WBTC & WETH: Accounting Treatment for Wrapped Tokens
Accounting treatment of wrapped tokens as receivables
A few weeks ago, I was attending Bitwave’s EDAS 2024 in Nashville, TN, and listened to the panel that involved the accounting team from Coinbase who was discussing how they viewed the wrapped tokens akin to rights to receive the underlying wrapped tokens, i.e. as tokens receivable. As such, post-adoption of FASB ASC 350-60 Coinbase measured wrapped tokens at fair value. I decided to take a better look at the two biggest wrapped tokens (WBTC and WETH) and figure out whether these tokens actually represent the rights to receive the underlying assets.
Let’s dive in.
Wrapped Bitcoin (WBTC)
WBTC is an ERC-20 token on the Ethereum blockchain that represents Bitcoin (BTC). However, when you hold WBTC, no single party directly owes you BTC. Instead, the system relies on multiple parties who each have different roles. This setup makes it hard to treat WBTC as a BTC receivable.
“Wrapped tokens follow the centralized model, but instead of relying entirely on one institution, they rely on a consortium of institutions performing different roles in the network.” [WBTC White Paper]
Below is the list of parties involved and their roles in the WBTC ecosystem:
Custodian: The custodian holds the actual Bitcoin (BTC). They are responsible for minting new WBTC tokens when they receive BTC from merchants. BitGo acts as the custodian.
Merchant: Merchants are responsible for distributing WBTC tokens. They send BTC to the custodian to mint the new WBTC and can also burn WBTC to get BTC back. Examples of merchants include CoinList, AirSwap, DDEX, LoopRing, Maker, AAVE, Crypto.com, Symbolic Capital Partners, FalconX, Kyber, and Wintermute.
User: Users are the holders of WBTC tokens. They can use WBTC like any other ERC-20 token on the Ethereum network to transfer and transact.
WBTC DAO Member: These are institutions that control the WBTC system through a multi-signature contract. They manage changes to the contract, add or remove custodians and merchants, and oversee the overall process of minting and burning WBTC. Examples of DAO members are Blockfolio, Gnosis, and The Ocean.
The WBTC White Paper discusses the legal contract in place between the parties:
“Contract between custodians and merchants. The process of minting and burning tokens does not involve the user and is between trusted institutions. Merchants are required to hold the identity information of the user securely. Custodians are required to publish details of assets under custody quarterly and perform minting/burning duties in a timely manner. Failure to meet these criteria can lead to removal from the network. It is to be noted that there can be multiple custodians in the network, but this comes at the cost of increasing the risk involved in the network. A model where custodianship is shared by different institutions holding keys to a multi-sig wallet is also possible in the future. Though operationally, minting/burning/auditing would require more coordination and time. A security breach among any of the custodians would cause the loss of trust and could lead to mass withdrawals. A security breach with a merchant is much less severe as all outstanding tokens will still be backed up by custodians, but instead could lead to a loss of KYC/AML user data.”
Holding WBTC does not mean one entity owes a user any Bitcoin. Custodians like BitGo hold the BTC and mint WBTC tokens when merchants send them BTC without users’ discretion. Users can acquire and sell WBTC from merchants once they pass KYC, but users do not directly engage with the custodian holding the BTC.
At the same time, no information of widely available with respect to the legal ownership of assets under custody or rights of parties in case of bankruptcy. Although the observability of WBTC transactions on public block explorers allows for a high level of transparency, the multi-party system and lack of a direct contractual obligation to any single entity add a significant layer of complexity to the scenario.
Below is the summary of the amounts of WBTC outstanding and in custody by networks as per the WBTC website:
As a result, WBTC should not be viewed as the right to receive BTC from a third party simply because this token does not grant such a right to its holders.
Wrapped Ether (WETH)
The following is an explanation of WETH on the website of the Ethereum Foundation:
“Ether (ETH) is the main currency of Ethereum. It's used for several purposes like staking, as a currency, and paying for gas fees for computation. WETH is effectively an upgraded form of ETH with some additional functionality required by many applications and ERC-20 tokens, which are other types of digital assets on Ethereum. To work with these tokens, ETH must follow the same rules they do, known as the ERC-20 standard.
To bridge this gap, wrapped ETH (WETH) was created. Wrapped ETH is a smart contract that lets you deposit any amount of ETH into the contract and receive the same amount in minted WETH that conforms to the ERC-20 token standard. WETH is a representation of ETH that allows you to interact with it as an ERC-20 token, not as the native asset ETH. You will still need native ETH to pay for gas fees, so make sure you save some when depositing….
