There are times when you wish your crypto could work on an unsupported network. Wrapped tokens build bridges across different blockchains to improve the quality of every crypto user's experience.
What Is a Wrapped Token?
Wrapped tokens are custom versions of native crypto tokens built to be transferable on foreign blockchains. Any token that can exist on a blockchain it doesn't originally belong to is classified as a wrapped token.
Wrapped tokens were created out of the need for cross-chain transactions or interoperability. All that technical jargon in simple words means the ability of any two given blockchains to interact with each other.
But why wrapped tokens?
Well, for one, it makes sending tokens to a different network a whole lot easier. If you didn't know, coins living on a particular blockchain are bound by a logic called token standards, which determines how they are minted, stored, and circulated on the network. In short, you can't send, receive or swap tokens on different networks. For example, tokens on Ethereum (e.g ETH) cannot be directly swapped for Bitcoin (BTC), and vice versa, since they exist on two separate networks.
However, taking a portion of bitcoin from its home blockchain, and wrapping it with the standard of the Ethereum blockchain (ERC-20), creates a new cryptocurrency called wrapped bitcoin (wBTC). The such token is readily exchangeable for any Ethereum-based crypto.
The wrapped version of bitcoin (wrapped BTC) is currently the most common wrapped token in the cryptocurrency world. Wrapped tokens also offer cross-chain liquidity solutions to decentralized applications.
As the biggest home to decentralized finance, the Ethereum blockchain is the most fattened with wBTC. Did you know that more than 5.5 million dollars equivalent amount of BTC lives on Ethereum decentralized platforms? The adoption of wrapped bitcoin (wBTC) on the Ethereum network took off in the first quarter of 2022, as bitcoin owners found them extremely convenient for storing their bitcoin on Ethereum wallets and interacting with ETH decentralized exchanges.
That way, this technique of wrapping tokens makes it possible for tokens to be transferred across multiple chains without the underlying blockchains communicating with each other.
If the concept of wrapped tokens still seems a little fuzzy, don't worry, in the next section we'll explain how wrapped tokens are created, who issues them, and their general working principle.
How Do Wrapped Tokens Work?
Three parties are usually involved in the minting process of wrapped tokens: the investor, the merchant, and the custodian.
Typically, the investor and merchant meet on centralized and decentralized exchanges. The user requests wrapped tokens from third-party merchants like AirSwap, CoinList, and AAVE, and sends over their crypto tokens. On behalf of the user, the merchant passes the tokens to a custodian which is a digital vault that holds both regular and wrapped tokens. Custodians have smart contracts programmed to automatically mint a tokenized form of the original tokens received in an equivalent value, and send them to the merchant. After it reaches the merchant's end, the user collects the wrapped token, confirms the transaction, and it's a wrap. Usually, exchanging regular tokens for wrapped tokens doesn't attract gas fees.
It's the same process for converting wrapped crypto assets to the original token, only in reverse. You can think of wrapped tokens as IOUs and the tokens deposited on the custodian as collateral. Users can redeem their original assets with wrapped crypto tokens by transferring them to the custodian holding their original crypto through the merchant once again. The custodian burns the wrapped tokens received and sends the exact amount of the original asset back to the user.
The custodian's treasury must have a reserve that is larger than the number of wrapped tokens issued at any given time. Otherwise, they will not return a user's original tokens whenever the wrapped versions are presented.
There is a technical standard for ensuring transparency between all parties involved in a token wrap process, especially on the custodian's side called proof of reserve. Proof of reserve is a trustless, automated system that verifies if the custodian holds the number of wrapped tokens issued. Tax deductions may apply for exchanging wrapped tokens for the original version.
Pros and Cons of Wrapped Tokens
The utility of wrapped tokens in decentralized finance (DeFi) is virtually undeniable but that doesn't mean we should ignore some of its risks. Check out the pros and cons list to see if it's worth giving a shot.
Benefits of using Wrapped Tokens
Lower fees
Using the Ethereum network can be quite expensive. In periods of peak traffic, network congestion leads to ultra-high gas fees. With wrapped ether (wETH), Ethereum holders can use ETH and other tokens on Ethereum to perform transactions on other blockchains with affordable transaction fees.
