17 September 2021
Cryptocurrency and Blockchain Technology are revolutionizing the Finance and Technology industries. But one of the pressing concerns it faces is its Interoperability. For example, have you ever been bothered by the fact that you can't use BTC on Ethereum? Or have you ever wondered in general whether you could use Cryptocurrency outside of its native Blockchain to carry out transactions?
Since different Blockchains offer different applications and functions; therefore, you can't just send a token from one Blockchain to another as it doesn't exist on that network. Due to their lack of cross-chain interoperability, they are unable to communicate with each other. In simple terms, coins that exist on a given Blockchain cannot be simply transferred to another. For instance, the Bitcoin Blockchain is completely unaware of what is going on with the Ethereum Blockchain.
This is when Wrapped tokens come into the picture. Considering Blockchains are distinct systems, there is no easy way to transfer data between them. Wrapped tokens are a way to circumvent this limitation and allow non-native assets to be used on the Blockchain. Furthermore, it improves interoperability across Blockchains by allowing the underlying tokens to flow cross-chain. Consequently, it allows information to be transferred amongst the different Blockchains, wherein they can be traded just like any other asset.
In this blog, we are going to discuss everything you need to know about Wrapped Tokens
What are Wrapped Tokens?
A wrapped token is a Cryptocurrency that has been tokenized. As the name suggests, the original asset is placed in a wrapper, a type of digital vault that permits the wrapped version to be formed on another Blockchain. Its value is pegged to the asset it represents, and it can usually be redeemed (unwrapped) at any time. It usually refers to an asset that isn't native to the Blockchain on which it was issued.
Wrapped tokens are simply one token on the "destination" Blockchain that is pegged to the value of the "origin" token. For example, Wrapped Bitcoin is pegged to the value of Bitcoin but it exists on the Ethereum Blockchain. Hence, it's a representation of Bitcoin that's been locked up in a vault on the original chain.
One of the foremost reasons why Wrapped tokens were created was in response to the fact that some Decentralized apps (dApps) on the Ethereum network were not Ether compatible. With the use of Wrapped tokens, users were able to convert their ETH into ERC-20 tokens.
How does it work?
For a token to be wrapped, it needs to have a custodian, as this ensures that the original token and its wrapped version have the same value. It is an entity that holds an equivalent amount of the asset as the wrapped amount. This custodian can be a merchant, a DAO, a multi-sig wallet, or even a smart contract.
The custodian holds the original token and uses a procedure known as minting to "wrap" it. After being minted into a wrapped token, the token is sent to the Blockchain, where it will be used. As a result, one token becomes one wrapped token or two tokens become two wrapped tokens, and so on.
On the other hand, the wrapped token can be "unwrapped" and reverted to its original state. This method is called “burning”, which can also be done by a custodian. After the Wrapped token is burned, it is converted to its original state and sent to its original Blockchain.
Hence, during the minting and burning processes, the wrapped token and the unwrapped token have the equivalent price.
Let's understand through an example - Wrapped Bitcoin (WBTC), an Ethereum-based tokenized version of Bitcoin. WBTC is an ERC-20 token that is designed to be pegged to the value of Bitcoin at one-to-one, allowing you to use BTC on the Ethereum network.
- WBTC is pegged to the value of BTC at a 1:1 ratio. Therefore, a custodian holds a Bitcoin for every WBTC that exists. In this case, the custodian must hold 1 BTC for every 1 WBTC minted. Proof of this reserve exists on-chain.
- The minting process begins when the merchant sends BTC to the custodian, who holds an equivalent amount of wrapped assets in the reserves.
- The custodian then mints WBTC on Ethereum based on the amount of BTC sent.
- When the merchant needs to exchange WBTC back to BTC, he submits a burn request to the custodian, and thus the BTC is released from the reserves.
The custodian can be compared to the wrapper and unwrapper. In the instance of WBTC, a DAO is responsible for adding and removing custodians and merchants.
Benefits of Wrapped Tokens
- Wrapped tokens offer interoperability since they enable the use of non-native tokens on the Blockchain.
- It helps centralized and decentralized exchanges to boost liquidity and capital efficiency as they offer greater trading options.
- They also boost usability, improve security, enhance transparency and scalability.
- Adopting a Blockchain-based wrapper version helps with faster transaction times and lower fees.
- It enables users to transact confidently since Wrapped tokens are kept through a framework that backs each one-to-one with the underlying assets.
Limitations of Wrapped Tokens
- Wrapped tokens can't be utilised for true cross-chain transactions, necessitating the inclusion of a custodian.
- Due to high gas fees, the minting procedure might be costly and may result in slippage.
- The ultimate purpose of Cryptocurrencies is to function in a decentralized environment. Since custodian issues Wrapped tokens, they are vulnerable to centralization.
Wrapped tokens are like a blessing in disguise in the Blockchain and Crypto space. They help create additional bridges between different Blockchains. This approach promotes interoperability in the Cryptocurrencies and the Decentralized Finance (DeFi) ecosystem. Wrapped tokens pave the way for a world where capital is more efficient and applications may conveniently share liquidity. They are the next best thing to a completely seamless transition for Cryptocurrency and Blockchain.
Disclaimer: The author’s views and opinions are for informational purposes only and do not constitute financial, investment, or other advice.