The Risks of Using Wrapped Tokens

I hope the FTX collapse has convinced you not to store your assets on a centralized exchange. Exchanges are still extremely convenient for fiat operations. But for long-term storage, you should definitely withdraw your crypto from the exchange to a real non-custodial wallet that you fully control.

Not trusting CEXs and using non-custodial wallets is very smart. This reduces non-market risks of losing assets. If you bought an asset and it got cheaper, that's market risk – you were unlucky, but that risk is part of the market. However, if you bought bitcoin, it grew 10x, but you kept it on FTX and they just stole your bitcoin – that is non-market risk.

Non-market risks can and should be reduced, but this requires understanding how the system you use works.

Choosing a wallet and safely storing your seed phrase is very important. This topic is often discussed so I'll just mention it briefly. This article will focus on networks and wrapped tokens.

For example, you bought ETH on an exchange and wisely decided to withdraw it to your non-custodial wallet.

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withdrawal of ETH from a centralized exchange

Which network should you choose? Maybe one with the lowest fees? Why is there such a wide choice of networks in the first place?

Let me make an analogy with the real world. When you order a product online, you may be asked "how would you like the product delivered" with options like "ground transport" or "air." You also provide a delivery address. After the product is successfully delivered, you don't care how exactly it was shipped.

Some users think choosing a crypto network is similar to choosing a shipping method for a physical good. But that is absolutely not the case.

Choosing a network is more like choosing a bank where you want your wire transfer to arrive. If you requested a payout to your City Bank account, the money will stay there until you transfer it somewhere else.

In other words, if you withdraw ETH bought on an exchange to, say, the BSC network, your wallet will contain not native ETH but an ERC20 token on Binance Smart Chain that is usually worth exactly the same as native ETH.

The difference between native ETH and a token representing ETH on another network is roughly the same as the difference between paper dollars and gold before the gold standard was destroyed.

The ETH token on BSC has the exact same price as original ETH because the centralized exchange Binance, which issued it, promises to accept their token back and give you real ETH 1:1 anytime.

But what do you think will happen if Binance goes bankrupt? Regulators and hackers are serious risks, and any centralized crypto exchange can go out of business instantly and completely unexpectedly. In this case, all tokens issued by Binance and its affiliates rapidly lose peg to the assets they represent and crash nearly to zero. Other exchanges quickly remove BSC from their deposit networks.

Storing assets on their native network is the safest option. If you keep an asset on any other network, you take on additional non-market risk of losing that asset. Therefore, ETH is most safely kept on the Ethereum network.

Let's understand how to identify an asset's native network. Each blockchain has its own native base asset that was issued on that chain. Some wallet interfaces label such assets as "native" for clarity. If you want to withdraw a native asset from an exchange, you must select that asset's blockchain as the withdrawal network.

As a second example, let's look at the very first wrapped token – WBTC. This is an ERC20 token on Ethereum, issued by BitGo. Its price closely tracks bitcoin's current price.

Say you decided to avoid centralized exchanges entirely. You found someone locally and bought USDT on Ethereum with cash. Now you want to buy Bitcoin on Uniswap.

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Uniswap (most DEX are very similar)

If you asked how to buy Bitcoin on Uniswap, you'd likely be told to buy WBTC – Bitcoin on Ethereum. You can buy it no KYC directly from your non-custodial wallet, wait for Bitcoin to grow, and sell back on Uniswap. Very convenient and private.

But there's a catch: WBTC is not native bitcoin. If the organization issuing and holding the collateral bitcoins goes bankrupt while you're holding WBTC, your asset will lose value. Meanwhile, those holding native BTC won't be affected.

Currently WBTC has an excellent reputation. BitGo publishes wallet addresses on their site as proof that all WBTC in circulation is backed 1:1 with native BTC. However, BitGo is a centralized entity, so it has the risk of shutting down – from regulators or hackers. If the bitcoins disappear from those wallets, WBTC will lose its Bitcoin peg and crash.

I described two hypothetical examples. Have users already suffered real losses from faulty network choices? Yes, it has happened.

For instance, on the DEX Waves, almost all assets traded were issued by a bridge that was part of their platform. 2 years ago they had problems and the bridge stopped working, causing all tokens to crash. For example, if you held USDT on Waves blockchain, it lost nearly all value because that USDT was issued by Waves' bridge, not Tether itself. Users lost around $100M.

4 months ago, the MultiChain bridge collapsed. MultiChain issued many tokens on the Fantom network. Now those tokens lost peg. For instance, USDC on Fantom crashed because that token was issued by MultiChain, not Circle who issues real USDC.

I highlighted those two cases to demonstrate that extra care in choosing networks is especially important for stablecoins. With native coins like BTC and ETH, just use their native chains for safety.

For stablecoins, check the issuer's site to see which exact blockchains they minted tokens on, and use those for long-term storage.