Understanding Wrapped Bitcoin and the Wrapped Tokens Framework
Ethereum based tokens have emerged as an important asset class, thanks to the massive adoption of the ERC20 standard and the preference of Ethereum as the go-to blockchain technology for Defi (decentralized finance) projects. Lately, the asset-backed token's market has also experienced exponential growth and hype as enthusiasts endorse them to be the “holy grail” of cryptocurrency.
Asset-backed tokens (stablecoins) are digital tokens that are usually backed by traditional assets (such as gold, fiat) — hence reflect the price of the underlying asset backing them. These tokens can be broadly classified into 2 design models:
1. Algorithmic — demand and supply of tokens is controlled by a set of Ethereum smart contracts such that to keep the token’s price in line with that of a fiat currency. MakerDAO’s DAI token is an example of an algorithmic stable-coin tied to the USD.
2. Centralized — assets are stored with a custodian organization that regularly publishes proof of reserves. Such tokens include Tether and TrueUSD.
Introducing the Wrapped Tokens
Wrapped tokens is a multi-institutional asset tokenization framework that adheres to the centralized approach. However, instead of relying entirely on a single institution, it relies on a consortium of institutions performing different roles in the network.
Wrapped tokens provide a methodology through which multiple institutions in the cryptocurrency space can cooperate to get past common issues faced by current stablecoin implementations. Thus, paving way for a new generation of stablecoins that can harness Ethereum in a much more trust-free manner towards enabling: global liquidity, reduced transaction fees, increased fractional ownership, and smart contract programmability.
WBTC (Wrapped Bitcoin), the first stablecoin based on the wrapped tokens framework, is an ERC20 token on Ethereum backed 1:1 by Bitcoin — allowing dApps native access to Bitcoin. No additional utility token is required to use WBTC and no extra transfer fees other than the gas consumed as blockchain fees. WBTC uses a simple federated governance model and strives to promote usability.
Custodian — The institution that holds the asset and also holds the keys to mint tokens. In the case of WBTC, this role is currently played by BitGo.
Merchant — The institution to which wrapped tokens are minted to and burnt from. Merchants play a key role in the distribution of the wrapped token. In the case of WBTC, this role is currently played by Kyber Network and Republic Protocol. Each merchant holds a key to initiate minting of new wrapped tokens and the burning of wrapped tokens.
User — The holders of the wrapped token. Users can use wrapped tokens to transfer and transact like any other ERC20 token in the Ethereum ecosystem.
WBTC DAO member — Contract changes and addition/removal of custodians and merchants are controlled by a multi-signature contract. Institutions are the holders of the keys to the multi-sig contract as part of the WBTC DAO. The WBTC DAO however, also allows for member institutions who are neither custodian nor merchant.
Custodians exchange assets for wrapped tokens with merchants. This is done through 2 different types of transactions; minting (creation of wrapped tokens) and burning (reducing the supply of wrapped tokens). These transactions are available publicly and can be viewed by anyone through a block explorer.
Minting is the process of creating new wrapped tokens. Minting in the wrapped framework has to be done by a custodian, but needs to be “initiated” by a merchant.
Burning is the action of redeeming BTC for WBTC tokens. Only merchant addresses can burn wrapped tokens. By so doing, the amount is deducted from the merchant’s WBTC balance and the WBTC supply is reduced.
After the initial exchange, merchants aim to maintain a buffer of wrapped tokens so that they can exchange it with users. The two-step minting process helps reduce the time it takes for users to get wrapped tokens, as minting and burning are more time-consuming processes.
Trust model in the Wrapped Framework
To some extent, custodians are the trusted intermediaries in the wrapped framework, as assets could be stolen or they might not honor the one-to-one backing. However, the wrapped framework aims to minimize this trust issue in a few ways:
i. Quarterly audits conducted by external third parties to verify that all wrapped tokens minted have an equal amount of assets stored among all custodians. In the case of WBTC, proof of reserves can be shown by publishing signatures from the addresses in which bitcoin is stored in.
ii. Custodians cannot mint tokens on their own, but would instead require the initiation of a merchant in order to do so. Hence the creation of new tokens involves both the custodian and the merchant.
iii. The user is insulated from interacting with the custodian through a set of merchant institutions. An individual merchant does not need to be trusted, but instead, all merchants together would need to be.
iv. Existing credibility is at stake for all institutions involved with the framework.
Uses Cases for Wrapped Tokens
1. Asset Tokenization
The act of tokenizing assets can:
Increase speed of transactions — Ethereum blocks are created every ~15 seconds and it is possible to have a fair deal of confidence in the irrevocability of a transaction in less than 5 minutes. This speed is faster than transacting natively compared to many other assets including Bitcoin, gold and fiat currencies
Improve transparency — The total number of tokens, token creation transactions, token removal transactions, number of token holders, and rules for transfers can be seen on a public block explorer by anyone.
Boost usability — The ERC20 standard has been adopted by a large number of institutions and products. This provides users with a variety of exchanges, wallets, and Dapps to use while handling their tokenized assets. They also have the ability to transfer tokens quickly, 24/7.
Enhance security — Tokenization enables users to have full control of the private keys of the asset. Users who do not want to hold keys can reduce counterparty risk by moving it from exchanges to a security-focused custodian.
2. Fiat backed stablecoins that offer a safer way for traders to keep their money in a cryptocurrency without having to worry about price fluctuations.
3. The wrapped framework makes it easy to represent any cryptocurrency, such as Bitcoin on Ethereum blockchain, thereby harnessing all Ethereum capabilities.
4. Tokenization provides a mechanism to enforce policies on-chain. On-chain policy enforcement makes rules more transparent and doesn’t rely on one single party to enforce them, hence immune to manipulation.
5. Today, the majority of ERC20 trading in centralized exchanges is done with BTC and not ETH — while most decentralized exchanges offer only ETH/Token and not BTC/Token trading pairs. Wrapped tokens can help bridge this gap and provide the much-needed liquidity on decentralized exchanges.