Faster Transaction Speed
Moving tokens across different blockchains can take considerable time and effort. Working with multiple blockchains may require the user to perform more than one transaction before they can achieve a single objective. Wrapping allows a native token on one network to be readily available on another. That way, cryptocurrencies can be simply transferred within the same blockchain.
Capital efficiency
Lending decentralized finance (DeFi) platforms with sophisticated borrowing systems need access to all blockchains to foster a vast settlement scheme.
Risks of using Wrapped Tokens
Market contagion is one of the most fatal risks of wrapped crypto tokens. Market contagion is any situation whereby the sudden loss in value of a crypto asset or protocol affects another one like a chain reaction.
In the event of a digital vault failing, any platform utilizing its wrapped assets will suffer some kind of liquidity crisis. In times like this, the reduced barrier and closely knit relationship between separate networks encouraged by wrapping become more of a disadvantage.
Trust Issues
Another major issue with wrapped tokens is the dependency on the custodian. The custodian may not be completely honest about the size of their original asset reserves. Issuing tokens or giving the underlying asset to another user without any real backing leaves holders of the tokenized version with no value.
Centralized
There are more worries about the trustworthiness of the platforms issuing wrapped assets in exchange for primary coins. The Ethereum wunderkind, Vitalik Buterin, aired his concerns about the risks posed by the centralized control of custodians over wrapped crypto assets. Citing more fears in the same direction, Vitalik pointed out the dangers of some of the tokens offered in exchange for wrapped versions being non-Turing complete. Such tokens cannot automatically execute the minting process and transfer of tokens in a trustless fashion via an Ethereum network smart contract and resolve to the centrally-enabled methods.
Pegged vs Wrapped Tokens: What’s the Difference?
A pegged token is any crypto coin linked to and backed by a physical asset (fiat currency, gold, and other precious materials) or other cryptocurrencies in a 1:1 price ratio. When you think of it, that practically describes how wrapped tokens work, so one can say they are both in the same class.
Although it is important to make it clear that stablecoins and wrapped tokens are two different assets. While stablecoins are digital assets fixed to the price of fiat currencies, a wrapped token is pegged to another cryptocurrency locked in a virtual vault.
Also, stablecoins are not backed with the same exactitude as the more modern wrapped cryptos. Tether (USDT), for example, is only approximately backed to one physical USD. USDT's reserves also consist of a mix of assets and financial instruments: cash, bonds, treasuries, e.t.c. On the other hand, one wrapped token has an exact value to its original equivalent.
Types of Wrapped Tokens
Wrapped tokens are commonly classified by how they are issued and redeemed for their original counterpart. They can be categorized as cash-settled or redeemable.
Cash-settled wrapped coins cannot be redeemed for their original crypto assets. Whereas, redeemable wrapped tokens (as you may have guessed) can be exchanged for unwrapped versions of equivalent amounts.
What Are Wrapped Bitcoin tokens?
A wrapped Bitcoin is an ERC-20 token designed to represent the value of an original Bitcoin on the Ethereum blockchain. However, Ethereum isn't the one blockchain that entertains wrapped bitcoin, other blockchains like TRON also have wrapped Bitcoin.
Wrapped Bitcoin was invented so BTC owners can use their holdings to interact with DeFi platforms outside the Bitcoin blockchain.
The boom of DeFi applications mounted atop the Ethereum blockchain fueled the demand for ERC-20 tokens in 2020. Being the cryptocurrency with more than half the total market cap in the cryptocurrency industry, the wBTC ERC-20 token came to play in an effort for developers to devise a means for bitcoin holders to participate in the DeFi activities on the Ethereum without forfeiting their Bitcoin holdings.
Conclusion
Wrapped tokens are new technologies that are pushing the upper limit of cryptocurrency proliferation. Now it doesn't matter what tokens you hold, you can leverage their wrapped version to interact with supported DeFis and make smooth transactions from anywhere.
