Bitcoin remains crypto’s most valuable asset, but we didn’t build its infrastructure for today’s fast-moving decentralized finance (DeFi) landscape. Just as gold certificates revolutionized commerce by making gold’s value easily transferable without moving physical bars, wrapped Bitcoin tokens do the same for the digital age—allowing Bitcoin’s massive value to flow freely through modern decentralized applications.
In this article, you’ll learn how wrapped Bitcoin works, why Coinbase launched its own cbBTC token, and how it compares with the established wBTC token.
How Wrapped Bitcoin Works
Wrapping a token involves locking a cryptocurrency in a smart contract and issuing a new token (the wrapped token) on a different blockchain to represent the original token. The goal is cross-chain compatibility, enabling customers to freely trade or transfer their assets on one chain while the underlying token remains locked on another.
You can think of wrapped Bitcoin as a secure storage service. When you wrap your Bitcoin, you’re essentially putting it into a highly secure digital vault (smart contract) and receiving a claim ticket (the wrapped token) that you can use elsewhere. You can always redeem this claim ticket for your original Bitcoin—and it’s much more versatile.
Some common use cases include:
- DeFi Participation. Platforms like Aave or Compound enable anyone to earn passive income. By wrapping Bitcoin, you can earn income using these DeFi platforms without selling your original Bitcoin.
- Faster Transactions. Thanks to its proof-of-stake mechanism, Ethereum transactions are much faster and cheaper than Bitcoin ones. So, if you’re transacting, wrapped Bitcoin can make transactions quicker and more affordable.
- Smart Contracts. Smart contracts power everything from DeFi platforms (mentioned earlier) to Web3 applications. You can participate in these smart contract-driven technologies by wrapping Bitcoins without selling your Bitcoin.
Of course, wrapped Bitcoin isn’t the only way to port Bitcoin to different blockchains. Cross-chain bridges are more popular since trading wrapped tokens in one place is easier than wrapping individual cryptocurrencies. However, numerous instances of bridge hacks have resulted in losses for their users.
Coinbase Launches the cbBTC Token
Coinbase, one of the world’s most established centralized crypto exchanges, has been at the forefront of innovation. Its new Coinbase Wrapped BTC, better known as cbBTC, is an ERC20 token that’s backed 1:1 with Bitcoin (BTC) held in custody. As an ERC20 token, cbBTC is fully transferable to Ethereum—and soon other compatible blockchains.
Currently, cbBTC is only available to Coinbase customers with an account in good standing and located in the U.S. (excluding New York State), UK, EEA states (excluding Germany), Australia, and Brazil. If you have a Coinbase account, you can purchase cbBTC through Coinbase Wallet or another third-party exchange supporting it.
Despite a positive reception overall, some users expressed concern over the new token’s terms of service. In particular, some suggested that Coinbase would not fully reimburse clients in the event of malicious activity or unforeseen events resulting in the loss of Bitcoin—they would only receive a proportional share of what Bitcoin remains.
Coinbase’s Chief Legal Officer, Paul Grewal, responded to these concerns, saying that Coinbase is committed to reimbursing clients for any Bitcoin lost due to malicious activity or unforeseen events. However, it would not cover any additional fees or losses from a loan liquidation or other adverse event related to the cbBTC transaction.
Ultimately, Coinbase’s legitimacy in the eyes of users and regulators could make cbBTC a popular way to use Bitcoin assets across different blockchains. The move could also pave the way for Bitcoin users to generate yield across other parts of the Coinbase ecosystem while managing their portfolio and taxes in one location.
Comparing wBTC vs. cbBTC Tokens
The first wrapped Bitcoin product, wBTC, was launched in 2019 and has over 280,000 tokens in circulation. Major DeFi players, including BitGo, Ren, Dharma, Kyber, Compound, MakerDAO, and Set Protocol, developed the token to bring more liquidity into the Ethereum network by dipping into the much deeper Bitcoin market.
Earlier this month, BitGo established a controversial joint venture with BiT Global, a Hong Kong-registered custody platform partially owned by Tron and its founder, Justin Sun. Last year, the SEC charged Sun and three of his companies for conducting an unregistered securities offering and fraudulently manipulating the secondary markets.
While an SEC indictment isn’t necessarily indicative of malicious behavior in the crypto space, the commission alleged that Sun directed employees to engage in more than 600,000 wash sales to create the appearance of trading activity. Then, as prices started to rise, he allegedly sold more than $30 million tokens to cash in on the activity.
Sun attempted to deflect these concerns, saying he’s merely a strategic investor in the new joint venture. Moreover, wBTC undergoes regular audits and publishes all on-chain transactions and verifications for the Bitcoin and Ethereum networks. This enables users to verify transactions independently and quickly surface any fraud.
And thus far, the reaction to the announcement has been muted. Under the new joint venture, no technical changes will occur to wBTC, and all data about underlying reserves will remain verifiable on-chain. Meanwhile, on-chain data shows no meaningful change in the supply of wBTC, suggesting traders aren’t quickly heading to the exits.
Don’t Forget About Tax Implications
Wrapped tokens are one of the most ambiguous parts of the IRS tax code. That’s because it’s unclear whether wrapping a token constitutes a “sale” of the original token, which would make the proceeds subject to capital gains taxes.
The conservative approach treats wrapping as a crypto-to-crypto swap and reports a capital gain or loss depending on how the price has changed since you initially acquired it. If you take this approach, you can also deduct any gas or transaction fees from your gross proceeds to arrive at your net taxable capital gain or loss.
The more aggressive approach treats wrapping a token as the equivalent of holding the same asset, which would not trigger a taxable event (and gas/transaction fees are not write-offs). Of course, if you take this approach and the IRS provides contradicting guidance, you could be on the hook for backed taxes and potential penalties.
ZenLedger makes it easy to aggregate transactions across different wallets and exchanges so you can accurately compute your cost basis. Source: ZenLedger
ZenLedger can help automate these concerns by connecting with your wallets and exchanges, aggregating your transactions, and computing your capital gains or losses. You don’t have to worry about maintaining your own records or spreadsheets, and you’ll always have a comprehensive record backing the taxes you pay.
The Bottom Line
While wrapped Bitcoin products like cbBTC and wBTC offer exciting possibilities for Bitcoin holders to participate in DeFi, you should carefully consider the risks and tradeoffs. Coinbase’s entry into the wrapped Bitcoin market offers a centralized alternative to wBTC’s largely decentralized approach—for better or worse.
If you trade crypto assets, ZenLedger can help you stay organized for tax season. Our platform automatically determines how much you owe (or can deduct) by connecting with your wallets and exchanges and matching up transactions. Using our analysis tools, you can also identify ways to save with tax loss harvesting.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.
