That’s a Wrap: DeFi Needs to Move Past Wrapped Tokens

Technological evolution is a cruel process, and history is littered with discarded innovations. 

Just as landlines gave way to mobile phones and email replaced fax machines, it seems to be only a matter of time before wrapped tokens end up in a metaphorical blockchain technology museum. 

They were only ever really intended as a band-aid solution to cross-chain interoperability, yet we’ve had to accept their existence as part and parcel of interacting with the DeFi world for far too long. Internet chatter in the DeFi summer talked of a brilliant future where composability truly extended across chains, though this is not what has occurred. 

In my view, if we were to keep on relying on wrapped tokens, we risk undermining rather than advancing the mass adoption of DeFi. 

When wrapped tokens began

Before we resign wrapped tokens to history, let’s take a look at the role they’ve played. 

Wrapped tokens were unarguably helpful in the early days of DeFi, providing holders of these assets access to borrowing, lending and trading opportunities in a brand new ecosystem of tools released at first only on Ethereum.

But using wrapped tokens introduces a level of counterparty risk that really shouldn’t be there in a truly decentralized financial system. 

Every time a wrapped token is minted, it means placing long-term trust in a third-party custodian or protocol that isn’t related to the underlying blockchain. If ever these services fail, not only do individual users lose out, but this could potentially have devastating consequences for entire ecosystems. 

We also have to trust any issuer’s ability to maintain the peg between the original asset and its wrapped token representation. As we have seen with the likes of TerraUSD, things can unravel incredibly quickly, which adds a further layer of unnecessary risk. The successive implosion of FTX could not have been a more dramatic reminder of the existential risks at play.

Asides from systematic concerns, wrapped tokens have also proven to have significant security challenges. By relying on bridges to move assets across blockchains, we are exposing users’ funds to unnecessary levels of risk. We only need to look at the Ronin bridge exploit to remember the scale of loss that can occur in bridge hacks

We have to move away from wrapped tokens to stop the erosion of users’ trust, which ultimately sets DeFi adoption back.

Putting trust on the table

Even if the assumptions of trust needed for wrapped tokens don’t seem to bother most everyday users, I would argue that the additional trust layer gives rise to a side effect that is even worse. 

As each representation of any given asset is issued on an alternative chain, each of these assets are non-interchangeable. As an example, WBTC and TBTC can’t be deployed together as BTC liquidity in a single pool. Instead, having both just causes fragmentation, hurting each other’s chances at achieving sufficient levels of liquidity to be competitive. 

Every wrapped token for each asset is more liquidity and users being diluted across that chain’s markets. We have too many stablecoins, bridges and wrapping services. Contrary to promises of saving users money, this fragmentation actually makes everything less efficient and more expensive for users, thus undermining true composability.

But slowly, we are seeing this wrapped token trend reverse. USDC and USDT are both natively issued on dozens of chains now, which has dramatically improved USD denominated markets across all of these ecosystems. As this continues, we will see the popularity and utility of wrapped USD tokens fade away forever. 

In the ever-evolving landscape of blockchain technology, the obsolescence of wrapped tokens appears inevitable. While they served a useful purpose in the early days of bridging ecosystems and instigating interest and growth of DeFi, their days are now numbered. 

Any focus on wrapped tokens has diverted attention and resources exactly at the time when it would have been more expedient to focus on developing more user-friendly and native cross-chain approaches. To create a more inclusive, secure and robust financial system for all, we must look toward decentralization — like making decentralized cross-chain swapping solutions the core of our DeFi ecosystem.  

It’s clear to me that the continued use of wrapped tokens has directly contributed to a delay in unlocking DeFi access for the masses. The industry needs to shift toward true decentralization, upending the DeFi ecosystem for the better and making wrapped tokens obsolete.

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Crypto exchanges face an existential challenge. What can bring users back?

A trend few have paid much attention to is the changing shape of the crypto industry’s spot markets — more specifically in the cross-chain space. What started on Ethereum is spreading as technology advances.

