By now for most following the recent apace movements of the DeFi sector within the blockchain industry, the amount of bitcoin value utilized within these DeFi applications, via their respective layer 1 protocols, has skyrocketed well past our expectations. Ethereum, which has been designated as the default protocol for DeFi, has seen the bulk of this trend propagated onto its ecosystem. At the time of this writing, there is over 38,000 BTC being used on Ethereum, which now represents 1% of the total ETH marketcap. Of course, this amount of BTC is only a measly 0.181% of the total amount of bitcoins available, but if we see the recent trend persist going forward, it’ll be interesting to see the effects this could have on the Bitcoin network itself.
And Ethereum isn’t the only layer 1 protocol that is allowing for these innovative bitcoin-backed tokens…
The most popular option for these bitcoin-backed tokens has been WBTC (Wrapped Bitcoin), which was developed and launched by BitGo in early 2019. To give you a sense of the rapid popularity of these tokens, mostly due to the DeFi frenzy, there were only 3,911 WBTC on June 1 compared to a current amount, as of this writing, of over 26,000 WBTC. That equates to a 570% increase in a span of 2 months.
There are now a concoction of different bitcoin-backed tokens sprucing up onto the other formidable layer 1 protocols as well. For example, the smart contract protocol, Tezos, has announced their own native bitcoin-backed token, tzBTC, which is currently under development and testing. Polkadot, with the engineering support of Interlay, also announced their development and testing plans for PolkaBTC. Below is a timeline encapsulating all the bitcoin-backed tokens that are either launched or recently announced on the major layer 1 protocols with Ethereum carrying the bulk of it.
(Figure 1) A timeline of all the bitcoin-backed tokens on the major layer 1 protocols, including their current amount of locked bitcoins and the team behind it.
In retrospective, the advent of these bitcoin-backed tokens is just genius. It allows bitcoin maximalists to use the application ecosystem of other layer 1 protocols, albeit being able to HODL their bitcoins. A WIN-WIN you could say. The way how most of the bitcoin-backed tokens work is simple. Holders of bitcoin just simply deposit their BTC in another controlled wallet address while simultaneously the token standard on whatever protocol mints a 1 for 1 bitcoin backed token. There are different nuances to this process but for the most part, they all essentially encapsulate the swapping of your bitcoins for a bitcoin-backed token that is compatible with the layer 1 protocol standard.
Let’s take the recently announced PolkaBTC by Polkadot and Interlay for example. A user transfers BTC to a vault of their choosing which then sends locked DOT collateral to an Interlay BTC Parachain. That will then send the user PolkaBTC. The redeem BTC process is just a mirror reflection.
(Figure 2) An overview of the issuance process for users to “swap” BTC for bitcoin-backed tokens on the Polkadot network.
In a way, bitcoin-backed tokens represent an accelerated way of interoperability between blockchains. It’s a streamline way of opening up the gateway for more use cases between protocols rather than being stuck in a silo effect. And with bitcoin being perhaps the most popular crypto, this reinforces its use cases outside of just holding bitcoin. In fact, Ethereum projects including WBTC and imBTC hold 70% more bitcoins than Lightning or Liquid. Lightning and Liquid also strive to galvanize the leading cryptocurrency’s utility, similar to the goals of tokenized bitcoin projects. But these protocols have a niche focus of improving the speed and privacy of small and large off-chain bitcoin transactions.
(Figure 3) The fortuitous growth of WBTC outpacing the bitcoin Lightning network over the past few months. The amount of value on the Lightning network has basically been flat compared to the exponential growth of bitcoin in WBTC.
But as innocent as this new use case has been for the blockchain and crypto community, there are implications to this that inadvertently could be divisive rather than innocuous. And it is never too early to postulate on what that might be. Below are some points that are worth to think about.
