Bitcoin Pegged Tokens: Satisfying Extreme Demand with Varying Tradeoffs

Written by BTSE

May 29, 2020

Bitcoin Pegged Tokens: Satisfying Extreme Demand with Varying Tradeoffs

In recent years, the idea of scaling Bitcoin via sidechains has gained a lot of community traction. After it was established that the block size would remain small to preserve decentralization and also support the development of a fee market for miners, various solutions emerged.

From Blockstream’s 2014 Bitcoin pegged sidechain research paper we got the Liquid Network. Ethereum developers have also tried to integrate digital gold transactions through pegged ERC-20 tokens. WBTC and tBTC are prime examples of this experiment. Furthermore, since “Ethereum killers” must keep up with the trends at all costs, Tezos developers have created tzBTC.

Now just because all of these projects serve a similar purpose doesn’t mean that they’re equivalent. Each of them comes with security, speed, and privacy tradeoffs. It should be established right from the start that none of these Bitcoin off-chain scaling solutions are as secure as base-layer transactions. The reason why Liquid, WBTC, tBTC, and tzBTC exist mostly concerns speed, privacy, and lower fees.

Conversely, just because no pegged bitcoin token is as secure as the Bitcoin network itself doesn’t mean that we should ignore the security argument altogether. Some projects are more secure and decentralized than others, while some exist only for convenience or bragging rights.

 

How do pegged bitcoin tokens work?

In plain language, real bitcoin gets time-locked on the base layer so equivalent assets can get issued or unlocked on another blockchain. This way, the base layer amounts can be moved faster, at lower costs, and sometimes more privately. As soon as these requirements are no longer required, the tokens are locked or burned and the base layer bitcoin is transferred to their rightful owners.

Think of it as if bitcoin were gold bars and pegged tokens are issued banknotes. In our open-source world, each bank tries to be competitive by creating a system that involves less trust in human action and more “code is law”. The value and quantities are transferred between chains on a 1 to 1 ratio, and the final settlement takes into consideration all the off-chain transactions. This allows the new owners to receive their corresponding amounts.

Pegged tokens do involve on-chain transactions that are sometimes considered slow and costly, but instead of doing a new base layer transaction for each amount of bitcoin you send, you move those operations to a quicker (albeit lesser secure) and more affordable blockchain. It’s all part of a scaling solution that preserves Bitcoin’s decentralization by allowing the blocks to remain small. This is also more private than on-chain transactions, as it takes a lot more time and resources to track operations across multiple chains.

 

The Liquid sidechain and L-BTC

Created by Blockstream, the Liquid Network functions as a federated sidechain which makes transactions faster, more affordable, and more private. Unlike every other pegged bitcoin token solution, Liquid was tailored for Bitcoin and takes into consideration all security aspects to maintain the base layer’s characteristics. In comparison, other solutions presented in this article are Jacks of all trades that were created with general-purpose standards. It can therefore be argued that Liquid has a smaller attack surface thanks to its specialization, and therefore contains fewer potential attack vectors than the ERC-20 projects.

The Liquid sidechain is clearly less secure than the Bitcoin main chain. This is why a peg-in (moving your bitcoin to the sidechain) requires 102 network confirmations – so both the Bitcoin miners and the Liquid functionaries get in sync and the amounts get “transferred” without any issues. This extra precaution exists specifically to avoid incidents and is established in the cautious and conservative spirit of Bitcoin.

L-BTC is quicker, more private, and cheaper to transact. The block time on the Liquid Network is 1 minute, and after only 2 confirmations any transaction is considered final. In comparison, the base layer issues new blocks approximately every 10 minutes and requires at least 6 confirmations to make a transaction irreversible. Liquid’s quickness is enabled by the decentralization tradeoff – a consortium of exchanges is not as permissionless, decentralized, and ultimately secure as the Bitcoin network. However, for the purposes of L-BTC transactions, it doesn’t have to be.

L-BTC is accepted across many exchanges among which one can find BTSE (whose co-founder and CPO Brian Wong is a member of the Oversight Board), Bitfinex, Bull Bitcoin, and HodlHodl. Thanks to Confidential Transactions, the amounts being traded on the Liquid sidechain remain secret to the eyes of outside observers. By the time a peg-out happens (the switch from L-BTC to BTC, which usually takes around 17 minutes), the degree of obfuscation will be so great that blockchain analysis companies will have a hard time figuring out what happened and why some amounts were transferred to other Bitcoin addresses.

Liquid Network is primarily designed to serve traders and exchanges. Since their settlements usually clog the blockchain, it is better for them to make their transactions on another network which also grants them more confidentiality. Liquid Network is not permissionless, it is centralized in the hands of a 2/3 majority of its functions, and is not governed by a DAO (Decentralized Autonomous Organization). For what it aims to do, it’s pretty good.

