What is Wrapped Bitcoin and How does it Work?

With the rise in popularity of ERC20, digital tokens in the Ethereum ecosystem have now become an important asset class. These tokens have all the advantages that blockchain and Ethereum can offer in terms of transparency in coin amounts, owners, minting, confirmation time speed, transaction details, and smart contract execution. While decentralized financial services (DeFi) in the Ethereum ecosystem may promise opportunities without being huge, several issues could stop it from achieving its goal of rivaling the current centralized economic system. One of these is incompatibility with the main cryptocurrency network, Bitcoin, which has a separate blockchain network from Ethereum. This is where Wrapped Bitcoin (WBTC) comes in. Basically, the idea is to develop a digital currency that represents Bitcoin on the Ethereum blockchain. For more details, let’s take a look at this article!

What is Wrapped Bitcoin?

Wrapped Bitcoin is a representation of the underlying asset Bitcoin, which is used on the Ethereum blockchain. Wrapped Cryptocurrencies track the value of the asset they represent and are fungible for that asset. In other words, Wrapped Cryptocurrency allows us to utilize crypto assets on non-native blockchains. This indicates that consumers can use Bitcoin in its ‘wrapped’ form to interact within the Ethereum ecosystem through the use of decentralized applications (DApps) and smart contracts. The Ethereum ecosystem can benefit from Bitcoin’s liquidity by tokenizing it as an ERC-20 token.

Blockchain systems are designed to function on their own. Different blockchains offer specific functions in the crypto world, and there needs to be a sufficiently precise method for data exchange between blockchain systems. Tokens created in one blockchain system are difficult to transfer to another. For now, some technologies enable communication between multiple blockchains. Others rely on a standalone root chain-based consensus model. In this case, wrapped bitcoin was created to solve the existing problems, improve inter-blockchain communication, and open up new opportunities for DeFi users. Wrapped tokens also generally improve liquidity and capital efficiency in decentralized exchange processes. 

Wrapped Bitcoin seeks to extend the advantages of Bitcoin by focusing on the following:

  • Increasing benefits for traders: as Bitcoin commands a large portion of the crypto market, decentralized exchanges, often limited to ERC-20 tokens, end up struggling and experiencing low trading volumes and liquidity. Wrapped BTC provides customers with better liquidity and engagement. In addition, Wrapped BTC users can benefit from high-speed transactions on Ethereum.
  • Institutions: Users of decentralized applications such as exchanges, wallets, and payment services no longer worry about handling multiple cryptocurrencies across nodes and transaction types. WBTC combines the advantages of Ethereum and Bitcoin, allowing users to manage wrapped assets using only Ethereum nodes.
  • DApps: Bitcoin payments can now be used in smart contracts for lending protocols, funds, market predictions, and token sales in decentralized applications.

According to its whitepaper, the WBTC implementation model and technology consists of four essential participants:

  • Custodian: The entity or party holding the assets is the custodian. The key to minting the tokens is in the hands of the custodian.
  • Merchant: The institution or party that issues wrapped tokens is known as the merchant. Wrapped tokens are distributed chiefly through merchants. Each merchant has a key that can initiate the minting of new wrapped tokens and the ‘burning’ of old wrapped tokens. Cryptocurrency burning is when a small portion of tokens is sent to a digital wallet that does not have a private key. This means the tokens are lost forever. Tokens are usually burned to reduce availability and increase market value.
  • Users: Holders of wrapped tokens are referred to as “Users.” Wrapped tokens can be transferred and transacted on the Ethereum network like any other ERC20 token.
  • WBTC DAO Members: The multi-signature contract governs contract amendments and the addition and removal of custodians and traders. The WBTC DAO holds the keys to multi-signature contracts owned by institutions.

Wrapped Bitcoin (WBTC) vs. Bitcoin (BTC)

The relationship between Wrapped Bitcoin and Bitcoin is similar to that between Tether (USDT) and the US Dollar: The value of USDT is tied to the US Dollar. So why do we need USDT if it’s worth the same as the US Dollar?

Despite having the same value, the US Dollar is a fiat currency issued by a sovereign body, the United States government, through the Treasury Department – which means you can’t use it for cryptocurrency transactions. Therefore, a crypto version of US fiat, the USDT stablecoin, was introduced, which can work on blockchain networks. The same goes for Wrapped Bitcoin and the “normal” Bitcoin everyone knows – except both are used for crypto transactions. However, the importance of Wrapped Bitcoin lies in the functionality of cross-chain transactions offered to Bitcoin holders. For example, if BTC holders want to deposit their Bitcoin on a DeFi platform (e.g., Aave) to earn interest, they need to use Wrapped BTC because AAVE tokens are only used on the Ethereum network, and Wrapped BTC is an ERC20 token.¬†

How Does Wrapped Bitcoin Work?

