Wrapped Bitcoin - The Bridge to Decentralised Finance

Why Wrapped Bitcoin is so important and how it works

If I told you you could earn ~10% APY on your Bitcoin holdings you might ask me where? A better question is how?

The first part of that answer is understanding Wrapped Bitcoin, what it is, why we need it and the technology that's being used to make it happen.

In this article I’ll address these topics and highlight how Bitcoin was brought into the Ethereum ecosystem and granted access to the insane yields we see in decentralised finance.

What is Wrapped Bitcoin?

You may have heard of stable coins, these are cryptocurrencies that are pegged to a fiat currency. They represent a non native asset on that blockchain (In this article we are specifically looking at the Ethereum blockchain) and their job is to accurately reflect the price of the asset backing them.

Wrapped assets do the same thing, they reflect the price of the asset backing them, because of this we could just as easily call these stable coins wrapped fiat coins.

There are 2 ways these coins maintain a peg to the offchain asset, algorithmically using smart contract or via a centralised reserve. If we take 2 examples for USD stable coins, coinbase’s USDC and MakerDAO’s DAI we can compare the methods they use to maintain the peg.

MakerDAO, DAI, Algorithmic

Ethereum smart contracts are created where demand and supply are controlled in order to keep the price of the token in line with a fiat currency.

Coinbase, USDC, Centralised Reserve

Coinbase holds a reserve of USD which it has received in return for minting new USDC tokens, this ensures a 1 to 1 ratio of USDC to USD is maintained. Coinbase is audited regularly by a third party and has to provide proof of reserves. Centralised Reserves will also often publically publish evidence of proof of reserves.

WBTC

Wrapped Bitcoin is an project jointly initiated by Kyber, Ren, and BitGo, designed to make Bitcoin compatible with the Ethereum chain. We can see from the above that wrapped bitcoin WBTC has a lot in common with stable coins, it is a on chain representation of a non native Ethereum asset. Just like stable coins it’s role is to accurately reflect the price of the asset backing it, Bitcoin.

It maintains its peg using the“Centralised Reserve” method with some additional safeguards intended to reduce the level of trust users need to have with that centralised entity. Before we get into the details of how this works let’s first address the question of why we need it.

Why we need WBTC?

It enables Bitcoin as an asset to interact with Decentralised applications (Dapp’s) the majority of which reside on the Ethereum network
Increased speed of transaction, Ethereum blocks are created every ~15 seconds while Bitcoin blocks are created every ~ 10 minutes
Bringing Bitcoins liquidity into the Ethereum Dapp ecosystem
Improving interoperability between cryptocurrencies and being able to leverage smart contracts for future ideas

Lets run through each one of these briefly;

Dapps & DeFi

First, Bitcoins ability to interact with Dapps. This opens lots of opportunities in the Decentralised Finance (DeFi) space. Loaning your BTC on a DeFi platform enables you to earn an yield on your BTC which previously had been a non yielding asset.

Moving your BTC to a Decentralised Exchange (DEX) enables to you swap BTC for currencies which aren’t listed on the centralised exchanges.

New ICO’s can accept both ETH and WBTC as payment enabling users to use BTC as an investment in an ICO. This list will only continue to grow as the Ethereum ecosystem becomes more mature.

Transaction Speed

Second, increased speed of transaction, this is less impactful than others on the list but does provide benefits to users. Say you have some BTC in cold storage and something is going on in the market that makes you want to sell.

You need to transfer that BTC to an exchange quickly. Typically for BTC the exchange will wait for 6 block confirmations before giving you access to you’re funds. In Bitcoin ~10 mins blocks means you’ll have to wait an hour to get access to your BTC on the exchange.

In contrast for WBTC which is on the Ethereum network requires 12 block confirmations however each block is only ~15 seconds. Instead of waiting an hour you only have to wait 3 minutes.

We know how much can happen in the crypto markets in 57 minutes. Not having this speed advantage could correlate to lots of lost $$$.

Liquidity in the Ethereum Ecosystem

Bitcoin is king in the crypto markets and as a result has the largest share of the overall market cap. Getting this liquidity onto the new and existing Dapp helps drive adoption and increases investor interest in these projects.

Interoperability

Interoperability between cryptocurriences is not a zero sum game, both networks can gain from that interoperability. Ideas that people may have had about Bitcoin but weren’t able to implement on it’s scripting language are now possible with WBTC.

There are clear advantages right now with WBTC and as we move forward new ideas and applications will only add to or strengthen those advantages.

How WBTC Works?

WBTC consists of 3 key actors, the user, the merchant and the custodian.