· Bitcoin being emblematic of real estate. People just wanting to hold bitcoin and use it on DeFi – I think one could state that the belief in Bitcoin is still prevalent as the asset of choice to have. As the mantra has been pervasively propagated to just HODL, as have our bitcoin holders have done. Just HODL. Because although Ethereum has been getting more of the attention in the past year due, bitcoin is still king in crypto. It’s been the first and most battle tested blockchain project to date. And don’t forget, it’s been the reason why all of us are here reading this today. Without Bitcoin, there will probably be either no blockchain industry or maybe even some other superior form of it might have spurred up. But who knows? It is worth nothing that our propensity of wanting to hold bitcoin and be used in other forms can be synonymously compared with real estate. We all want to own real estate in its essential nature of providing us a shelter but it’s also leveraged as an investment vehicle by taking out home equity loans (allowing us to be equipped with short term liquidity), investment real estate (renting it out to the market), house flipping, or even in niche cases where owning a home in a certain district will grant your children to attend a prestigious grade school. Owning a home satisfies our most basic of Maslow’s hierarchy of needs, but what we do with that home allows us to realize our self-fulfillment needs.
(Figure 4) A fundamental look at Satoshi’s hierarchy of needs.
Owning bitcoin also satisfies our most basic of needs (security and safety of our wealth), but being able to cross chain the asset onto other smart contract protocols for our yield farming orgasm satisfies our psychological and self-fulfillment needs. This all may be a bit exaggerated for the time being but the similarities are evident. As ubiquitous as real estate is, bitcoin can have the same roadmap.
· Ethereum expeditiously needing rollups. Let’s say in an extreme case where a significant amount of bitcoin gets “wrapped” and used on the Ethereum blockchain. This could accelerate Ethereum’s development of Ethereum 2.0, which as of this writing still has not been released yet. But from many Ethereum developers and Vitalik himself have pointed out, such increased on-chain activity could spur a need for the rollups scaling techniques to be used more pervasively. Currently there have been two types of rollup techniques proposed: zk-Rollups and Optimistic Rollups, with the former being the more preferred. Although this could be argued but zk-Rollups have been proven to be faster and cheaper than Optimistic Rollups and Plasma. On a public chain, a maximum of 15 TPS can be done. But according to Vitalik, added that with rollups, and Ethereum 1.0 as the data layer, the TPS will be reaching 2,000-3,000.
· Out with the old and in with the new. Eventually some of these users might just want to give up BTC and use ETH. Maybe a gradual realization to the increased utility of Ethereum might persuade some wrapped bitcoin users to just give up their BTC for ETH out of simplicity. They are already spending most of the time and usage on the Ethereum network anyways. This is a more of a far-fetched scenario. Persuading one that bitcoin is no longer the “it” crypto will take decades, probably centuries.
· Some of these bridges or centralized wrapped tokens becoming security threats. As useful and innovative one may think this is, there are security concerns to this. For example, Wrapped Bitcoin is realistically just holding the locked bitcoins of users in a centralized third-party custodian. So as secure and trustless bitcoin may be when you hold your own keys, the step of giving your bitcoins to a custodian for WBTC represents an unconscious centralized security threat while you farm those yams on Ethereum. The renBTC design uses smart contracts to lock Bitcoin, as opposed to trusted third-parties used by WBTC. In an actual case of these bitcoin-backed token models going awry, the folks at Thesis, which is the team behind tBTC had to stop their platform from taking in deposits after only a month from its launch date due to a bug in their code. Community contributors started noticing issues when tBTC’s Solidity code wasn’t able to differentiate between P2SH and P2PKH bitcoin addresses.
(Figure 5) A prime example of the technical risks of “wrapping bitcoin” that occurred with tBTC.
· Arbitrage trading between different bitcoin-backed tokens or even between Bitcoin itself. One could even envisage a scenario where new financial arbitrage occurs between bitcoin backed tokens and bitcoin itself leading to Bitcoin community members pitted against each other for extra margin. This could lead to a creation of more complex financial derivatives or trading pairs such as BTC/WBTC, BTC/renBTC, BTC/tzBTC, BTC/PolkaBTC, etc. As of this writing, EBTC (EOS BTC) is trading at $13,075 compared to bitcoin’s current price of $11,907. But this would not be something new as BTC arbitraging between different exchanges already exists.
