What are Wrapped Tokens and how do they Work?

Introduction

Over the past few years, financial markets have started to wake up to the many benefits, use cases, and large growth potential behind cryptocurrencies. However, there have been numerous complications that digital assets have had to contend with. One of these limitations is that some digital assets cannot be transferred from their original blockchain to another blockchain. This means that some tokens cannot enjoy the added benefits of blockchains other than their native chain, or the blockchain on which they were created. To solve this problem, “wrapped” tokens were developed and introduced to the market.

What are Wrapped Tokens?

A wrapped token is a tokenized version of another cryptocurrency that exists natively on a different blockchain. This type of asset has currency parity with the original token. In addition, it can be redeemed or “unwrapped” at any time.

The name comes from the fact that the original asset is protected or wrapped in a kind of digital vault, that is, metaphorically “put into a wrapper”. This allows the wrapped version to be created on a different blockchain, and these tokens allow information to be exchanged between two blockchains. Nonetheless, they can be traded like any other cryptocurrency.

Think of wrapped tokens as a passport that allows you to “travel” out of the native blockchain of the digital asset you own to other blockchains.

How do Wrapped Tokens Work?

Wrapped tokens are minted on a new blockchain after the required number of tokens to be created are sent to a custody wallet. For example, if a merchant wants to convert Bitcoin into Wrapped Bitcoin, he/she will have to send the exact amount of Bitcoin to be converted to the custodian’s wallet. For reference, a custodian is essentially just a bank where you can store your coins, manage their liquidity, and protect them from theft. Merchants, multi-signature wallets, or even a smart contract can serve as a custodian. You send your collateral to the custodian and a wrapped version of your coin is minted. Once this is done, the custodian locks the Bitcoin in a vault and, in turn, mints WBTC.

Users might wonder how wrapped tokens are returned to their original state. It is through the same process that the custodians converted them in the first place. This means that the custodian has to release the Bitcoin stored in the vault for this to happen. This shows that each wrapped Bitcoin has an equivalent value of Bitcoin kept in a vault. One thing that traders have argued is the limitation of trust. With this, the custodians holding the funds erase trust and decentralization in the ecosystem.

Image Source: Accubits

Wrapped Token Example: WETH

Almost all fungible tokens on Ethereum adhere to the 2015 ERC-20 standard. This token standard was created to create a uniform set of guidelines for tokens on Ethereum, simplifying the issuance of new tokens, and bringing all tokens on the blockchain into parity. Unfortunately, the ERC-20 standard is not supported by Ether itself. Wrapped Ethereum (WETH) was created to improve blockchain compatibility and enable use of Ether in decentralized apps (dApps).

With Wrapped Ethereum, you could visit a decentralized exchange (DEX) like Uniswap and exchange your Ether for Wrapped Ethereum. As with dollar-pegged stablecoins, the original Ether is changed to Wrapped Ethereum, but the value is maintained. Wrapped Ethereum is required to exchange between tokens in decentralized applications on the Ethereum network. For instance, certain decentralized applications require WETH as collateral rather than Ether in order to function. WETH is an ERC20 currency that can be exchanged for other ERC-20 tokens on DeFi applications, whereas Ether is required to pay for gas. A mirror image of Ether could exist on other blockchains thanks to their versions of WETH.

What Makes Wrapped Tokens Unique?

Tokens can exist on many chains thanks to wrapped tokens like WETH, WBTC, and others. To have price exposure to ETH while not using the Ethereum chain, for example, if an investor wishes to own Ether but utilize it on the Avalanche network, they would need Wrapped Ethereum. This boosts the liquidity and capital efficiency of blockchains by enabling investors to wrap assets and deploy them on other chains. Since it is regarded in the cryptocurrency world as a “safe haven” asset, Bitcoin is especially well-liked in this context. By wrapping their Bitcoin, investors can keep it while still using it for yield farming or other DeFi operations.

Additionally, coin wrapping helps speed up transactions and cut costs. Due to the high gas costs that Ethereum currently faces, wrapping it on another blockchain enables investors to exchange Ether at significantly lower prices. On the other hand, wrapping coins necessitates the use of a custodian, which exposes investors to further risks. While custodians like Thorchain are susceptible to hacking, decentralized exchanges may also have smart contract risks. There is currently no completely decentralized method of currency wrapping. Additionally, not every blockchain can encompass every token. While most significant blockchains have variants of WETH, this is not always the case.

Benefits of Wrapped Tokens

There are many benefits and use cases that come alongside using wrapped tokens. We have identified four main pros of wrapped tokens as follows:

  • Interoperability — Allows the use of non-native tokens on other blockchains.
  • Increased Transaction Speed — Ensures fast trading. Since time is a valuable asset in the cryptocurrency industry and cryptocurrencies are volatile, this is a huge advantage.
  • Liquidity — Increases the efficiency of capital and the availability of liquidity for exchanges, offering investors more trading options.
  • Lower Transaction Fees.

By: Jack Nelson, Defy Trends

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Disclaimer: This article is for educational purposes only and must not be treated as financial or legal advice.

Please conduct due diligence and manage your risks accordingly.

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