Part 1: Token Wrapping & Custodial Asset Wrapping

Part 1: Token Wrapping & Custodial Asset Wrapping

From January 1, 2020, to January 1, 2022, the global crypto market cap grew more than tenfold (from $196 billion to more than $2 trillion). Unfortunately, this massive growth has been accompanied by a fragmentation of liquidity. As of March 2022, more than 15 different blockchains had native tokens with market caps above $5 billion. Despite the rapid adoption of these blockchains and currencies, it is still incredibly difficult to move assets from one blockchain to another. Developers have tried to solve the liquidity problem by creating bridges that “wrap” tokens.

What Is Token Wrapping?

Token wrapping is a solution for moving assets from one chain to another. The core idea is that an asset (e.g., ETH) gets locked on one chain (e.g., Ethereum), and a synthetic, “wrapped” asset (e.g., wrapped ETH) appears on another chain (e.g., Solana). In this way, an asset is “moved” across blockchains.

The main technical challenge with token wrapping is to ensure that the wrapped asset stays in sync with the underlying reserves (e.g., the number of Wrapped ETH on Solana remains in one-to-one correspondence with the ETH held in escrow on the Ethereum chain).

There are two core methods for ensuring that the wrapped asset remains synchronized to the reserve asset — custodial and non-custodial. In this article, we’re going to talk about custodial wrapping.

What is Custodial Token Wrapping?

In custodial asset wrapping, a custodian (or a group of custodians) holds private keys controlling accounts on two chains. The off-chain custodian monitors and keeps both chains in sync by issuing signed transactions to the appropriate blockchain.

One of the earliest successful examples of token wrapping is WBTC, where a group of custodians hold BTC (on the Bitcoin blockchain) and issue a “wrapped” BTC (WBTC) on Ethereum (and Tron). The WBTC custodians monitor their WBTC wallet/wallets. When BTC is deposited, they use their private key to issue (“mint”) new WBTC on the Ethereum blockchain. Conversely, when Ethereum users redeem (“burn”) their WBTCs, custodians use their private keys to release BTCs on the Bitcoin blockchain. As of March 30, 2022, more than $12.9B worth of WBTC was in circulation on the Ethereum blockchain (and the corresponding amount of WBTCs was in the custodians’ wallets on the Bitcoin blockchain).

Custodial token wrapping is frequently used to move assets across blockchains. The Wormhole Bridge connects 8 blockchains (Avalanche, BSC, Fantom, Ethereum, Oasis, Polygon, Solana, and Terra), and its network of 19 “guardians” controls almost $3B in assets across these chains. Many other bridges, e.g., the Binance Bridge, the Nomad Bridge, Allbridge, and Sollet, also use custodial token wrapping to “move” liquidity across chains.

The Disadvantages of Custodial Asset Wrapping

The problem with the custodian token wrapping is mainly security. Custodians pose both internal and external security risks.

1. The Inside Threat. Custodians hold private keys to accounts on both chains they monitor and can potentially use these keys to steal reserve assets or mint unbacked wrapped assets.

2. The External Threat. Bridges controlled by guardians rely on smart contracts. The more complex the smart contract, the more vulnerable it is to manipulation and exploitation. Attackers can potentially subvert the minting capability of the smart contract to mint unbacked wrapped assets and immediately cash out.

The risk of contract vulnerabilities increases with the complexity of the on-chain bridge contracts. For example, the Wormhole bridge uses multisignatures instead of threshold signatures. In other words, the smart contract has to aggregate multiple signatures from different accounts before updating its state. As a result, the smart contract is more likely to get exposed to hacking attacks. Unfortunately, this is exactly what happened with the Wormhole bridge in February 2022.

In the following article, we’ll explore non-custodial asset wrapping and its drawbacks for a truly secure, interoperable blockchain ecosystem.

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