…Besides the canonical implementation of WETH described on this page, there are other variants in the wild. These may be custom tokens created by app developers or versions issued on other blockchains, and may behave differently or have different security properties…”
Ethereum Foundation references three canonical WETH contracts and each of these smart contracts has a different coding implementation as obvious from the very first line of code declaring the version of the Solidity compiler used:
“pragma solidity >=0.6.2 <0.8.0” [Arbitrum]
“pragma solidity >=0.4.22 <0.6;” [Optimism]
“pragma solidity ^0.4.18;” [Ethereum]
In addition to the intriguing differences in the code base of different WETH implementations, we also noted that the market price of WETH is different than the price of ETH (see Coingecko).
Notable common things among the smart contracts are:
Licensing under the terms of GNU license that disclaims any liability for damages arising from the use of smart contracts
Absence of formally submitted smart contract audit results
Mechanics of transactions that are similar to a swap:
“When you "wrap" ETH, you aren't really wrapping so much as trading via a smart contract for an equal token called wETH. If you want to get plain ETH back you need to "unwrap" it. AKA trade it back for plain ETH.”
[RADAR]
To sum up what we’ve covered above:
WETH and ETH have substantially different qualitative characteristics (ability to swap for other tokens and ability to use as payment for gas to transact on a blockchain network)
No formal or informal contract exists with a specified third party that undertakes an obligation to make a payment of ETH in exchange for WETH
No party is responsible for damages and losses that may arise from the use of the smart contracts
The fair value of WETH is different from that of ETH
Finally, there is a (remote and impractical but verified) scenario under which total ETH locked in the smart contract may differ from WETH in circulation. As a result, WETH does not appear to represent tokens receivable, but rather a separate intangible token that can be minted in exchange for the surrender of the ETH equivalent to the amount of minted WETH increased by transaction costs (gas fees).
Other Considerations
Let’s remember the following notable narrative from FASB:
Ҥ148. The concepts underlying the financial-components approach could be applied by analogy to accounting for transfers of nonfinancial assets and thus could result in accounting that differs significantly from that required by existing standards and practices. However, the Board believes that financial and nonfinancial assets have significantly different characteristics, and it is not clear to what extent the financial-components approach is applicable to nonfinancial assets.
Nonfinancial assets have a variety of operational uses, and management skill plays a considerable role in obtaining the greatest value from those assets. In contrast, financial assets have no operational use. They may facilitate operations, and financial assets may be the principal "product" offered by some entities.
However, the promise embodied in a financial asset is governed by contract. Once the contract is established, management skill plays a limited role in the entity's ability to realize the value of the instrument. Furthermore, the Board believes that attempting to extend Statement 125 and this Statement to transfers of nonfinancial assets would unduly delay resolving the issues for transfers of financial assets, because of the significant differences between financial assets and nonfinancial assets and because of the significant unresolved recognition and measurement issues posed by those differences. For those reasons, the Board concluded that existing accounting practices for transfers of nonfinancial assets should not be changed at this time. The Board further concluded that transfers of servicing assets and transfers of property subject to operating leases are not within the scope of Statement 125 and this Statement because they are nonfinancial assets.”
[Basis for Conclusions of FASB Statement 140]
Although this quote is slightly dated, this reference is relevant to our topic. “The significant unresolved recognition and measurement issues posed by” differences between financial and nonfinancial assets is the main issue of web3 accounting.
The following characteristics appear important (although maybe not relevant) for final conclusion:
Treating wrapped tokens as tokens receivable rather than separate tokens with standalone functionality appears inappropriate when we realize that there is no legally binding right to claim wrapped tokens from a specified third party or jointly liable parties.
The ability to enforce an exchange of wrapped tokens to its unwrapped version 1:1 (regardless of the difference in market prices as of the date of an exchange), may be seen as indirect evidence of the right of claim on the underlying assets.
Overall, it appears that wrapped tokens represent a class of digital assets that have different qualities and features compared to the tokens being wrapped but still contain the ability to claim on underlying assets. As a result, the two wrapped tokens we discussed above:
ARE NOT receivable denominated in the underlying tokens, but they
DO contain a right of claim on the underlying tokens.
Thus, I believe that economically WBTC and WETH are nonfinancial assets. These two tokens should be classified as intangible assets rather than accounts receivables. But at the same time, the nature and economics of WBTC and WETH differ substantially from the crypto assets in ASC 350-60 scope. As a result, it is not appropriate to account for these tokens at fair value under the current set of accounting rules. Finally, even if the entity treats wrapped tokens as tokens receivable, the fair value of wrapped tokens would be recorded as a change in the value of an embedded derivative and not as part of a digital assets account.