Bitcoin is being tokenized at an accelerated pace, and miners may suffer losses in profits as they abandon the old and embrace the new

The new trend of Bitcoin-backed tokens (i.e. wrapped Bitcoin) is enabling more and more users to get the best of both worlds on both Bitcoin and Ethereum.

In the blockchain industry, with the recent rapid development of DeFi, the value of Bitcoin adopted by various DeFi applications through their respective Layer 1 has soared so far, far exceeding our expectations. Most of them have spread in the Ethereum ecosystem, the "default protocol" of DeFi. As of August 16, more than 38,000 BTC are used in Ethereum, which currently accounts for 1% of the total market value of Ethereum. Of course, the number of these Bitcoins only accounts for 0.181% of the total available Bitcoin, but if this trend continues, then, this may have an impact on the Bitcoin network itself.

And, Ethereum isn’t the only Layer 1 protocol to embrace these innovative Bitcoin-backed tokens…

The most popular of these Bitcoin-backed tokens is WBTC (Wrapped Bitcoin), which was developed and launched by BitGo in early 2019. Take a look at the rapid popularity of this token: thanks to the DeFi craze, as of June 1, there were only 3,911 WBTC in the token, while as of August 16, there were 26,000 WBTC, which is equivalent to a 570% increase in 2 months.

Now, different Bitcoin-backed tokens have also emerged in some Layer 1 protocols. For example, the smart contract protocol Tezos has announced their own native Bitcoin-backed token tzBTC, which is currently under development and testing. With the support of Interlay, Polkadot has also announced its development and testing plans for PolkaBTC. The timeline below lists the Bitcoin-backed tokens that have been launched or recently announced on the mainstream Layer 1 protocols, most of which are on Ethereum.

Figure 1. Development timeline of Bitcoin-backed tokens on major layer 1 protocols, including their current locked Bitcoin amounts and the teams behind them.

In retrospect, the emergence of these Bitcoin-backed tokens was a stroke of genius. It allowed Bitcoin maximalists to "HODL" their Bitcoin while using it in the ecosystem of other Layer 1 protocols. You could call it a win-win. The way most pegged Bitcoin tokens work is simple: Bitcoin holders simply deposit their Bitcoin into another controlled wallet address, and at the same time, the corresponding protocol will mint a 1:1 pegged Bitcoin token according to the token standard. This process varies slightly from protocol to protocol, but in most cases, they basically wrap and replace your Bitcoin with a pegged Bitcoin token that is compatible with the Layer 1 protocol standard.

Let’s take the example of Polkadot and Interlay’s recently announced PolkaBTC. Users transfer BTC to a vault of their choice, which sends the locked DOT collateral to the Interlay BTC parachain, which then sends the user PolkaBTC. The reverse operation can then be redeemed for BTC.

Figure 2 outlines the process by which a user “exchanges” BTC for a Bitcoin-backed token on the Polkadot network.

In a sense, pegging Bitcoin tokens represents an accelerated form of interoperability between blockchains. It’s a simplified way to open gateways, allowing for more instances of use between protocols, rather than being stuck in silos. And, since Bitcoin is probably the most popular cryptocurrency, this approach strengthens Bitcoin’s use cases beyond “just holding Bitcoin.”

In fact, Ethereum projects including WBTC and imBTC hold 70% more Bitcoin than Lightning or Liquid. Similar to the goals of Bitcoin tokenization projects, Lightning and Liquid are working to stimulate utility for the leading cryptocurrency, but their focus is on improving the speed and privacy of both small and large off-chain Bitcoin transactions.

Figure 3: WBTC’s incidental growth has outpaced Bitcoin Lightning Network over the past few months. Compared to the exponential growth of Bitcoin in WBTC, the value of Bitcoin on the Lightning Network has remained roughly flat.

However, while new use cases like Bitcoin-pegged tokens are innocuous for the blockchain and crypto communities, their impact could be unintentionally divisive. Of course, it’s too early to assume what will happen next, but here are some points worth considering.

