DeFi Guides

To effectively understand what wrapped Bitcoin – or wBTC means – one must first have a grasp of what a wrapped token entails and how it works. To begin with, a wrapped token, based on various industry definitions, refers to a cryptocurrency that is pegged to the value of another crypto

Although a curious concept to some, the rationale behind this isn’t too far-fetched. There are various blockchains, and each one has its own native coin. In some circumstances, where interoperability is not achievable, a cryptocurrency belonging to one blockchain can be wrapped on another blockchain and used effectively within the other ecosystem. 

Basically, wrapped tokens are a means of bridging the gap between two or more different blockchains that do not support interoperability. So what does this means for wrapped BTC?

Overview

One thing that is peculiar to most traders is the frustration that comes with realising that you can’t use a certain cryptocurrency on a particular blockchain.

Perhaps you didn’t read much about it, and naturally just assumed it should be interoperable? For example, that you can transfer from one blockchain wallet to another. 

If you ever felt that way, then you are not alone. In most cases, people who are new to the crypto trading space encounter a similar experience when they try to use BTC on Ethereum. Bitcoin’s host blockchain is different from any other blockchain. Let’s use Ethereum as a case study – hence, transferring between the two different ecosystems is technically impossible.

That said, the only alternative to make use of BTC (a non-native asset) on Ethereum, for instance, is to employ the wrapped token approach. This further implies that an equivalent amount of BTC will be pegged to a unit of wrapped token on the said blockchain.

In this context, wrapped BTC (or wBTC) is pegged to the Ethereum blockchain native asset and is backed one-to-one by Bitcoin. This also means that wBTC is a version of Bitcoin but on the Ethereum blockchain. As such, while it has the shares the same value as regular Bitcoin, it is developed based on the ERC-20 token standard, allowing users to effectively utilise BTC on the Ethereum blockchain or a variety of decentralised applications (dApps) built on it.

How does wrapped BTC work?

Wrapped Bitcoin, as mentioned earlier, is an ERC-20 token that is pegged to an actual BTC on a 1:1 ratio. As such, it is created upon request for an Ethereum-based token from a merchant (dApps, for example) in exchange for a regular BTC.

Before we proceed, it is important to note that for a merchant to issue a wBTC, it requires a custodian – an entity that holds an equivalent amount of the asset as the wrapped amount. The custodian, in this case, acts as an intermediary or reservoir with whom funds are kept for safety and transparency purposes.

That said, upon receipt of the request, the merchant conducts a know your customer (KYC) and anti-money laundering (AML) process to authenticate your identity and initiate a transaction with a custodian after receiving the request. Currently, BitGo, an institutional asset platform acts as the custodian for wBTC.

Once the KYC and AML processes are completed, a BTC holder can subsequently proceed to swap or exchange BTC for wBTC using either a centralised exchange (CEX) or a decentralised exchange (DEX) via a peer-to-peer transaction. Either way, a BTC holder would be leaving the merchant with actual Bitcoin, in exchange for wBTC. 

Afterwards, a token holder can decide to use the wBTC on Ethereum-based dApps or perhaps stake it in any DeFi platforms such as Compound, and MakerDAO where it can generate yields over a period of time. 

If a holder wishes to exchange wBTC for actual BTC, the same procedure can be used. This time, however, the merchant sends the wBTC to the custodian in a burn request, and the BTC is released from the reserves.

Use cases

In addition to interoperability, there are numerous use cases for wBTC – some of which include yield farming – where a trader stakes or locks up an amount of wBTC for a period of time after which a ROI is awarded.

Another use case for wBTC is collateralisation, which is a situation when a borrower utilises wBTC as a pledge for loan repayment when taking out a cryptocurrency loan on DeFi platforms. The collateral, in the form of wBTC, is repaid upon repayment of the crypto borrowed. However, in the event that the collateral is liquidated, the wBTC is recouped by the platform.

Furthermore, both centralised and decentralised exchanges can benefit from wBTC’s increased liquidity and capital efficiency. The ability to wrap idle assets and use them on a different chain can help to connect otherwise separate liquidity sources.

Ultimately, wBTC enables the expansion of liquidity pooling on the Ethereum blockchain for decentralised exchanges (DEXs) and other DeFi applications.

Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.