What Are Wrapped Tokens?
Cryptocurrencies have introduced a revolutionary concept known as wrapped tokens, which effectively link the value of one digital asset to another cryptocurrency. This ingenious system encapsulates the original asset within a secure digital vault, aptly termed a wrapper. This process generates a replicated version of the token on another blockchain.
The primary motivation behind the development of wrapped tokens stems from the distinct functionalities offered by various blockchains. Given their independent nature, these blockchains operate in isolation, impeding seamless communication between them. For instance, the Bitcoin and Ethereum blockchains remain oblivious to the activities transpiring on each other's platforms. However, the introduction of wrapped tokens bridges this gap, fostering many connections across diverse blockchains.
Basics
Interoperability between different blockchains has long been a challenge, leaving cryptocurrency enthusiasts unable to utilize certain assets across multiple platforms. This predicament arises from the inability to effortlessly transfer coins from one blockchain to another.
However, a groundbreaking solution has emerged: wrapped tokens. These innovative digital assets provide a workaround to this limitation, enabling users to leverage non-native assets on various blockchains. Whether it's utilizing BTC on Ethereum or ETH on Polygon, wrapped tokens pave the way for seamless cross-blockchain functionality.
What Is a Wrapped Token?
A wrapped token is significant in the cryptocurrency industry as it represents a tokenized version of another digital currency. Designed to mirror the value of the underlying asset it signifies, these tokens can typically be redeemed (or "unwrapped") for the original asset at any given moment. Crucially, wrapped tokens are frequently deployed to represent assets that do not naturally exist on the blockchain where they are issued.
Analogous to stablecoins, wrapped tokens derive their value from an external asset. However, while stablecoins often rely on fiat currency as their foundation, wrapped tokens find their value in assets that natively inhabit alternative blockchains.
Blockchains, operating as distinct entities, lack a reliable mechanism for seamless data transfer between them. This limitation is where the significance of wrapped tokens emerges, as they catalyze heightened interoperability between diverse blockchain networks. Essentially, the underlying tokens, through the mechanism of wrapping, gain the ability to transcend blockchain boundaries, enabling cross-chain functionality.
It is essential to note that the intricacies of the wrapping and unwrapping processes need not burden ordinary users. For users, engaging with wrapped tokens entails treating them as any other cryptocurrency, seamlessly trading them within the cryptocurrency market. As an illustration, consider the WBTC/BTC market on exchanges, exemplifying the ease with which wrapped tokens can be accessed and traded.
How Do Wrapped Tokens Functionate?
In our exploration of wrapped tokens, we shall examine Wrapped Bitcoin (WBTC) as a prime example—an Ethereum-based tokenized rendition of Bitcoin. WBTC, an ERC-20 token, is meticulously designed to maintain an equal value peg to Bitcoin, enabling seamless utilization of BTC within the Ethereum network.
The Role of Custodians in Wrapped Token Ecosystems
Wrapped tokens typically necessitate the presence of custodians—entities entrusted with holdings equivalent to the wrapped asset's value. These custodians may manifest as merchants, multisig wallets, decentralized autonomous organizations (DAOs), or even smart contracts. In the case of WBTC, for every minted WBTC, the custodian must possess an equal amount of BTC, with proof of this reserve being publicly recorded on-chain.
Wrapping Process
To comprehend the intricacies of the wrapping process, envision a merchant initiating the transfer of BTC to the custodian for minting. Subsequently, the custodian generates the corresponding amount of WBTC on the Ethereum network, reflecting the BTC received. When the need arises to convert WBTC back to BTC, the merchant submits a burn request to the custodian, triggering the release of BTC from the reserves. In essence, the custodian functions as both the wrapper and the unwrapper. Notably, the management of custodians and merchants in the WBTC ecosystem is facilitated by a DAO.
Difference Between Wrapped Tokens and Tether (USDT)
While certain community members may mistakenly refer to Tether as a wrapped token, this assertion is inaccurate. Although USDT typically trades one-to-one with USD, Tether does not maintain an exact equivalent of physical USD reserves for every circulating USDT. Instead, their reserves encompass cash, various real-world cash equivalents, assets, and receivables from loans. Nevertheless, the concept bears remarkable similarity, as each USDT token effectively represents a wrapped version of fiat USD.
The Potential of Ethereum's Wrapped Tokens
In the Ethereum ecosystem, wrapped tokens are popular because they allow for the inclusion of tokens from different blockchains while following the ERC-20 standard. This remarkable achievement allows users to seamlessly harness non-native Ethereum network assets. Nonetheless, it is crucial to note that wrapping and unwrapping tokens on Ethereum incur gas costs, as expected.
A captivating exemplification of a wrapped token on Ethereum emerges as wrapped Ether (WETH). To recap briefly, ETH (Ether) serves as the fundamental medium for transactional payments within the Ethereum network, whereas ERC-20 functions as a technical standard governing the issuance of tokens on Ethereum. Tokens such as Basic Attention Token (BAT) and OmiseGO (OMG) are prime examples of ERC-20 tokens.
However, a predicament arises as ETH predates the establishment of the ERC-20 standard, rendering it non-compliant. This limitation poses challenges, particularly when decentralized applications (DApps) necessitate seamless conversion between ether and ERC-20 tokens. To address this concern, wrapped Ether was ingeniously conceived—a tokenized rendition of ether that strictly adheres to the ERC-20 standard. WETH is a compliant substitute for ether within the Ethereum network, bridging the gap between these two entities.
The Advantages of Using Wrapped Tokens
Unlocking Cross-Chain Compatibility
Although various blockchains possess their unique token standards (e.g., ERC-20 for Ethereum or BEP-20 for BSC), these standards are confined within their respective chains. Wrapped tokens, however, revolutionize this limitation by enabling the utilization of non-native tokens across different blockchains, fostering unprecedented connectivity.
Amplifying Liquidity and Capital Efficiency
The adoption of wrapped tokens yields significant liquidity and capital efficiency benefits, transcending the boundaries of centralized and decentralized exchanges. By combining unused assets and connecting them to different networks, we create a new interconnected system of resources that were previously separate.
Streamlining Transaction Times and Fees
One of the remarkable advantages of wrapped tokens lies in their ability to address transaction time and fee concerns. While Bitcoin showcases remarkable attributes, its transaction speed and cost can occasionally pose challenges. By leveraging a wrapped version of Bitcoin on a blockchain boasting faster transaction times and lower fees, these obstacles can be effectively mitigated, ensuring a smoother user experience.
Constraints Associated with Wrapped Tokens
In the present landscape, most wrapped token implementations necessitate a degree of trust in the custodian responsible for safeguarding the underlying funds. While existing technology falls short of enabling true cross-chain transactions with wrapped tokens, as they often rely on custodians as intermediaries, promising developments are underway to introduce more decentralized alternatives. These innovations hold the potential to offer trustless minting and redemption of wrapped tokens in the future.
It is important to acknowledge that minting wrapped tokens may incur substantial costs due to high gas fees. Additionally, participants should remain mindful of potential slippage during the minting process.
Conclusion
Using wrapped tokens can facilitate the creation of connections between various blockchains. A wrapped token represents an asset from a different blockchain. This enhances the ability of different cryptocurrency and DeFi platforms to work together smoothly. The use of wrapped tokens allows for greater efficiency in the use of capital and makes it easier for applications to share liquidity with one another.