That’s a Wrap: DeFi Needs to Move Past Wrapped Tokens

Technological evolution is a cruel process, and history is littered with discarded innovations.

Just as landlines gave way to mobile phones and email replaced fax machines, it seems to be only a matter of time before wrapped tokens end up in a metaphorical blockchain technology museum.

They were only ever really intended as a band-aid solution to cross-chain interoperability, yet we’ve had to accept their existence as part and parcel of interacting with the DeFi world for far too long. Internet chatter in the DeFi summer talked of a brilliant future where composability truly extended across chains, though this is not what has occurred.

In my view, if we were to keep on relying on wrapped tokens, we risk undermining rather than advancing the mass adoption of DeFi.

When wrapped tokens began

Before we resign wrapped tokens to history, let’s take a look at the role they’ve played.

Wrapped tokens were unarguably helpful in the early days of DeFi, providing holders of these assets access to borrowing, lending and trading opportunities in a brand new ecosystem of tools released at first only on Ethereum.

But using wrapped tokens introduces a level of counterparty risk that really shouldn’t be there in a truly decentralized financial system.

Every time a wrapped token is minted, it means placing long-term trust in a third-party custodian or protocol that isn’t related to the underlying blockchain. If ever these services fail, not only do individual users lose out, but this could potentially have devastating consequences for entire ecosystems.

We also have to trust any issuer’s ability to maintain the peg between the original asset and its wrapped token representation. As we have seen with the likes of TerraUSD, things can unravel incredibly quickly, which adds a further layer of unnecessary risk. The successive implosion of FTX could not have been a more dramatic reminder of the existential risks at play.

Asides from systematic concerns, wrapped tokens have also proven to have significant security challenges. By relying on bridges to move assets across blockchains, we are exposing users’ funds to unnecessary levels of risk. We only need to look at the Ronin bridge exploit to remember the scale of loss that can occur in bridge hacks.

We have to move away from wrapped tokens to stop the erosion of users’ trust, which ultimately sets DeFi adoption back.

Putting trust on the table

Even if the assumptions of trust needed for wrapped tokens don’t seem to bother most everyday users, I would argue that the additional trust layer gives rise to a side effect that is even worse.

As each representation of any given asset is issued on an alternative chain, each of these assets are non-interchangeable. As an example, WBTC and TBTC can’t be deployed together as BTC liquidity in a single pool. Instead, having both just causes fragmentation, hurting each other’s chances at achieving sufficient levels of liquidity to be competitive.

Every wrapped token for each asset is more liquidity and users being diluted across that chain’s markets. We have too many stablecoins, bridges and wrapping services. Contrary to promises of saving users money, this fragmentation actually makes everything less efficient and more expensive for users, thus undermining true composability.

But slowly, we are seeing this wrapped token trend reverse. USDC and USDT are both natively issued on dozens of chains now, which has dramatically improved USD denominated markets across all of these ecosystems. As this continues, we will see the popularity and utility of wrapped USD tokens fade away forever.

In the ever-evolving landscape of blockchain technology, the obsolescence of wrapped tokens appears inevitable. While they served a useful purpose in the early days of bridging ecosystems and instigating interest and growth of DeFi, their days are now numbered.

Any focus on wrapped tokens has diverted attention and resources exactly at the time when it would have been more expedient to focus on developing more user-friendly and native cross-chain approaches. To create a more inclusive, secure and robust financial system for all, we must look toward decentralization — like making decentralized cross-chain swapping solutions the core of our DeFi ecosystem.

It’s clear to me that the continued use of wrapped tokens has directly contributed to a delay in unlocking DeFi access for the masses. The industry needs to shift toward true decentralization, upending the DeFi ecosystem for the better and making wrapped tokens obsolete.

Simon Harman is the Berlin-based founder and CEO of Chainflip, a cross-chain decentralized exchange set to launch in mid-2023. He is also a board member of the Oxen Foundation. Prior to Chainflip, Simon led teams that produced products including Session, a messaging app based on the Signal protocol. Simon has been a cryptocurrency enthusiast since 2014.

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