· A substantial decrease in Bitcoin’s on-chain activity. What if activity dies down on the Bitcoin network, forcing bitcoin miners to take matters into their own hands? Banning transfers to those bitcoin addressees from those bitcoin-backed token projects? If a large significant amount of all bitcoins just eventually freeze for the sake of being wrapped up in other blockchain networks, what happens to the on-chain activity of Bitcoin? Decreased on-chain activity could to a decreased amount of tx fees to miners. It would be close to nothing to have a transaction validated on the Bitcoin network eventually. Dormant bitcoins isn’t something new as the network has seen this become more prevalent. Earlier this year, a report by Digital Asset Data shows that more than 10 million BTC have not moved for a whole year which represents about 60% of all bitcoins. This also could lead to the conversation of are on-chain tx a determinant of price or is price a determinant of on-chain transaction. Fellow Messari community analyst George Adams puts it best stating:
“I believe there's reflexivity between the two (positive feedback loop). For example- in Bitcoin, more on-chain volume = more demand for BTC, which increases price. And then a higher BTC price means more interest from people, which means more on-chain volume. So I think they feed each other.... although I don't have confidence in a first mover”
This question of who the first mover is as difficult as answering the age-old question of if the chicken or the egg came first. But based on what we know about finance and fundamental investing, the FUNDAMENTALS should be a driver of price (theoretically). Where in the case of Bitcoin, on-chain transactions should be the driver to its price. Many general crypto valuation frameworks would give a rebuttal on this stating that velocity is not necessarily always a driver of network value. But as all of them do agree on is that there are remedies to prevent a token suffering from the token velocity issue, and in bitcoin’s case, it’s the store of value factor. So then if take this thinking, then a decrease in on-chain tx should be a determinant of price and have a substantial impact on transaction fees paid to miners. So as a result, this could lead to the controversial hypothetical death spiral theory. For now, it’s statistically shown that on-chain tx has a significant correlation to that of the transaction fees collected by miners. And as we progress to the year of 2140, transaction fees will be the sole source of income for miners.
(Figure 6) After running a multiple regression on % change in on-chain tx and % change in price with % change of miner revenue from fees acting as the dependent variable (with 10 years of daily data), the p-value for % change in on-chain tx is way below the threshold rendering this as being more significant.
(Figure 7) With on-chain tx being statistically more determinant on % change in miner revenue from fees with a 1.19 coefficient, it’s also interesting to note that on a logarithmic scale, on-chain tx have been flat-lining for the past few years.
But let’s back this thinking up a bit. The relationship between on-chain tx and price, regardless if it is liner or non-linear, shouldn’t be too much taken for face value. As the real determinant should be positioned as, if bitcoin price markets are rational vs irrational, or another way of putting it: efficient vs inefficient.
This is all digressing a bit put I think you can see the implications of the initial innocuous effect of reducing on-chain transaction that could lead to a scenario where sustained low on-chain transaction start to effect network security.
The whole notion of being able to use your bitcoins on other blockchain protocols is unanimously supported. We are not trying to give warnings but rather highlight some of the caveats that could emerge down the line. A significant reduction in Bitcoin’s on-chain network activity could straddle the line between network security and usage. Perhaps prompting miners to proactively pull out or take a more drastic approach. But we also see this trend giving way to concomitants of how we use bitcoin. As pointed out earlier, we already see a trend in the amount of bitcoins traded on exchanges slowly pull out in this chart below.
(Figure 8) Through data pulled from Glassnode’s API, there has been a opposite trend of bitcoin’s price moving up while the number of BTC coins on exchanges taking a reverse dive down 10%.
Better yet this could be the point of when we crossover the chasm towards mass adoption. The numbers speak for itself as the TVL in DeFi smart contracts on Ethereum has just whiffed past the $6 billion mark as of the time of this writing. And bitcoin-backed tokens is one of the reasons for that.
- Justin Sun’s Twitter