The collapse of FTX sent shockwaves throughout the digital asset industry. It also triggered a domino effect of sorts; any firms with exposure to the bankrupt exchange started to crumble. For instance, leading crypto lender, BlockFi, also declared bankruptcy on November 28, citing exposure to FTX.
The latest entities rumoured to be facing the heat from the collapse of FTX are Grayscale, Wrapped Ethereum (WETH) and Wrapped Bitcoin (WBTC). Tag along as we tell you more about these projects, the speculation around them and whether or not you should be worried. Let's begin with Grayscale, the asset manager behind the world's largest Bitcoin fund.
Following the collapse of FTX, Binance, the world's largest crypto exchange, introduced the proof-of-reserves (PoR) initiative. PoR is an auditing procedure that helps certify a centralised platform's fund reserves. The main goal of such an initiative is to prevent future FTX-like crashes. As such, several centralised exchanges and crypto platforms began announcing their PoR initiatives.
However, on November 18, Grayscale stated that it would not share its proof of reserves with customers. Instead, the company published a blog highlighting all the safety measures it takes to protect customer funds. This led to immediate speculation; people began to wonder if Grayscale avoided a PoR to hide its financial shortcomings. But are these speculations well-founded? Let's find out.
To begin with, let us establish the scope of Grayscale's operation. As the world's largest digital asset fund manager, the firm controls over $10 billion in BTC, Ether and other assets. Grayscale's parent company — the Digital Currency Group — owns several other crypto firms, including trading platform Genesis, the mining company Foundry, media outlet CoinDesk, and many others.
The Digital Currency Group (DCG) also derives a large chunk of its revenue from Grayscale's operations. Therefore, if Grayscale goes belly-up, it will cause a massive fallout within the crypto industry. However, this seems highly unlikely, as DCG recently stated that it is on track to reach $800 million in revenue this year.
Further, Coinbase Custody Trust Company, which currently holds Grayscale's digital assets, vouched for the security of its funds. Coinbase reassured users, stating that cryptocurrencies underlying each Grayscale product are segregated, in cold storage and could not be lent out or used by Coinbase Custody. "We will never, directly or indirectly, lend, pledge, hypothecate or rehypothecate any of the digital assets underlying any Grayscale products," Coinbase said in a letter signed by Chief Financial Officer Alesia Haas.
The company also explained why Grayscale could not publish a PoR. "Coinbase frequently performs on-chain validation. Due to security concerns, we do not make such on-chain wallet information and confirmation information publicly available through a cryptographic Proof-of-Reserve, or other advanced cryptographic accounting procedure. We know the preceding point, in particular, will be a disappointment to some, but panic sparked by others is not a good enough reason to circumvent complex security arrangements that have kept our investors' assets safe for years," the letter went on to state.
Moving on to Wrapped Ethereum (WETH). WETH is an ERC-20 token whose value is pegged 1:1 with Ether (ETH). Tokens with ERC-20 technical standards offer unparalleled practicality, transparency and flexibility. As such, they have become a norm for many decentralised applications (DApps), crypto wallets and exchanges.
However, Ether (ETH) does not follow the same rules as ERC-20 tokens. This is because ETH was introduced before the ERC-20 token standard was. This creates a hurdle for investors who want to use their ETH on DeFi protocols and DApps.
The solution? Wrapped ETH. Users have been using WETH to tap the full potential of their ETH holdings without having to trade them for other ERC-20 tokens. However, over the last couple of weeks, several prominent figures from the cryptoverse began pushing the notion that WETH was on the brink of collapse.
"ATTENTION: WETH is about to be insolvent," said crypto influencer Cygaar in a Nov 27 tweet. "I will begrudgingly bail out anyone holding WETH at a rate of 0.5 ETH per WETH in order to save this space. You can thank me once the crisis has been averted," he added. "We might see a bank run on redeeming WETH soon," tweeted Gnosis co-founder Martin Köppelmann.
However, it was later found that these tweets were part of a joke and completely untrue. Why? Well, because WETH does not have any counterparty risk. There is no centralised organisation holding the underlying Ethereum and taking any risks with user funds.
Instead, all user ETH is deposited in a smart contract. To unwrap their tokens, users simply need to send their wETH tokens to a smart contract on the Ethereum network, which will then return an equal amount of ETH.
Sure, this does create the possibility of smart contract risks, where hackers can breach the agreements and make away with the stored coins. However, the project's underlying smart contracts have existed and operated smoothly for years, and any vulnerabilities or bugs would have already been exploited/rectified by now.
Finally, there is Wrapped Bitcoin WBTC, which functions slightly differently than WETH. WBTC allows you to create an Ethereum-compatible, ERC-20 version of Bitcoin. This allows Bitcoin holders to use their tokens on different DeFi applications.
However, unlike WETH, WBTC stores its Bitcoin holdings with BitGo, institutional custody, staking, and trading platform. And Alameda Research, FTX's sister trading firm, was a huge WBTC user. This created some issues for WBTC due to how it maintains its peg with the value of Bitcoin. Let us explain.
When users buy WBTC, they deposit an equal amount of Bitcoin, which is stored with a custodian firm, BitGo, in this case. Therefore, BitGo has one real Bitcoin for every WBTC in circulation. If a user wants to "unwrap" their WBTC and redeem the Bitcoin they deposited, they must go through a merchant (this could be an exchange like Holdnaut or CoinList, for example). The process entails destroying (or burning) that WBTC and withdrawing an equivalent amount of Bitcoin from BitGo's custody.
All this works fine until the value of WBTC loses its peg with Bitcoin, which happened a few weeks ago, sparking fears of an FTX-like bank run. Whenever the value of WBTC experiences a discount, arbitrage traders buy the cheaper WBTC and trade it for actual bitcoins. The added demand causes the price of WBTC to rise, and the arbitrage traders also land nifty profits.
However, since Alameda was such a large user of WBTC, its absence has left a lot of work for arbitrage traders. "Bitgo froze FTX assets, creating a 4k surplus of BTC and the wBTC depeg," revealed Rugdoc.io, a community-driven project that reviews smart contracts.
Since then, WBTC has been steadily regaining its lost valuation. At the time of writing, WBTC was up 7.44 percent for the week, as compared to BTC's 7.07 percent. It is expected that arbitrage traders will continue to level out the difference, as there is a lot of profit to be made in the process.