Bitcoin symbolizes "real estate". People just want to hold Bitcoin and use it on DeFi - it can be said that people's belief in Bitcoin as an asset is still prevalent. Just as our slogan "HODL" has been widely spread, our Bitcoin holders are doing just that - just HODL (hold and don't sell). Because although Ethereum has received more and more attention in the past year, Bitcoin is still the king of cryptocurrencies. Bitcoin is the first and "long-standing" blockchain project to date (and it is also the reason why we are all here today reading this article).

Without Bitcoin, there might not be a blockchain industry, and it might even inspire some other advanced forms. There is no doubt that our tendency to hold Bitcoin and use it in other forms can be equated with real estate. Each of us wants to own real estate, essentially it can provide us with housing, but it can also be used as an investment tool in other ways: buying a mortgage (allowing us to have short-term liquidity), investing in real estate (renting it to the market), flipping houses, school district housing, and so on. Owning a house can meet Maslow's most basic hierarchy of needs, but what we do with the house allows us to achieve the need for self-satisfaction.

Figure 4 Overview of Satoshi's hierarchy of needs

Owning Bitcoin also satisfies our most basic need (security of wealth), but being able to cross-chain assets to other smart contract protocols to get the thrill of yield farming satisfies our psychological and self-actualization needs. This may all be exaggerated for the time being, but the similarities are obvious. Real estate is already everywhere, but Bitcoin can have the same development path.

Ethereum needs rollups to speed up. Suppose in extreme cases, a large amount of Bitcoin is "wrapped" and used on the Ethereum blockchain. This may speed up the development of Ethereum 2.0. However, many Ethereum developers and Vitalik himself pointed out that these increased on-chain activities may stimulate the demand for more widespread use of rollups technology. Currently, two types of rollups technology have been proposed: zk-Rollups and Optimistic Rollups, with the former being a better choice. Despite the debate, zk-Rollups have proven to be faster and cheaper than Optimistic Rollups and Plasma. Currently, the TPS of a public chain can reach up to 15. But according to Vitalik, Ethereum 1.0, as a data layer, will reach 2,000-3,000 TPS after using rollups.

Out with the old, in with the new. Maybe eventually some users will want to abandon BTC and use ETH. Perhaps, as they gradually realize the increased utility of Ethereum, some wrapped Bitcoin users may abandon Bitcoin for Ethereum for simplicity. In any case, these people have already spent most of their time and Bitcoin usage on the Ethereum network. But this is a "far-fetched" scenario. It will take decades, even centuries, to convince people that Bitcoin is no longer the "it" in cryptocurrencies.

Some bridges or centralized wrapped tokens become security threats. Although these wrapped tokens are considered useful and innovative, they still have security issues. For example, wrapped Bitcoin actually just keeps the user's locked Bitcoin with a centralized third-party custodian. Therefore, when you hold your own keys, Bitcoin is safe and trustless; but when you hand over Bitcoin to the custodian of WBTC, it represents a possible centralized security threat, just like the "Yam" contract vulnerability incident that just happened on Ethereum two days ago. Although renBTC is designed to use smart contracts to lock Bitcoin instead of using a trusted third party like WBTC, there are still risks when these Bitcoin-backed token models go wrong. For example, the staff of Thesis, the team behind tBTC, had to stop deposits on its platform just one month after the platform was launched due to errors in its code. Community contributors began to notice problems when tBTC's Solidity code could not distinguish between P2SH and P2PKH Bitcoin addresses.

Figure 5 An example of the technical risk of “wrapped Bitcoin” in tBTC

Arbitrage trading between different Bitcoin-backed tokens and even Bitcoin itself. One can even imagine a situation where new financial arbitrage is conducted between Bitcoin-backed tokens and Bitcoin itself, so that members of the Bitcoin community compete with each other for additional profits. This may lead to the birth of more complex financial derivatives or trading pairs such as BTC/WBTC, BTC/renBTC, BTC/tzBTC, BTC/PolkaBTC, etc. As of August 16, EBTC (EOS BTC) is trading at $13,075, compared to Bitcoin's price of $11,907. But this is nothing new, as BTC arbitrage between different exchanges already exists.

