How Wrapped Tokens Bring More Liquidity to DeFi
This is part of a series of articles from ConsenSys Codefi’s Q4 2020 Ethereum DeFi Report. Download the full report to learn more about token standards for assets and payments, NFT marketplaces, social and community tokens, DAOs, flash loans, wrapped Bitcoin and Filecoin, lending projects and more.
Ethereum is increasingly attracting digital assets from other blockchain protocols. With new design patterns, it’s now possible to put digital assets like Bitcoin or Filecoin on Ethereum so they can interact with DeFi applications. Q4 2020 saw exponential inflows of value tokenized on Ethereum, and as the DeFi ecosystem’s network effects continue to grow, we predict additional protocols will launch wrapped versions of their tokens on Ethereum in 2021.
In this post we discuss wrapped tokens, teach you how Bitcoin can be used on Ethereum and become an income-generating asset, and discuss the ways in which wrapped tokens are bringing more liquidity to Ethereum’s DeFi ecosystem.
What are wrapped tokens?
Wrapping tokens on Ethereum describes the process for transforming an existing crypto asset into an ERC-20 token. ERC-20 tokens remain the most widely-used standard for token design, and ensures that the rules of smart contracts remain compatible with applications like decentralized exchanges or lending protocols.
The introduction of wrapped tokens actually began with ETH itself, since the ERC-20 token standard came after the attributes for sending and storing ether were established. Wrapped ETH (or WETH) transforms ETH into an ERC-20, which provides all the functionality and transferability of an ERC-20 token. To wrap a token, typically a user “locks” the original token in a smart contract, which then mints an equivalent amount of wrapped tokens. This is analogous to a traditional structured note, issued by a DeFi robot. To unlock your original tokens, you simply trade your wrapped tokens back to the smart contract. “Wrapping” seems like a misnomer, since you’re actually just trading one token for an ERC-20 token of equal value. But this simple action has powerful consequences, evidenced by the 5.5 million ETH transformed into WETH by the end of Q4 2020.
As covered in the ConsenSys Codefi Q3 DeFi report, one of the major trends in the middle of 2020 was the rise of decentralized exchanges (DEXes). The total trade volume on DEXes in Q4 topped $60 billion, and one of the main drivers of this activity is because WETH makes it simple to swap ETH for any other ERC-20 token.
The method of wrapping tokens has also been generalized across other types of tokens and protocols, further catalyzing the ubiquity of ERC-20 tokens.
Bitcoin on Ethereum
If you can turn ETH into an ERC-20 token, why not also turn Bitcoin into one so that it can interact with smart contracts and protocols on Ethereum? Wrapped Bitcoin gained significant momentum in Q4 2020. Now over 159,991 BTC (about $5.5 billion USD) exist on the Ethereum network, with WBTC and renBTC as the dominant wrapped Bitcoin. Ultimately, this means that now Bitcoin holders can use their BTC with Ethereum-based wallets like MetaMask and access decentralized financial applications.
Initiated in January 2019, Wrapped Bitcoin is a collaborative project from BitGo, Ren, Dharma, Kyber, Compound, MakerDAO, and Set Protocol. The project is now controlled by a Decentralized Autonomous Organization (DAO) called the WBTC DAO, which governs the addition and removal of merchants and custodians for WBTC on Ethereum through a multi-signature contract. WBTC has brought greater liquidity for Bitcoin to the Ethereum ecosystem, as WBTC is used to trade on decentralized exchanges, as collateral for borrowing and lending, or for derivatives trading. For example, Compound allows anyone to secure a passive income lending out WBTC to other users in the network. WBTC has also helped shift trade volume away from centralized exchanges to DEXes.
Another method for wrapping BTC that gained momentum in Q4 2020 is the use of synthetic Bitcoin, where a user locks their BTC into a smart contract and receives a synthetic asset with equal value. Synthetix, a derivatives trading platform, pioneered this technique calling their wrapped Bitcoin sBTC. While the synthetic token isn’t backed by BTC directly, Synthetix backs each BTC with 800% of BTC’s value in SNX tokens, which are also used for governance and providing liquidity.
All this BTC on Ethereum is yielding some interesting trading products. TokenSets, a DeFi company that automates portfolio management strategies, introduced a product that automatically trades between WBTC and ETH to capture gains in both assets by rebalancing the composition of ETH/WBTC depending on the relative price momentum.
By the end of Q4 2020, there was 141,322 BTC on Ethereum, which represents approximately $4.2 billion USD.
Filecoin on Ethereum
The launch of Filecoin in Q4 was one of the most anticipated launches in the decentralized protocol space. On the Filecoin Network, FIL is the native currency used to pay for data storage on a global network maintained by storage miners. (Filecoin is a complementary protocol to IPFS; the difference is that Filecoin incentivizes storage and therefore offers stronger persistence guarantees.)
In Q4, ConsenSys Codefi introduced DeFi Bridge in order to convert Filecoin’s FIL to an ERC-20 token using the Ren Protocol, which also wraps BTC. Once on Ethereum, FIL holders and miners can deposit their renFIL as collateral in DeFi lending markets to earn interest, or borrow more FIL needed for storage mining operations. Ensuring a liquid supply of FIL through lending markets is a critical element of building out the storage market and driving network utilization of IPFS. Using the Codefi-built platform, storage miners can deposit ETH-based assets as collateral, borrow wrapped FIL, and convert it to native FIL to store data or engage with the Filecoin network.
Since launch, 48,575 renFIL has been issued, or approximately $1,020,075. Other exchanges like Binance and Huobi launched their own versions of wrapped FIL, with 33,000 BFIL and 59,999 HFIL issued, respectively. All told, there is 143,843 wrapped FIL on Ethereum, or more than $3 million USD.
How to get a wrapped Bitcoin with MetaMask
So you may have been recently influenced by Elon Musk to buy Bitcoin. Now that you have Bitcoin, what can you do? On the Bitcoin blockchain, besides HODLing, or sending it to someone else, not much. But if you buy wrapped Bitcoin, which is BTC in an ERC-20 wrapper, you can access a full suite of decentralized finance applications. Lending your wBTC on Aave and liquidity provisioning your wBTC on Uniswap is just as easy as performing those actions with ETH.
So, how do you buy some wBTC? First download MetaMask, which is available as a browser extension or on mobile. You’ve now equipped yourself with a key vault that only you can access, a secure login, a wallet to view your tokens, and a way to exchange tokens or access the decentralized web. Think of it as a way of managing your money, digital assets, unique art and identity as you use various decentralized finance applications.
First you need to add some ETH to your MetaMask wallet in order to pay for transactions on the Ethereum network. You can buy ETH directly on MetaMask or from an exchange like Coinbase. After you acquire ETH you can then swap that ETH for a wBTC.
Select the amount of ETH you would like to convert into a wBTC. You will see an estimate, but when you select “Get quotes” MetaMask checks 7 different decentralized exchanges and Automated Market Makers (AMMs) to offer you the best trade for the lowest fees.
If you are satisfied with the rate, click “swap,” and wBTC will be added to your MetaMask account. Here’s a video of the process using a different token. Of course, unlike the user in the example above, you must have enough gas in order to pay for the transaction.
Your new balance of wBTC can be used on any Ethereum financial application you grant permission. Swapping ETH for a wBTC is a terrific way to put your BTC to work through lending and providing liquidity. Make that BTC work for you with wBTC!