Sanctions, Centralization, and wBTC
On Monday, the U.S. Treasury sanctioned the mixing service Tornado Cash and wallet addresses associated with the tool. Shortly after the announcement, USDC stablecoin issuer Circle blacklisted 45 sanctioned Ethereum addresses, making it impossible for any of these addresses to send or receive USDC. This is the first time a U.S. regulator has sanctioned a smart contract, and the implications of this move are wide ranging and unknown.
USDC is the most used stablecoin in DeFi, with billions in total value locked across DEXs and lending protocols. While it isn’t a surprise that a centrally-issued stablecoin was immediately impacted, we wanted to understand whether another systemically important component of DeFi could be affected by sanctions. This week, we take a look at wrapped assets, specifically wrapped BTC, which today is the 18th largest cryptocurrency by market cap.
Wrapped Assets
Wrapped assets are cryptocurrencies that allow the value of a native asset from one blockchain to transfer to another blockchain, enabling its use on multiple networks. There are dozens of wrapped versions of assets across various blockchain networks, facilitating billions of dollars worth of value transfers every day. Wrapped BTC (wBTC) was announced in late 2018 as a community effort to bring bitcoin to Ethereum, with launch partners including the DeFi applications Compound and Maker, and today has a market cap of more than $6bn.
Its supply grew quickly as it was adopted in a variety of DeFi use cases; for example, over 32k wBTC (about $730mn USD) are deposited on AAVE and 18k wBTC ($420mn) are deposited on Compound. Only recently has supply begun to fall after Celsius unlocked large amounts of wBTC from lending protocols (to be redeemed for BTC) and Three Arrows Capital (which completed the single largest mint of wBTC at the time in 2020, receiving just over 2,316 wBTC) entered liquidation.
Its original purpose — to enable bitcoin’s usage in Ethereum-based DeFi protocols — has clearly been borne out when comparing volumes on both centralized and decentralized exchanges; wBTC-wETH volumes on Uniswap V3 are routinely 5 times larger than the highest volume CEX pair: wBTC-USDT on OKX.
Additionally, DEXs account for the majority of wBTC pairs.
How wBTC Works
The issuance of wBTC is managed by a DAO, which is in charge of adding or removing merchants and custodians. Merchants initiate mints or burns of wBTC based on demand: in the case of a mint the merchant will send bitcoin to a custodian and receive wBTC from the wrapped token contract. This mechanism ensures that wBTC supply increases when there is increased demand and vice versa.
The price of wBTC is thus always supposed to equal 1 BTC because redemptions with various merchants are always 1:1. However, wBTC also trades on open markets, which means its price relative to BTC can fluctuate. For the most part, wBTC-BTC pairs on centralized exchanges have traded tightly within the 1:1 ratio.
Unlike undercollateralized stablecoins, the risks of “de-pegging” don’t apply to wrapped assets if we assume that wBTC merchants will always be able to redeem 1:1. But who actually issues wBTC?
Some of the biggest wBTC merchants include Kyber, Ren, Maker, AAVE, Alameda Research, Three Arrows Capital, and others. While early announcements and some areas of the website reference custodians (plural), according to the same website there is only one custodian: BitGo. All merchants must interface with this single entity to facilitate any wBTC mint or burn. BitGo was purchased in 2021 by Galaxy Digital Holdings, which is headquartered in New York. BitGo also holds a coveted BitLicense allowing it to operate in New York State.
The Risks of Sanctions
So a heavily regulated entity operating in the U.S. holds nearly $6bn BTC that is wrapped on Ethereum. Yes, there is a DAO that controls wBTC, but in the U.S. DAOs are still relatively ethereal, while OFAC sanctions are very, very real.
Wrapped BTC doesn’t appear to have the same blacklist function as USDC, but there are a variety of levers that BitGo could pull to essentially freeze wBTC that has passed through Tornado Cash or other sanctioned addresses. The simplest way would be for BitGo to tell merchants that it will not redeem wBTC that has touched sanctioned addresses, which would put pressure on merchants, including DeFi applications and exchanges, to blacklist these addresses.
It appears that DeFi is marching ever closer to an inflection point in which regulations start to hit and the industry and users will have to decide on the importance of decentralization. Do a majority of ecosystem participants (as measured by total value controlled, or put simply: the richest) care enough about decentralization to eschew easy centralized solutions like USDC and wBTC?
My hunch is no, and we will continue to see a bifurcation between “regulated” and “unregulated” DeFi, with regulated growing much faster unless there is rapid adoption of decentralized stablecoins and wrapped assets. Thus far, the best attempt at a decentralized wrapped version of BTC came from renBTC, whose supply peaked at nearly 30k wrapped BTC but has since dipped. Other attempts like Badger/DIGG have largely fizzled out, at least for now.
But crypto and DeFi move extremely quickly, and no one should be surprised if there is rapid growth in decentralized stables and wrapped assets. Hopefully next time they won’t come with 20% APY.
