What are Wrapped Tokens in Crypto?

Key Takeaways

• Wrapped tokens facilitate the utilization of crypto like Bitcoin or Dogecoin on blockchains different from their native blockchain.
• These tokens maintain a 1:1 backing with their underlying asset, securely held within a digital vault.
• Wrapped tokens provide a remedy for the challenge of achieving blockchain interoperability.

Introduction

With a $3.13 billion market capitalization, wrapped tokens are gaining significant attention in the blockchain industry. Different blockchain protocols, like Ethereum, Solana, and Bitcoin, have unique ecosystems based on distinct consensus algorithms.

While these algorithms enhance network security and autonomy, they also hinder blockchain interoperability. For instance, in the decentralized finance (DeFi) sector, the swift and seamless transfer of assets is essential.

Wrapped tokens address this challenge, enabling smooth cross-chain transactions and interaction, especially for earlier-generation blockchains like Bitcoin and Ethereum.

This article will explore wrapped tokens’ core concepts, features, development opportunities, and commonly used examples.

What are Wrapped Tokens?

Wrapped cryptos, or wrapped tokens, serve as digital assets that accurately mirror the value of an original crypto from a distinct blockchain or one that adheres to a different token standard on the hosting blockchain. To illustrate this concept, consider WBTC and WETH as prime examples of the former and latter, respectively.

The process of wrapping native tokens is essentially a means to generate fresh tokens that adhere to a separate blockchain’s standards, allowing users to harness assets from one blockchain in an entirely different blockchain’s environment.

For example, consider Bitcoin (BTC). Initially, Bitcoin can only exist within the Bitcoin ecosystem. But what if you want to use the world’s largest crypto on the Ethereum blockchain, the leading decentralized application (dApp) platform?

To achieve this, you can deposit your BTC from your Bitcoin wallet and receive wrapped Bitcoin (WBTC) – an ERC-20 token – in your Ethereum wallet. WBTC essentially represents the original value of your BTC deposit. With this wrapped Bitcoin, you can engage in Ethereum-based decentralized applications that support transactions involving wrapped Bitcoin, effectively allowing you to transfer Bitcoin’s value using Ethereum’s infrastructure.

It is important to note that the term “wrapping” is more of a figurative expression used to depict the process of minting or generating a novel token that derives its value from an underlying digital asset.

To gain a deeper understanding of this, let’s delve into how wrapped cryptos function in more detail.

Read More: What is Wrapped Bitcoin(WBTC)?

How do Wrapped Tokens Work?

So far, you’ve learned that a wrapped token serves as an analogous representation of a crypto native to a different blockchain. Alternatively, in some cases, it may represent an asset from the same blockchain but adhering to a distinct token standard.

But what exactly is the process of “wrapping” these tokens?

Let’s delve into the concept of wrapped Bitcoin (WBTC) as an illustrative example.

To initiate the wrapping of BTC to create an equivalent quantity of WBTC on the Ethereum blockchain, three primary entities are involved:

1. Merchants: These are entities that lock their BTC to generate fresh WBTC on the Ethereum blockchain or, conversely, burn WBTC to release the locked BTC.
2. Custodians: These are organizations entrusted with the responsibility of safeguarding the BTC reserves on the Bitcoin network.
3. Wrapped Tokens DAO: Comprising various organizations, this collective forms a decentralized autonomous organization (DAO) that collectively determines the inclusion or removal of custodians and merchants from the WBTC Network. The organizations within this DAO employ a multi-signature wallet to facilitate these decisions.

Now that you have a grasp of the three key actors in the WBTC process, let’s explore a straightforward, step-by-step overview of the token wrapping procedure:

• Step 1: A merchant transmits 10 Bitcoin (BTC) to the custodian.
• Step 2: The custodian incorporates these BTC assets into a reserve, typically stored in a crypto wallet. This reserve’s proof is then made available on the blockchain.
• Step 3: An equivalent volume of WBTC, compatible with the ERC-20 token standard, is minted on the Ethereum blockchain.

Merchants can replicate this process to burn WBTC and unlock an equivalent number of BTC on the Bitcoin network. While WBTC relies on a DAO model for security and decentralization, wrapped tokens can be issued by centralized entities or smart contracts.

However, the DeFi community strongly advises against using wrapped tokens from centralized entities due to the risk of fraudulent activities that can jeopardize the asset reserves and the token’s value, leading to rapid depreciation.