There are two ways to get WBTC tokens. You can either mint them or buy them from a decentralized or centralized exchange (which generally means higher fees). The process of minting WBTC involves two principal transactions – minting and burning. To mint WBTC, you must submit a request and make a payment to a WBTC merchant, such as Loopring or DeversiFi. The merchant will then transact with the custodian, who mints the tokens by sending Bitcoin in exchange for WBTC. The custodian locks the Bitcoin in reserve and holds it. To redeem your Bitcoin, you will have to pay a small fee again to the merchant, who will initiate a burn transaction with the custodian. The custodian will release the Bitcoin and burn the WBTC. The transaction is tracked and verified on the Ethereum blockchain and can be viewed publicly through block explorers like Etherscan.

The problem posed by the oversupply of Wrapped Bitcoin is solved through the process described above. With the maximum supply of Bitcoin capped at 21 million coins, the total supply of wrapped cryptocurrency may also be capped at that amount – as WBTC tokens can only be minted when the corresponding Bitcoin holdings have been verified. So each token is tied to its respective Bitcoin. The procedure follows the institutionalized bank lending process, where users needing a loan must temporarily give the bank ownership of their assets of equal or more excellent value. When the loan is repaid, ownership of the asset is restored. But in this case, the value of both assets is tied, so any depreciation or increase in value is reflected on both assets.

Pros of WBTC

  • Faster Transaction Speed: Wrapped Bitcoins do not run on Bitcoin’s proprietary blockchain network. Therefore, their block speed – the network’s speed – is based on the Ethereum blockchain, not on Bitcoin. Ethereum takes much less time to validate blocks to be added to the blockchain, so transactions on the network are faster. In this way, WBTC helps its holders to make transactions faster than those using the original Bitcoin.
  • Lower fees: The transaction fees with Ethereum are lower than Bitcoin to encourage developers’ use of the network. As such, WBTC holders can make transactions at cheaper rates than those holding BTC. For example, if a user intends to do a lot of fund transfers, they would instead use WBTC because of the fees they will pay per transaction. This difference in fees is due to the level of congestion on Bitcoin. Transactions on the Bitcoin network get clogged, causing higher fees to clear blocks, while Ethereum has a faster clearing rate.
  • Interoperability: WBTC lets one quickly move crypto holdings between blockchains. The interoperability issue has been a recurring problem for crypto users, especially those in the DeFi space. However, wrapped cryptocurrencies, including WBTC, are a viable solution to this problem through their interoperability. This feature means users don’t need to sell part of their Bitcoin holdings to access DeFi services on Ethereum. At any time, whenever they want, they can get their coins back, even after “converting” them into Ethereum tokens.

Disadvantages of WBTC

  • Security issues:¬†Since the minting process for encased cryptocurrencies is similar to centralized bank lending, users have to trust that custodians won’t run off with their Bitcoins. This defeats the purpose of a decentralized system, which is the raison d’√™tre behind crypto. Recently, emerging blockchain technologies have helped address this security issue. BadgerDAO, a decentralized autonomous organization (DAO) dedicated to simplifying the use of Bitcoin, aims to solve this problem with its Badger Bridge, which allows liaisons across the asset chain to exchange BTC for WBTC seamlessly. The wrapping process is fully decentralized, like Wrapped Ether (WETH), which can be minted through smart contracts. Threshold Network presents another form of wrapped Bitcoin with its tBTC that not only bridges BTC to Ethereum, but also other blockchains such as Celo, in a decentralized manner.

Risks of WBTC

While WBTC has many advantages of its own, it is important to understand the limitations and risks involved with wrapped BTC. One of the questions you need to ask is: ‘Is it safe to invest in WBTC? The technical specifications of the wrapped token suggest that WBTC is likely safe to use. Although WBTC remains in a controlled system as in Binance Smart Chain or Ethereum, users can have the advantage of the security of the existing system. However, the security offered by custodians does not necessarily translate into positive results in the long run. If the custodian unlocks and releases the Bitcoin associated with the ERC-20 token, then the relevant wrapped Bitcoin will become worthless. Therefore, it is important to note that the security of wrapped Bitcoin depends on the custodian and the level of security offered.

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