In 2020, Uniswap exploded (in a good way) and took billions in daily volume away from centralized exchanges, to the point where much of the price discovery for many ERC-20 tokens now occurs on-chain.

If the trend of the last two years is anything to go by, the same is likely to happen in 2023 in other markets. With dozens of new layer-1 chains emerging and growing, and cross-chain technology getting better and more refined over time, it is slowly becoming possible to swap assets cross-chain in a comparable experience to Uniswap. Even Uniswap itself is expanding to other chains.

With multiple bankruptcies and collapses still filling crypto news feeds, it has never been clearer to both users and regulators that the industry must reduce its dependence on centralized exchanges. When it comes to transparency and user control of customers’ funds, nothing beats on-chain trading through protocols rather than trusted entities.

There are still many problems plaguing cross-chain experiences, namely low liquidity, poor user experience, lack of aggregation, market fragmentation and lack of support for non-Ethereum Virtual Machine chains.

Luckily, cross-chain aggregators are helping to pull together the patchwork of cross-chain messaging, bridging and native swapping protocols out there. The nature of decentralized finance (DeFi) means that disparate protocols can come together in transparent partnerships — protocol interacting with protocol — for the benefit of users and the ecosystem overall. In fact, much of the time, such cooperation isn’t required. Protocols can use other protocols without the permission of the other, removing yet more barriers to this development.

That is a markedly different approach to a centralized environment where cooperation between competitors is pretty much unheard of. What this means is that the pace of development — and the ability to build resilience into DeFi — while slow to begin with, has all of the ingredients necessary for a rapid expansion, and strategic partnerships will play a key part in driving the growth of the decentralized protocols. There is still plenty of work to do to make this competitive with centralized exchanges, but Uniswap has proved that when liquid and accessible enough, there is nothing stopping protocols from attracting volume away from the centralized exchanges for all crypto-to-crypto swaps.

This liquidity issue is more important than many realize, as crypto-to-crypto spot markets make up the largest fee-paying trades in the US$1 trillion markets of today, and have done so since very early in its history. Derivatives may appear to have more volume, but that apparent size advantage quickly vanishes once leverage and differing fee models are taken into account. In terms of what users are paying for in fees, spot markets are and will continue to be fundamental to the industry. If the liquidity issue can be addressed sustainably, then the spot-market cash cow that the exchanges rely on may end up being pulled in by DeFi.

The remaining barrier to the complete adoption of on-chain spot trading in the mind of users is that of security. The last two years have provided far too many expensive lessons for cross-chain providers of various kinds. In particular, bridges remain a risk to users due to the tail risk associated with wrapping and the centralized nature of many bridging products. However, as more efficient native cross-chain swapping becomes available, and the expansion of natively-issued stablecoins to many more chains with their own spot markets continues, bridges become less important to users. Aggregators are already helping the user navigate their options, with security a very real consideration. The collapse of FTX and others has demonstrated that self-custody is essential for user security, and on-chain trading is the way to get there.

Over the remainder of 2023, users will likely be surprised by the rapidly improving swapping experiences on offer, and through close collaboration, the builders in this space will be able to invoke the “Uniswap Effect” on most crypto spot markets, just as was done to the ERC-20 token markets in 2020. 

Users will gradually switch not simply because of a desire for the principle of decentralization, but because these new experiences will be safer, cost-competitive, offer unprecedented access to assets across the entire ecosystem and remain maximally transparent.

Does this mean that Binance, Coinbase and so on will follow FTX to the depths of the deep blue sea? No, but their market share of the spot markets will likely wane throughout the year to the massive benefit of both users and protocols. Centralized exchanges will continue to have an important role to play, particularly in the “on and off ramp” stage where crypto interacts most closely with the fiat monetary system. 

Ultimately, volume will flow to the optimal path of least resistance — and now is the time for those of us in the cross-chain space to present a compelling alternative to the status quo.