 

WBTC on Ethereum

The Ethereum blockchain is complex enough to enable advanced smart contract features and tokenization. Yet history teaches us that the security of the system is lower and there is a lot more trust involved in network operators. Also, ERC-20 tokens and their subsequent contracts can sometimes be buggy.

In spite of all this, Wrapped Bitcoin (WBTC) is still interesting. It’s supported by exchanges such as HitBTC and IDEX, custodian solution providers like BitGo, plus many other Ethereum applications and services. Basically, WBTC exists to make bitcoin transactions faster and more affordable. However, it’s up to the Ethereum blockchain to provide speed and cost efficiency. So if the ETH network is congested, then delays and price increases may occur – negating the purpose it was specifically created for.

WBTC is possibly the worst solution for privacy. It was created for the same purpose of moving bitcoin between exchanges as Liquid Network was, but happens to require KYC/AML procedures for identity verification. Users, regardless of their status, must transact WBTC without anonymity. If they happen to receive some WBTC but refuse to undergo the KYC/AML process, they will end up holding an asset that they can’t burn to retrieve on the Bitcoin blockchain.

In comparison, only Liquid functionaries must identify themselves – joining the network to trade is pseudonymous and permissionless to the extent that federation members don’t blacklist your address and your coins don’t carry the kind of taint that makes them undesirable. WBTC requires full compliance with identity verification procedures, which might be a complete turnoff for some users.

WBTC tokens are minted by custodians under the clauses of a smart contract and later burnt by merchant addresses to allow the coins to become unlocked on Bitcoin’s blockchain. It’s basically an interoperability protocol that brings relative improvements in costs and scalability but also enforces KYC/AML on the coins going through the peg-in and peg-out process.

 

tBTC on Ethereum

In its whitepaper, tBTC acknowledges the projects that came before it (Liquid and WBTC), and then proceeds to make a bold statement about trying to create a truly automated and decentralized cross-chain peg for Bitcoin.

Like WBTC, tBTC is an ERC20 token, but unlike it, the design doesn’t rely on a consortium of entities and decides to pursue decentralization. This means that the underlying structure is a lot more complex and involves other Ethereum-only features such as the DAI stablecoin, MakerDAO, Keep, Summa, and Compound.

The purpose of tBTC is also more financial. On the official website, the three steps involved are the initial BTC deposit, the minting of tBTC, and the financialization of the ERC20 tokens via lending and earning interest. Therefore, it’s safe to say that tBTC is part of the ambitions of the DeFi (decentralized finance) movement.

If you think that tBTC is simple and straightforward then you should know that the whitepaper describes a multi-wallet architecture with lots of signers who are distributed across many geographic points, so that single points of failure can be eliminated. The design is over-financialized to the extent that incentives are determined according to rewards or penalties.

tBTC is a complicated protocol, to say the least. It aims to accomplish something truly ambitious, yet is built on top of a network that isn’t as decentralized or censorship-resistant as Bitcoin (which may defeat the purpose of such an invention). Also, the initial launch in mid-May 2020 resulted in a soon and unexpected shutdown that was caused by technical problems. So it’s going to take a while until the financial mechanisms can be successfully applied to the tokenized bitcoin according to the self-imposed standards of decentralization.

 

tzBTC on Tezos

Tezos is a Proof of Stake network which aims to compete with Ethereum in the field of enabling smart contracts and decentralized applications. Given the rivalry between the two protocols, tzBTC was released as a bona fide clone of WBTC. tzBTC is still in its infancy, as it appears that one BTC address provides the entire liquidity of 357.94 bitcoin (at least as of May 29th, 2020).

As a network, tzBTC operates under the same “initialize, mint, and burn” procedures as WBTC on Ethereum. To eliminate single points of failure, the system has Keyholders (the ones who mint and burn the tzBTC), gatekeepers (the ones who watch over the network to see if the rules are being respected), and regular users. There is also an “Association” which oversees the operations and published quarterly reports on the status of tzBTC.

Just like WBTC, tzBTC complies with KYC/AML procedures, therefore it’s pretty terrible for privacy. With that said, as is the case with Ethereum, transactions are expected to propagate across the network faster and require lower fees.

Ultimately, tzBTC exists for two purposes: to bring more liquidity to the Tezos blockchain by issuing an asset that is pegged to the most credible form of digital money, and compete with Ethereum. It is clearly inferior in scope and implementation to the Liquid Network and has yet to catch up with the liquidity of WBTC. As for tBTC, it’s still in a league of its own and it’s going to be interesting to observe if it manages to reach its goals without compromising on decentralization.

 


Our aim is to create a platform that offers users the most enjoyable trading experience. If you have any feedback, please reach out to us at feedback@btse.com or on Twitter @BTSE_Official.

Note: BTSE Blog contents are intended solely to provide varying insights and perspectives. Unless otherwise noted, they do not represent the views of BTSE and should in no way be treated as investment advice. Markets are volatile, and trading brings rewards and risks. Trade with caution.

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