Bitcoin on Ethereum? Real world assets on blockchains? Lets see how this is accomplished.
If you’ve spent some time peering at prices on CoinMarketCap or CoinGecko, you have probably come across a token on there called WBTC and noticed it’s priced the same as bitcoin, yet the market cap is very different. If you are unsure of what wBTC is you may be new to the space or just never got around to looking into it, but today we’ll discuss what is a wrapped token and or asset, how its created, how/why it keeps value, and finally discuss one major risk of holding wrapped tokens.
What is a Wrapped Token?
Wrapped tokens can represent many different assets and be utilized on many chains, but for the sake of this article, we will focus on wrapping Bitcoin to be used on Ethereum mainnet.
Wrapped tokens are tokens minted on chain to represent an asset that may not natively live on that chain, or even an asset not related to crypto. Simply put, there are no actual Bitcoin on the Ethereum chain, and they can not be sent there either. However, by creating a wrapped token (wBTC) we can use the value of the underlying Bitcoin within the Ethereum ecosystem. To be utilized by smart contracts, you need some type of ERC token. WBTC is just an ERC-20 token, where 1 token is minted to represent 1 Bitcoin, and the price of the wBTC should mirror that of Bitcoin. This is similar to the early days of the monetary system in the U.S. where paper dollars represented gold in reserves, as it was easier to exchange denominated paper instead of weighing gold. In this case wBTC would be the paper dollars and Bitcoin would be the gold.
Why does this exist? Why would you want a token on one chain that represents a coin from another chain or any real world asset? In short the answer is interoperability. Wrapped Bitcoin was created to take advantage of Bitcoin’s liquidity and bring it onto Ethereum. With the number of use cases growing and decentralized applications being created, if a user wanted to make use of their Bitcoin’s value, as collateral for example, this would allow them to do so on the Ethereum chain. With wBTC, users could take advantage of their bitcoins value while still having exposure to the asset itself. This also allows users on Ethereum to technically buy and hold Bitcoin without having to use any other chain to do so. We are also seeing this done with other real world assets such as gold. Paxos has created the PAXG token, which tokenizes gold onto the blockchain where 1 PAXG token represents 1 troy ounce of real gold.
Mechanics of WBTC
You can’t just create a token — say it represents something else and call it a day, it would quickly make its way to zero if it didn’t already start there. So what are the mechanisms in place to ensure one wBTC always represents one Bitcoin, and how does it keep it’s value?
This is where the ‘Merchants’ and ‘Custodians’ come in to the picture. The merchants are the front facing entity that interacts with the end users, and the custodians hold the underlying asset that the wrapped tokens represent, as well as the responsibility of minting and burning of the wrapped tokens.
If a user wants 1 wBTC, they would initiate this transaction with the merchant and it would look something like the following.
- The user sends 1 bitcoin to the merchant on the bitcoin blockchain.
- The merchant then sends the bitcoin to the custodian.
- The custodian puts the bitcoin into storage.
- The custodian then mints 1 wBTC on the Ethereum blockchain.
- The custodian sends the wBTC to the merchant.
- The merchant then sends the wBTC to the requesting users Ethereum address, thus completing the transaction.
The reverse of this would look very similar, with the user interacting with a merchant and sending 1 wBTC, but instead of storing wBTC the custodian would burn (destroy) the wBTC tokens and remove the equivalent amount of BTC from their storage.
Here we see why the wBTC token holds its value and mirrors the price of Bitcoin. 1 wBTC at any time should and can be used to redeem the underlying asset if the user wishes to do so. It is the custodians responsibility to hold the Bitcoin and mint the wBTC tokens, ensuring that there is always enough Bitcoin in storage for the amount of issued wBTC tokens. Any variation in this would greatly effect the price of wBTC and more than likely people’s ‘trust’ in the product. In a system where people are the custodians of their own funds, wrapped tokens are one aspect where you must trust the custodians in order to use the tokens, leading us into the last section of this article.
The Major Risk of Wrapped Tokens
Custodians do represent a weak link in the chain, and therefore carry some amount of the risk. We must put all our faith into these organizations to be good actors and take all necessary steps to ensure the security of the underlying assets. If they were to somehow mismanage or run off with the funds, the tokens representing these assets would quickly drop in value.
In the case of wBTC, it is a joint venture between BitGo (custodian), Kyber Network (merchant), and Ren formerly known as Republic Protocol. Since the creation of wrapped bitcoin in October of 2018, it has been operating smoothly without any major issues or hiccups, which has instilled confidence within the crypto community, that these organizations will continue to be good actors within the space. Everything this group does in relation to wBTC can be verified on chain, and they do a great job of making this information readily available and easy to find on their website at wbtc.network. You can view the order book in relation to burning and minting of wBTC, their proof of reserves where you can see how many Bitcoin BitGo currently holds, as well as a list of partners so you can be sure you are transacting safely with a real merchant if you choose to mint wBTC using your own Bitcoin.
Lets take a quick look at an example of what could happen if the custodian was not so transparent and turned out to be a bad actor. With the rise in popularity of Solana, it only made sense that users there should want to utilize the value of their Bitcoin on that chain as well. So when it comes time to have a custodian for the Bitcoin, who at the time would have seemed to be a better / safer choice than FTX, with Sam Bankman-Fried being a major supporter of the Solana ecosystem. With the funds and coins at FTX being mismanaged, used, and or lost, it was clear that the Bitcoin backing the $SOBTC were no longer accessible or in FTX’s possession. With this news the price of the SOBTC token acted accordingly, and if you were the last to find out, your SOBTC tokens were now worth a fraction of Bitcoin’s value.
Along with crypto has come great innovation, but with the speed of innovation and the desire to be first to market, certain trade offs have been made to achieve this. Here the trade off was the trustless nature of crypto must be removed and you must put your trust into these organizations behind the product. Could this same concept be done in a decentralized manner through smart contracts — possibly yes. It may even exist at some scale and I have not come across it yet. But as we have seen, contract risk continues to be a huge barrier to many of these protocols as exploits and hacks continue to occur. And at the time of writing, BitGo currently holds 153,164 (~$3.7B) Bitcoin.
Hopefully, dear reader, you now have to tools to understand the risk and reward of wrapped assets. As blockchains permeate more aspects of our lives the opportunity to bring off chain assets on chain will only grow. Remember to always educate yourself to the best of your ability on these assets. With great power, and all that jazz!
Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions. As always, please do your own research. This is not financial advice. Every strategy is not for everyone. Each investor needs to understand what is right for them.
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