The Beauty of Cross-Chain Digital Assets and Their Impending Doom

Since I was a child, I fell in love with the internet and most that has spawned since its inception! There is one piece of technology that has a special place in my heart, and you’ve guessed it; Blockchain and Distributed Ledger Technology.

Why this technology you may ask? Well, that’s a complicated subject, but I believe that it essentially holds the key to transforming the global economy, governance on all levels, and even freedom from financial oppression.

Until recently, each and every blockchain has been their own “data silo” containing their own asset(s) with no ability to transfer between each chain/silo. During the early days of blockchain, this was not an issue but with the rise of Ethereum, and many other smart contract blockchains, having the ability to move assets from one chain to another is not only a logical approach but even a necessity for true decentralized finance (DeFi).

In fact, with the rise of DeFi, about 150,000 BTC now exists as ERC20 tokens on the Ethereum blockchain, and since this occurred incredibly fast, it allowed Bitcoin holders to participate in the wealth of new DeFi projects (some good, some not so good).

Without a doubt, there has been a giant leap for cross-chain functionality, and while this all sounds amazing, I was initially for it! However, I’ve come to recognize some of its inherent flaws that must be addressed.

So, what’s the problem?

You know that slightly annoying statement “not your keys, not your coins?” Well, this is absolutely true for current cross-chain solutions, but it goes much deeper.

One of the most popular methods of moving BTC over to Ethereum is the wBTC (Wrapped Bitcoin) project. It’s a simple enough process — complete a KYC/AML, wait for approval, transfer your BTC, submit a Ethereum address where you want your wBTC coins to be sent and done! You now have Bitcoin on Ethereum completely backed by a Bitcoin custodial service (a company that holds digital assets) which has the same value as the real thing.

The problem:

Let’s review two facts:

  1. Simply put, your wBTC is backed by the real BTC being held by a custodial service;
  2. The amount of Bitcoin in the world technically increases if you consider:
    a) The BTC being held via a custodian as the genuine item and
    b) You consider wBTC as good as BTC (most do) but with the extra benefits of the Ethereum blockchain.

With this in mind, I have a question for you:

Let’s say, hypothetically, that the Bitcoin being held via a custodian is hacked and stolen, and consequently, 10’s of thousands of BTC hit shady exchanges where they are sold and instantly back in circulation on the Bitcoin blockchain. Of course, if this happens, there is no going back.

So, here’s the million dollar question, does this invalidate the value of wBTC sitting on Ethereum?

Logically, a few possibilities could occur:

  1. Somehow, the custodian service has the ability to repurchase all stolen Bitcoin (possibly via an insurance policy); the books balance and problem is resolved.
  2. The wBTC coins become worthless since they are no longer backed by anything.
  3. The custodian is able to support a partial buyback to barely stay afloat — trading wBTC back to BTC and vice versa.
  4. The custodian has no ability to repurchase the lost Bitcoin, but amazingly, wBTC retains its value and continues to be traded like nothing has happened.

In my opinion, scenarios 3 and 4 are the most likely to occur. While the true supply of BTC does not change, the supply indeed increases since holders on Ethereum still require wBTC to continue participating in DeFi and could not accept the loss.

Now, some of you may be thinking that this is absolutely impossible.

While the wBTC asset should be worthless while doing significant damage to the entire blockchain ecosystem, there is evidential proof that assets do not need 1:1 backing to retain their value.

Moreover, I am sure that many of you reading this are aware of the cryptocurrency with the third highest market — Tether/USDT. For those who don’t know about Tether, it began trading in 2015 and was designed to be a stable coin/token that was completely backed by the U.S. Dollar. Essentially, if there is 1 billion of USDT issued on the blockchain, there would be 1 billion U.S. dollars being held in escrow to secure the token.

In 2017, the blockchain community was rattled when it came to light that the supposed stable asset which so many counted on, in fact, did not hold a 1:1 ratio of USD (learn more about Tether by clicking here).

At the time of this writing, Tether has an astounding market value of over $25.5 BILLION, but in reality, the parent company Bitfinex does not have $25.5 billion in USD. Few know the real backing ratio of Tether since they refuse to publish a full audit. In addition, Bitfinex is currently being investigated by the New York Attorney General due to their controlling assets. I personally would not touch Tether under any circumstances, especially since many other stable coin options are available. However, it appears that Tether is “too big to fail” (at least for the moment).

To me, it’s clear that the ideology of a token is tied to its intrinsic worth and wBTC already has the ingrained ideology of being a 1:1 backed asset just like USDT, and I truly hope it remains that way.

What about the other options?

Now, some of you reading this article may be screaming “THERE ARE DECENTRALIZED OPTIONS” and I too thought this would be the saving grace of wrapped assets (and I still do — just not yet) until recently.

Besides wBTC, one of the most popular decentralized wrapped Bitcoin projects is the REN project, and honestly, I was quite excited about their future — at least, until a Twitter thread in August destroyed my faith in the project.

Essentially, the CTO of the REN Protocol publicly admitted that the team can collude to move all held BTC within the REN protocol to a privately controlled address.

While I am not positive if this issue is as severe as it was a month ago, it shows that:

  1. There are exploitable holes in decentralized wrapped asset methods.
  2. All exploits may not be known and pose a potential serious threat (an audit cannot catch all bugs and there is always someone smarter looking for holes).

Overall, decentralized wrapping methods for cross-chain interoperability have great potential, but at this time, they pose the same threat as centralized methods.

So what can we do now?

Since wrapped assets are growing in popularity and they allow for some great cross-chain features, it makes sense to embrace them — but safely.

  1. Understand the risk you take when swapping to or holding wrapped assets. These include custodial risk and smart contract risk.
  2. Don’t hold more wrapped assets than you need. If you are holding wrapped assets just because you like the idea of having them on Ethereum (or other chains), you may want to rethink your personal asset security preferences.
  3. Don’t be a test subject with new projects that promise decentralized wrapped assets.
  4. If you want to trust a security audit, read the full audit report and verify the auditor’s history.

In a nutshell, at this point in the game, the greatest threat to digital assets is security vulnerabilities and single points of failure. Nonetheless, the future looks bright!

How the future looks:

Together, as a Blockchain Community, we are building a whole new world through global participation. Although new technologies always present unknown challenges, as long as we learn from trial and error, and we make necessary changes and improvements along the way, our technologies will inevitably reach an optimum point where they are both secure and trustworthy.

Therefore, I anticipate a future where there is minimal risk with cross-chain interoperability along with a proven track record. However, since we are not there yet, it’s important to be diligent about the security of your personal assets, and therefore, always think before you act!

Go Blockchain!

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