25th December 2022 > > Wrapping and decentralisation.

tl;dr

The wrapping process can give us some insights into how the relationship between the centralised world and the decentralised world may develop over time.

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That is five consecutive days for no change in the price of BTC which has surely never happened before.

Curious Cryptos’ Commentary — Wrapped coins and the decentralisation debate

Wrapped coins first started appearing in 2019 with the launch of wBTC (wrapped BTC) jointly created by Bitgo, Kyber, and Ren.

The BTC blockchain and the ETH blockchain have different protocols and functionalities. They cannot talk to one another. Sending BTC to an ETH address, or vice versa, will either fail, or will result in the loss of your coins.

With the growth of DeFi (decentralised finance) and opportunities to earn passive income largely confined to ETH rather than BTC (though there are some exceptions) the limitations of this non-interoperability are made plain. BTC holders are denied such opportunities, and the ETH network is denied the liquidity and scale of the BTC network.

These limitations made necessary the invention of wBTC – a coin that represents the value of BTC that can transact on the ETH blockchain.

A simple enough concept in hindsight with elegance built into its construction.

A user will deposit BTC and in exchange receive the exact same amount of wBTC. At any point in time wBTC can be redeemed (“burnt”) in exchange for the exact same amount of BTC. Assuming the pool of wBTC is collateralised 100% with BTC, arbitrage opportunities ensure that the value of wBTC will be the same as BTC, with very minor fluctuations reflecting arbitrage transaction costs, and timing.

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wBTC was created with a centralised custodian of the collateral.

That sentence makes crypto maximalists bristle, but they are of a sensitive nature. Purity trumps practicality for a maximalist, but I prefer to live in the real world. The irony is that the end goal of maximalists – an entirely decentralised world – cannot be achieved without compromise as the purist approach prevents wholesale adoption, leaving cryptos as a niche technology. But the compromise required to achieve maximalists’ aims embeds and guarantees that the centralised and decentralised worlds exist alongside each other, complementing each other, and enhancing each other’s positives.

In the case of wBTC, trusted organisations, of which Bitgo is one, hold custody of the BTC deposited in exchange for wBTC. On redemption, Bitgo must approve the redemption once the wBTC has been returned and burnt.

This process has been working very well except for one recent incident. And it will come as no surprise to regular readers that this hitch involved the fraudulent centralised cryptocurrency exchange FTX.

Just two days before FTX filed for bankruptcy an individual at FTX sent 3,000 wBTC (worth approximately $55mm at time) for redemption. Those coins were burnt but Bitgo refused to release the BTC as the individual at FTX was not known to them.

At this stage, it is not just crypto-maximalists who are bristling, but me too. The minting and burning process is executed using smart contracts. I understand why this first iteration of wrapped coins decided the path to quickest adoption involved centralised custody, with audits and insurance to prove the collateralisation ratio is 100%, but to add in an extra layer of centralised approval doesn’t sit right.

The result is that 3,000 wBTC have been burnt and 3,000 BTC have not been returned. wBTC is now overcollateralised, and FTX creditors must prove ownership of those BTC.

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XRP (Ripple) – currently at the centre of the SEC’s (Securities and Exchange Commission) regulatory land grab – also boasts its own wrapped coin, wXRP for use on blockchains other than the native one.

TokenSoft provided a wrapping service for several coins including XRP to transaction on the ETH blockchain (https://wrapped.com/).

Again the minting and burning process takes place using smart contracts, and again there is a centralised custodian, Hex Trust, to ensure 100% collateralisation of all wrapped coins. To the best of my knowledge, there is no additional approval process as we saw with wBTC and Bitgo.

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One example of a fully decentralised wrapped coin is WETH (wrapped ETH)

The reason for WETH will come as a surprise to most of us.

Though the ERC-20 standard (used by hundreds of thousands of coins) is built on top of the ETH blockchain, ETH is incompatible with it.

To exchange ETH for an ERC-20 token requires ETH to be deposited and WETH to be minted.

To interact with many Ethereum based dApps (decentralised applications) requires ETH to be deposited and WETH to be minted.

This process is fully decentralised, using only smart contracts, with no centralised input into the process at all. WETH is simply the ERC-20 compatible version of ETH.