests optimal yields automatically, so all an investor has to do is provide the funds. Deposit some wrapped Bitcoin and let Unagii take care of the rest.
Margin Trading
If you're an advanced trader and something like margin trading appeals to you, wBTC unlocks the potential of decentralized finance and the large store of liquidity it offers. Users can also simply lend their wrapped Bitcoin to the protocol to give to those who prefer margin trading. Doing so provides liquidity to the protocol and earns the lender a fee.
Providing legitimacy to the DeFi market
We're quickly approaching the day when Bitcoin and DeFi will no longer be considered two separate and distinct entities. Through the use of wrapped cryptocurrencies like wBTC, Bitcoin and Ethereum can bridge that gap. The more users and investors realize the potential of wrapped crypto, the more opportunities there will be for development and growth within this market.
Additionally, the possibility of using Bitcoin in decentralized finance has to be appealing to investors who are hesitant to pull the trigger, and with Unagii providing a hands-off approach for investors to earn interest on their Bitcoin, it's only a matter of time before more users join the fray.
