Advantages and Disadvantages of Wrapped Assets.
When we talk about the present state of the decentralized finance (DeFi) industry, we cannot ignore the topic of wrapped assets. Even before the creation of one of the most famous of these cryptocurrencies, the Wrapped Bitcoin (wBTC) designed by MakerDAO, wrapped assets have been quickly gaining notoriety. Over time, as these wrapped assets have grown in popularity and proven themselves through a multitude of use cases, they have gained more and more trust. However, even many cryptocurrency users are still skeptical about wrapped assets and have many lingering questions on the topic.
Therefore, in this article, we will clarify what wrapped assets are and discuss the advantages and disadvantages of these cryptocurrencies.
So, what are wrapped assets?
To explain in simple terms what wrapped assets are, we will use the prime example of wrapped Bitcoin (wBTC). A wide range of other wrapped assets exist, but wBTC is by far the most commonly held and used.
Almost everyone in the crypto sphere holds Bitcoin (BTC); this cryptocurrency makes up 57% of all crypto assets according to CoinMarketCap. Bitcoin’s liquidity, brand awareness, and user base are leagues ahead of other cryptocurrencies.
However, there is a problem with this asset:
The Bitcoin protocol cannot keep up with the new developments associated with decentralized finance (DeFi), which is simply the creation and use of financial tools that operate along the blockchain. The Bitcoin protocol has no Turing-completeness, meaning that it cannot take and run any program and output the program’s calculation or answer. Therefore, it is impossible to create and run the smart contracts needed for DeFi projects along the Bitcoin blockchain.
Ethereum, on the other hand, is Turing-complete and has a rich, intelligent smart contract ecosystem. Thus, the Ethereum blockchain is a compatible basis for DeFi products (called decentralized applications, or DApps). In fact, Ethereum is the primary blockchain used for this purpose.
The disadvantage of the Ethereum blockchain is that it limits its users to Ethereum-based assets, such as tokens designed using the ERC-20 token standard. This puts an upper limit on the growth of the DeFi industry as a whole.
This is where Wrapped Bitcoin (wBTC) comes in. This cryptocurrency is an excellent bridge between Bitcoin and the Ethereum-based DApps that dominate the DeFi field. wBTC is an ERC-20 token operating on the Ethereum network. This token is “wrapped on” BTC, meaning it is backed by BTC. Specifically, every existing wBTC is secured in a 1:1 ratio to Bitcoin, which is stored in the depot of the platform that is wrapping the coins.
As mentioned, many other wrapped assets exist in addition to wBTC. These include other ERC-20 tokens that are wrapped on Bitcoin as well as ERC-20 tokens that are wrapped on other cryptocurrencies. All of these wrapped assets are created and implemented in a similar manner to that of wBTC.
What are the advantages of wrapped assets?
Wrapped assets standardize Bitcoin and other coins to the ERC-20 format reliably, transparently, and in a manner that backs the new wrapped asset by the original asset in a 1:1 ratio, which is similar to USDC, PAX, and other reserve-backed stablecoins. The resulting wrapped assets can be used in any Ethereum smart contract, meaning they are able to be used in DApps. wBTC in particular brings the power and trust associated with BTC into the DeFi industry, enabling BTC’s deep liquidity and large volumes to be injected into DApps.
Therefore, token wrapping enables holders of assets that are otherwise incompatible with DApps to invest them profitably in these projects. For example, in DeFi protocols such as MakerDAO, Compound, or Set Protocol, wBTC is already accepted.
As a result of token wrapping, there is an ample supply of tokens suitable for DeFi uses, so the addressable market is expanding rapidly.
This certainly sounds like a win-win situation.
What are the disadvantages of wrapped assets?
There is only one largely recognized disadvantage of wrapped assets. However, it is quite a substantial limitation; the safekeeping of the deposited wrapped assets is currently worrisome.
As recently pointed out by the inventor of Ethereum, Vitalik Buterin, the trustworthiness of many of the coins offered in exchange for wrapped versions is questionable. He explains that many of the issued tokens are sensitive to centralization because they depend on the platform that issues them. Since decisions about wrapped assets are thus made centrally, there is a risk of market consumption and possible biased abuse of power.
This issue exists because the protocols for wrapping assets such as Bitcoin and NXM are not Turing-complete. In other words, wrapping cannot be automated via a smart contract on the Ethereum blockchain. Instead, the wrapping is usually done instantaneously via a central program, which is therefore open for manipulation.
It is Buterin who best described this limitation of wrapped assets:
“I’m worried about the trust models of some of these tokens. It would be sad if there ends up being $5b of BTC on Ethereum and the keys are held by a single institution.”
In the long run, this could seriously undermine the principle of decentralization that forms the basis of Bitcoin, Ethereum, and the rest of the blockchain industry.
Summary
As a concept, wrapped assets are excellent; they give the owners of previously non-compatible crypto assets the opportunity to invest them profitably through DApps. Furthermore, the providers of DApps benefit from the additional capital in the market and can therefore better grow their projects.
In practice, however, a significant limitation of wrapped assets has appeared; the current mechanism for wrapping assets could lead to a major centralization issue.
Overall, there needs to be an advanced solution to this shift towards centralization in order to preserve the integrity of the decentralized finance space.