Custodian — The custodian holds the asset (The real Bitcoin). In the case of WBTC, this will be played by BitGo. Custodians hold the keys to mint WBTC tokens via smart contracts.

Merchant — The merchants acts as a middle man between the users and the custodian, they play a key role in distribution of the wrapped token. In the case of WBTC, this will be played initially by Kyber and Republic Protocol (this has now expanded out to multiple other merchants). Each merchant holds a key to initiate minting of new wrapped tokens and 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.

The Process

Custodians exchange wrapped tokens for assets with merchants. This is done through two different types of transactions; minting (creation of wrapped tokens) and burning (reducing supply of wrapped tokens).

These transactions will be available publicly and can be viewed by anyone through a block explorer. Heres an example of one of the biggest WBTC mints ever on etherscan. 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.

Custodian & Merchants Fees

You should be asking what’s in it for the custodians and merchants, why would they do this. Transfers of WBTC between users will have no cost apart from network fees. There are a couple ways in which different parties in the network can earn fees:

Custodian fees: This is taken by the custodian at the time when a merchant mints or burns wrapped tokens. (Varies from 0.04% - 0.1% trading fee)
Merchant fees: This is taken by the merchant who the user exchanges wrapped tokens with for the asset. (As an example Coinlist charges a flat 0.25% trading fee to wrap or unwrap WBTC)

WBTC DAO

A Decentralised Autonomous Organisation is intended to enable a project to make changes in a decentralised fashion. The powers of a WBTC DAO member are listed below.

WBTC DAO member — Contract changes and addition/removal of custodians and merchants will be controlled by a multi-signature contract. Holders of the keys to the multi-sig contract will be held by institutions as part of the WBTC DAO.

Trust Model

The set up described above requires the WBTC user to trust the centralised custodian entity. The custodian holds all the real Bitcoin, if they decided to exit scam the value of WBTC would quickly go to zero.

BitGo being the only custodian does imply a significant counterparty risk to the asset directly, but we must take into account that BitGo is a crypto financial institution of significant importance for the crypto financial market.

Having said this it is no different to trusting Coinbase as a custodian of you’re dollars when they mint USDC. There are a number of additional features WBTC have included to attempt to build more trust with users.

Audits

First quarterly audits will verify a 1 tot 1 match of WBTC to BTC reserves for the custodian. Proof of reserves can be shown by publishing signatures from the addresses which bitcoin is stored in.

Audits are a key part for any custodian. While they don’t protect against an exit scam they do protect against the custodian using the Bitcoin they have in custody of to try and generate more revenue ie trading BTC, loaning BTC etc. which is risk the WBTC user hasn’t signed up for.

The private public key set up of Bitcoin addresses enables an owner of a Bitcoin address to provide cryptographic proof of ownership without revealing their private keys.

This is how BitGo would prove to the auditor they own the addresses they provide. See the dashboard of Bitcoin addresses owned by BitGo and the amount of BTC they hold here.

Recently BitGo the custodian for WBTC has partnered up with chainlink to create a chainlink oracle for these proof of reserves. This enables DeFi projects to call a smart contract to verify the reserves everytime new WBTC is minted or burned. Instead of having to trust a third party audit every 3 months they are now able to verify this themselves on demand.

Minting

Custodians will not be able to mint tokens on their own, they require the initiation of a merchant in order to do so. Hence creation of new tokens involves both the custodian and the merchant.

This prevents the custodian from arbitrarily minting new WBTC, the risk would be that they could mint new WBTC for Bitcoins that don’t exist. Additionally the minting contract only allows the WBTC to be sent to an approved merchant. While this doesn’t completely protect user against bad actors it does mean you would need 2 bad actors coordinating together, custodian and merchant rather than 1.

Transparency

WBTC have been very transparent with how the token functions and have provided key details on the following;

Actors involved at the custodian and merchant level
List of custodian BTC addresses
Total value of custodian BTC addresses VS Total value of minted WBTC
Merchant and Custodian Ethereum addresses
Open sourced contract code
Status of mints and burns, as these are Ethereum smart contracts they can easily be viewed

Conclusion

Wrapped Bitcoin is a great tool that will help accelerate the adoption of Decentralised Finance and other Ethereum Decentralised Applications. It cannot be seen as a decentralised implementation as there is still counter party risk. The implementation requires users to trust BitGo as the custodian of their real Bitcoin.

Despit this there has been great adoption of the token with approximately 1% of all circulating BTC now wrapped as WBTC. This represents over $7 billion dollars worth of value. As new useful applications appear on the Ethereum network I can only see this percentage increasing as users look for ways to make their Bitcoin capital work harder for them.