Why Bitcoin on Ethereum is just getting started

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, Author: Xiaopang waiting for the wind.

Since its inception 11 years ago, Bitcoin's use cases, and descriptions of it, have changed dramatically, from peer-to-peer cash, anonymous darknet currency, digital gold, and more. Throughout its journey, one core part has arguably not changed: its approach to decentralized finance. As mentioned by Satoshi Nakamoto in his introduction to the original Bitcoin white paper.

The white paper goes on to propose a decentralized electronic transaction system, introducing the concept of blockchain and proof of work. While Bitcoin has made significant progress since then, it has still failed to gain traction as a trustless instrument for financial services. This is evidenced by a University of Zurich research report showing the low adoption and high concentration of the Lightning Network, where 10% of nodes hold 80% of Bitcoin. Likewise, the decline in Tether (USDT) transactions and supply on Bitcoin’s Omni layer highlights possible issues with conducting financial services on the Bitcoin blockchain. This is not to disparage Bitcoin (I personally believe that Bitcoin has high potential as a store of value), but just to emphasize that there are opportunities to extend its strong decentralization and security beyond current use cases.

At the same time, Ethereum and other smart contract protocols developed an ecosystem around the concept of programmable money. Inspired by the fundamentalist spirit of Bitcoin, a new wave of decentralized services is taking Bitcoin one step closer to disrupting financial services. Ethereum is open source and permissionless, allowing the decentralized application ecosystem to thrive. Although the term DeFi may be relatively new, I think the space is dominated by cryptocurrencies and would not be possible without Bitcoin. As these protocols reshape finance, Bitcoin's role in them has the potential to evolve in a symbiotic relationship, driving crypto forward.

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Bitcoin's Journey on Ethereum Begins with Incentives

Since Bitcoin cannot be easily moved across chains, a tokenized version of Bitcoin is available on the Ethereum blockchain. The price of these ERC-20s is pegged 1:1 to the price of an equivalent amount of Bitcoin. The first recognized Bitcoin ERC-20 to launch was wBTC, released in January 2019. wBTC is led by the Circle consortium similar to USDC. While using wBTC does require trusting the custodian of the token, trustless alternatives are emerging and growing rapidly, such as renBTC and tBTC.

At the start of 2020, wBTC’s market capitalization was less than $5 million despite being a year old. The low adoption rate in the first year may be due to the lack of integration and features, so there was no clear advantage over Bitcoin at that time. This is starting to change as DeFi protocols integrate tokenized Bitcoin ERC-20 and provide user services on top of it. MakerDAO accepted wBTC as collateral for DAI loans in May, a breakthrough for bitcoin on ethereum as several protocols began offering financial services on tokenized bitcoin. These integrations are mutually beneficial as they increase the liquidity of DeFi protocols while locking the supply of Bitcoin.

It’s important to note, though, that tokenized bitcoin deposits are growing faster than stablecoins stored in Curve. As a result of this move and other similar incentives, the amount of tokenized bitcoin locked on Ethereum has reached $800 million, or about 0.38% of the circulating supply.

While the sustainability of 50%+ APY on Curve tokenized Bitcoin is debatable, the protocol has managed to generate a positive feedback loop. The first is rewards for users who provide liquidity to utilize CRV for liquidity mining, which increases the value locked in Curve. By doing so, the underlying value accumulated by CRV governance tokens increases, thereby incentivizing more liquidity to be provided. Plus, in theory, this drives demand for assets that earn that yield. Bitcoin should therefore benefit as investors chasing these returns also lock up their tokenized Bitcoin, making it less likely to be sold.

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Scaling Tokenized Bitcoin Beyond Whales and Early Adopters

By analyzing key on-chain metrics from IntoTheBlock, we can determine that the growth of tokenized Bitcoin is largely driven by whales and institutional investors. This is reflected in the average balances of wBTC and renBTC holders reaching $95,000 and $217,000, respectively.

Given that users have to pay high gas fees to tokenize and deposit Bitcoin into DeFi protocols, it is not surprising that it is generally adopted by large players. This is partly because the total number of addresses holding these tokens has not grown significantly, with only 4,600 and 750 addresses holding wBTC and renBTC, respectively. Another potential reason is that, aside from early adopters, the average retail user typically takes longer to trust and learn how to use these yield-generating Bitcoin alternatives.

As the cryptocurrency space increasingly shifts its focus to high-yield opportunities, I suspect a significant portion of Bitcoin traders will join the trend. By looking at the Hodlers metric, we can observe that more than 20.69 million addresses have held a total of 11.7 million bitcoins over a period of more than a year. Since interest-bearing DeFi and CeFi solutions are still relatively new technologies, it is unlikely that most of these products will be profitable.

This suggests that nearly two-thirds of all Bitcoin holders in circulating supply have not traded for a year. I expect this number to decrease as more and more long-term token holders are attracted by the high yields of DeFi. Of course, there are risks and learning curves associated with these protocols, so I predict that most Bitcoin users will hang around for the next few years. However, this could be a multi-year trend as the industry and its use cases for Bitcoin evolve.

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Final Thoughts on Future Trends

In addition to existing DeFi protocols, given the rapid pace of innovation, the demand for tokenized Bitcoin in the next decade may come from projects that do not yet exist. Due to the permissionless nature of DeFi, it will be easier for the protocol to provide financial services that support Bitcoin ERC-20. At the same time, however, the risks of using Bitcoin on Ethereum may increase in the short term, especially if the protocol continues to deploy unaudited smart contracts that can attract millions overnight. Unfortunately, I am inclined to believe that sooner or later a hacker will exploit the access vulnerability of tokenized bitcoins, which may stall its progress for at least a few months.