Bitcoin on-chain activity has dropped significantly. What would happen if Bitcoin on-chain activity died and Bitcoin miners were forced to take matters into their own hands? Ban transactions that transfer from Bitcoin-backed token project addresses to Bitcoin addresses? What would happen to Bitcoin on-chain activity if a large number of Bitcoins were eventually frozen because they were encapsulated in other blockchain networks? The reduction in on-chain activity could lead to a reduction in transaction fees for miners. Eventually, there would be almost zero transactions verified on the Bitcoin network. Dormant Bitcoin is not new, as the phenomenon is becoming more and more common. Earlier this year, a report from Digital Asset Data showed that more than 10 million BTC had not been moved for a whole year, accounting for about 60% of all Bitcoins. This may also spark a discussion: does on-chain transactions determine price, or does price determine on-chain transactions?

Messari community analyst George Adams has a good comment on this: “I believe there is reflexivity (positive feedback loop) between the two. For example, in Bitcoin, more on-chain transaction volume = more demand for BTC, which drives the price up. Then a higher BTC price means more interest in it, which means more on-chain transaction volume. So I think they motivate each other... although I’m not sure which one changes first.”

Answering which changed first is as hard as answering the age-old question of “which came first, the chicken or the egg?” But based on what we know about finance and fundamental investing, in theory fundamentals should be the driver of price. For Bitcoin, on-chain transactions should be the driver of its price. Many common cryptocurrency valuation frameworks would argue against this — velocity is not always the driver of network value. But some remedies prevent a token from suffering from velocity issues — in the case of Bitcoin, that remedy is that it can act as a store of value. So, if this line of thought goes, then a decrease in on-chain transactions should be the determinant of price and have a significant impact on the transaction fees paid to miners. So, this could lead to the controversial hypothetical death spiral theory. Currently, on-chain transactions are statistically significantly correlated with the transaction fees charged by miners. By 2140, transaction fees will become the only source of income for miners.

Figure 6. The percentage change in miner transaction fee income is used as the dependent variable. A multivariate regression is performed on the percentage change in on-chain transactions and the percentage change in price (using 10 years of daily data). The p-value of the percentage change in on-chain transactions is far below the threshold, indicating that it is more significant.

Figure 7: Statistically speaking, on-chain transactions are more decisive for the percentage change in miner revenue, with a coefficient of 1.19. It is worth noting that on-chain transactions on a logarithmic scale have been stable over the past few years.

But let’s recall that the relationship between on-chain transactions and price, whether linear or nonlinear, should not be taken at face value. The real determinant should be whether the Bitcoin price market is rational or irrational — or, to put it another way, efficient or inefficient.

I believe that reducing on-chain transactions would not be harmful initially, but could lead to sustained low on-chain transaction volumes, which would begin to affect network security.

in conclusion

In summary, the idea of ​​"using your Bitcoin on other blockchain protocols" has merit, but we would like to highlight some points that may be of concern as a warning: a significant decrease in network activity on the Bitcoin chain may cross the line between network security and usage; perhaps these tokenized Bitcoins will prompt miners to voluntarily withdraw or take a more stringent attitude, but this trend may gradually be replaced by "how do we use Bitcoin". As mentioned earlier, the figure below shows that the number of Bitcoins traded on exchanges is slowly declining.

Figure 8 The price of Bitcoin increased while the amount of BTC on exchanges decreased by 10%, according to data extracted from the Glassnode API.

The good news is that this could be the key to us crossing the chasm of Bitcoin’s “mass adoption.” As of August 18, DeFi Pulse data showed that the TVL (total locked value) in DeFi smart contracts on Ethereum had just reached $6.3 billion.

The numbers speak for themselves, and Bitcoin-backed tokens are one of the reasons why.

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