In addition to WBTC, the landscape of wrapped tokens encompasses various other examples, including WETH, WMATIC, renBTC, and WFTM. Within the DeFi sector, multiple wrapper platforms issue these tokens, further expanding the realm of possibilities.

Read On: What are BRC-20 Tokens?

Types of Wrapped Tokens 

In the crypto realm, various wrapped tokens like wBTC, wETH, stablecoin equivalents, and blockchain-specific variants offer seamless asset integration. For instance, Wrapped Bitcoin (wBTC) enables BTC holders to engage with Ethereum’s DeFi platforms. Wrapped Ether (wETH) streamlines Ethereum’s operations, while wrapped stablecoins like USDT, USDC, and DAI ease cross-blockchain transactions. Additionally, blockchain-specific wrapped tokens, found on networks like BNB Smart Chain and Polygon, promote cross-chain compatibility and diverse decentralized applications. These tokens are instrumental in enhancing liquidity, interoperability, and accessibility within the evolving crypto landscape.

What is Wrapped Bitcoin?

Wrapped Bitcoin (WBTC) is a collaborative effort led by three Web3 entities: Kyber, Ren, and BitGo, among 15 members of the Wrapped Tokens DAO. They manage WBTC minting and burning, alongside merchant and custodian management.

The Wrapped Bitcoin Network includes 65 projects, protocols, and companies, from lending platforms to decentralized exchanges and centralized custodians. WBTC is now integral to various DeFi and beyond platforms.

Engaging with Wrapped Bitcoin is simple. Users can effortlessly convert their ERC-20 tokens to WBTC and back, treating it like any other fungible Ethereum token.

What is Wrapped Ethereum?

Wrapped tokens on Ethereum are assets from other blockchains adapted to meet the ERC-20 standard, enabling their seamless use within the Ethereum network. It’s essential to consider that wrapping and unwrapping tokens on Ethereum involve gas fees. These tokens can vary significantly in their implementations, as discussed in our comprehensive tokenized Bitcoins article.

A prominent example of a wrapped Ethereum token is wrapped ether (WETH). Ethereum’s native currency, Ether (ETH), is used for transaction fees, while the ERC-20 standard governs token creation on the Ethereum platform, including tokens like Basic Attention Token (BAT) and OmiseGO (OMG).

However, as Ethereum predates the ERC-20 standard, it lacks compliance, making conversion between Ether and ERC-20 tokens challenging for many DApps. Wrapped ether (WETH) was introduced to address this issue by offering a tokenized, ERC-20-compliant version of Ether, seamlessly integrating it into Ethereum’s diverse token landscape.

Benefits of Wrapped Tokens

• Interoperability: Wrapped tokens enable cross-chain compatibility, allowing assets like Bitcoins to function on the Ethereum network, and promoting a wide range of applications, including DApps and DeFi services.
• Enhanced Liquidity: Utilizing wrapped tokens enhances the liquidity and capital efficiency of both centralized (fiat currencies) and decentralized assets.
• Speedy Transactions: Wrapped tokens expedite transaction processing, offering a faster alternative to traditional blockchain transactions, a critical advantage in the volatile crypto market.
• Improved Security: Token wrapping provides enhanced security by granting users more control over their private keys, while custodians, such as DAOs, smart contracts, and multisig wallets, prioritize secure exchanges.
• Reduced Transaction Fees: Wrapped tokens can lead to lower transaction costs, providing practical savings for users involved in various blockchain activities.

Additional Read: What BEP-20 Tokens?

Limitations of Wrapped Tokens

Custodian Dependency:

• Wrapped tokens still depend on custodians for minting and burning.
• Custodian flaws can disrupt the wrapping and unwrapping processes.

Centralization Risk:

• Wrapped tokens introduce centralization concerns, contrary to the decentralization goal of crypto.
• Ethereum’s founder, Vitalik Buterin, has raised concerns about their centralized nature.
• Minting wrapped tokens involves a central program, heightening centralization risks.

Minting Expenses:

• Wrapped tokens entail minor minting costs.
• Wrapping and unwrapping involve gas fees, potentially causing slippage.

Despite these issues, the benefits of wrapped tokens often outweigh these drawbacks.

Conclusion

In short, wrapped tokens have the potential to transform how we view blockchain interoperability, enabling different blockchain assets to collaborate in a single ecosystem. As demand for wrapped tokens grows, more projects are likely to adopt this innovative approach. With continued developments underway, the limitations may be eliminated, potentially removing the need for custodians by employing methods like DAOs, smart contracts, or multisig wallets for wrapping and unwrapping tokens.