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The demand for DeFi transcends any smart contract platform like Ethereum. In this article we will look at how that demand has materialized in Wrapped Bitcoin (WBTC) to provide DeFi to the leading cryptocurrency.
Next we will see what is WBTC, what are its advantages, disadvantages and its incredible success in Ethereum.
What is WBTC?
Wrapped Bitcoin is an Ethereum ERC-20 token that maintains a 1:1 parity with Bitcoin. In other words, it is Bitcoin tokenized in Ethereum. It achieves this with a centralized model in which a custodian makes sure to back each WBTC with a BTC.
To obtain WBTC, and to retrieve the BTC, users have to go through an identification process due to KYC/AML regulation. However, there are also other platforms such as Curve where you can buy it in a decentralized way. Once you have the token, it can be used freely on Ethereum.
The most popular use of WBTC is to get profitability out of your bitcoin, using it in the wider DeFi ecosystem built on Ethereum.
To decentralize control over the Wrapped Bitcoin system, a Decentralized Autonomous Organization (DAO) is used. Each DAO participant maintains a secret key with which it can sign and authorize changes. Changes become effective if a number of N signers (out of a total of M) authorize them. This is known as a multi-signature scheme.
The DAO can vote on changes to smart contracts and participating institutions. If, for example, a Bitcoin custodian fails to perform its duty, the DAO can remove it from the protocol.
Below we will take a closer look at the roles of the financial institutions participating in Wrapped Bitcoin.
What is the role of traders and custodians?
Merchants are the institutions that intermediate between users and custodians. When a user asks to exchange BTC for WBTC (and identifies himself), the merchant initiates an Ethereum transaction to create WBTC.
The merchant sends the specific amount of BTC to the custodian and the custodian finalizes the Ethereum transaction, creating that same amount of WBTC. These tokens will now be held by the merchant who will be responsible for sending them to the user (in exchange for bitcoin).
Both merchants and custodians take a BTC commission for their services. But once with WBTC on Ethereum, the only commission paid is the mining commission.
Once you want to exchange WBTC for BTC, you will repeat the same process but “burning” or destroying the WBTC token.
To provide transparency, the Bitcoin custodian uses Proof of Reserves. Proof of Reserves is a concept popularized by Nic Carter that consists of cryptographically proving the holding of cryptocurrencies. This avoids fractional reserve practices (holding less money than you owe).
Pros and Cons of Wrapped Bitcoin
Let’s see what are the advantages and disadvantages of using Wrapped Bitcoin:
- Faster transactions than Bitcoin (on Ethereum).
- Transactions without intermediaries.
- Control of your own private keys, although when it comes down to it, the BTC is not under your control.
- Usability. The ERC-20 standard is widely implemented in wallets and decentralized applications.
- Transparency. We can see how much WBTC exists in Ethereum, the transactions being made, etc.
Disadvantages and risks
- It requires trust in third parties. By having Wrapped Bitcoin you only have the promise of being able to exchange it for the same amount of BTC. Therefore it requires trust in the custodian and merchants.
- High Ethereum commissions. As is known, Ethereum usually has high commissions that can worsen the user experience.
- Regulation. As a centralized system, with a consortium of financial institutions, they are susceptible to regulation (or even prohibitions). Merchants also maintain private user information. This does not occur in a fully decentralized system..
- Smart contracts. Ethereum smart contracts, being more complex, are susceptible to attacks. In addition the DAO could vote on a change to the contracts that would be detrimental to users.
One possible solution to Ethereum’s scalability and fees for WBTC would be the use of a sidechain. As outlined in Wrapped Bitcoin’s own whitepaper, a sidechain could be created based on Proof of Authority, and which requires more trust as it is federated.
The upside of this would be minimal commissions and much faster transaction speeds. But of course, at the cost of even more reliance on third parties.
A better solution may be the use of optimistic Rollups, for the time being, and in the future of ZK-Rollups.
What can we learn about the success of WBTC?
In closing, I find the success of Wrapped Bitcoin very telling. At the time of writing we are talking about almost 200,000 WBTC in circulation, or about $9 billion.
This means that for every 105 bitcoins, 1 is tokenized in Ethereum. It is clear that DeFi is in high demand for Bitcoin.
With these figures one can imagine that, the moment it becomes more accessible, DeFi (truly decentralized) for Bitcoin will be a resounding success.