Part 2: Non-Custodial Asset Wrapping

Part 2: Non-Custodial Asset Wrapping

In the previous article, we talked about custodial asset wrapping and the issues it presents for the interoperability of Web3. In this article, we’ll look at non-custodial token wrapping and its contribution to Web3’s interoperability problem.

Custodial vs. Non-Custodial Custodial Token Wrapping

The custodial asset wrapping solutions require a trusted custodian to coordinate actions between different blockchains. In this case, the custodian serves two roles.

  1. The custodian relays messages between chains.
  2. The custodian acts as the sole source of truth, showing the state of the other chain. Thus, if the custodian authorizes the minting of wrapped assets, those assets will be minted regardless of whether reserves were actually deposited.

With non-custodial asset wrapping, a custodian can be replaced by an untrusted relayer, whose sole job is to pass messages between the chains.

How Does Custodial Asset Wrapping Work?

The core idea of the non-custodial token wrapping is that each chain runs the other’s light client — a piece of software that connects to other nodes to interact with the blockchain network — directly on-chain.

Suppose an on-chain contract can validate transactions for the other. In that case, an untrusted relayer can simply forward the state of the source chain to the verifier contract on the destination chain, where it can be verified.

In other words, if it is possible to generate succinct “state proofs” that encode the current state of the source chain and an efficient verifier (that can run inside a contract on the destination chain), then an untrusted relayer can “prove” that an action happened on the source chain. This way, both the reserve contract on the source chain and the wrapped token contract on the destination chain can be keyless, eliminating the need for a custodian to safeguard the keys.

This type of non-custodial wrapping is only possible when the source chain has a light client that is simple enough to execute within a smart contract on the destination chain.

Another type of non-custodial asset wrapping is using inter-blockchain communication (IBC) protocols. These protocols allow Cosmos-based blockchains to interact. Almost all blockchains built using the Cosmos SDK can wrap tokens this way, including several large-market-cap chains, like Terra, the Cosmos Hub, crypto.org, Thorchain, Axelar, Secret network, Binance Chain, etc. In addition to the IBC-enabled chains, several other layer-1 blockchains have been built to enable efficient light clients, e.g., Mina and Algorand.

Issues with Non-Custodial Asset Wrapping

The existing problems of implementing non-custodial asset wrapping relate to technical and security aspects.

First, there’s a problem with generating light clients. It is usually possible to make light clients for existing blockchains, but this is a highly challenging task and typically requires complete redesign for each supported blockchain.

Second, the non-custodial token wrapping solution crucially relies on the honesty of the oracles providing the block headers.

The core role of a light client is to verify that a given transaction occurred on the source chain. Usually, a light client relies on block headers to confirm this transaction happened. However, malicious oracles could provide invalid block headers, allowing them to certify non-existent deposits and make real withdrawals.

Finally, non-custodial token wrapping is not risk-free, as the smart contracts that run them are not exempt from errors and bugs. We’ll cover this, as well as how Diversifi addresses these interoperability issues, in the next article.

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