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If you are someone who has been dabbling in the cryptocurrency and DeFi ecosystem, you might have come across the term “wrapped” in association with a cryptocurrency. The wrapped tokens have a lot of uses and utilities that anyone in the cryptocurrency market should know about. In this article, we will be covering all the basics you need to know about wrapped tokens and how it is utilized in a DeFi (decentralized finance) environment.
Wrapped tokens make the interoperability of blockchains possible, enabling users to use a native cryptocurrency on another blockchain and enjoy their features and services without actually cashing out the original crypto coin the user owns. This article can help you understand what wrapped tokens are, and what are its advantages as well as limitations in the DeFi setting.
What is a Wrapped Crypto Token?
Let’s get straight into the crux of the matter, what is a wrapped token? Well, the straight answer is, that wrapped tokens are a cryptocurrency that is pegged to another cryptocurrency or other assets, like a stablecoin is. This pegging allows users to use a cryptocurrency they own a foreign blockchain without having to cash out or exchange the token they hold. The user can also unwrap a token and receive their original token through the process called “unwrapping”.
The wrapping works through a custodian, in which the asset that needs to be wrapped is stored in a secure digital vault and the new, wrapped token is created. As the wrapped token and the original coin are pegged together, the newly minted token will have the same value. Examples include Wrapped Bitcoin (WBTC), Wrapped Ether (wETH), Wrapped Polkadot (WPOLK), etc.
What is the Importance of Wrapped Tokens?
Cryptocurrencies are native to a blockchain. You usually cannot use a blockchain’s asset on another blockchain. So, what if you have the coin of one blockchain and you want to use the features of another blockchain? Wrapped tokens simply solve this problem by generating a new crypto token or the wrapped tokens.
But why would someone want to use a crypto coin on another blockchain? While blockchains work similarly there are many fundamental differences between each other. For instance, while Bitcoin is far superior the Ethereum in terms of average value, the Bitcoin blockchain is slow and has a higher transaction fee.
Additionally, the Ethereum blockchain offers some outstanding features such as dApps (decentralized applications), and DeFi(decentralized finance) protocols. This is where wrapping comes in handy. The Wrapped Bitcoin (WBTC) can be used in the Ethereum blockchain.
Wrapping increases the use cases of cryptocurrencies makes interoperability possible, possibly increases liquidity, and enables users to participate in various dApps, and DeFi smart contracts to find more trading and passive earning opportunities.
How Does Cryptocurrency Wrapping Work?
Cryptocurrency wrapping involves the users, the coin that they own, and the custodian. The custodian is ideally a smart contract or a DAO that you can find with the help of an exchange, or a digital crypto merchant.
When the user requests their asset to be wrapped by sending cryptocurrency to the wallet of the merchant, they transfer the request to a custodian. The custodian locks the received coins in the digital vault and mints new wrapped tokens, which are then transferred to the merchant and then to the user.
When the user needs their original asset back, they send the wrapped tokens to the merchant, which will be then transferred to the custodian who burns and destroys the wrapped token and releases the original coin back to the merchant and finally to the user.
Advantages of Wrapped Tokens
Wrapped tokens have several advantages that make them an integral part of the cryptocurrency ecosystem. To better understand the wrapped tokens, let’s see some of their major advantages:
1. Better Accessibility
Wrapping cryptocurrencies allows users to get into a blockchain or DeFi space without having to swap or bridge the tokens they own regularly. This improvement in accessibility makes it easier for users to find potentially lucrative services such as yield farming, staking, lending, borrowing, etc.
2. Increased Liquidity
Liquidity is the ability to trade a cryptocurrency without significantly affecting its market value. The liquidity varies according to the visibility of the token, demand, and the exchange or DeFi you are using. Wrapping the low-liquidity coin can enable users to find a platform that offers better liquidity.
3. Interoperability
As we have been mentioning from the beginning, the interoperability of two independent blockchains is one of the major advantages of wrapped tokens. This allows the users to enjoy the features of two networks simultaneously.
Drawbacks of Wrapped Tokens
Wrapped tokens have multiple advantages and various use cases. It also has some drawbacks, which are important to consider. They are:
1. Custodial Vulnerabilities
To facilitate wrapping, you need to trust a centralized vault for safe-staring your cryptocurrency. This poses some security and fraudulence risks. Firstly, your original coin is only as secure as the custodian is. Additionally, if the custodian fails to properly manage the original asset, you can run into issues when attempting to unwrap your token.
2. Technical Challenges
The technical process involved with wrapping can be challenging and overwhelming for beginners in the cryptocurrency ecosystem. Novice users can also have difficulty wrapping their heads around the concept of wrapping and why it matters.
3. Smart Contract Vulnerabilities
Smart contracts are used in wrapping to keep the cryptocurrencies in custody. While smart contracts are decentralized and safe digital contracts that will only facilitate the transaction once the agreed-upon conditions are satisfied, hackers have made it clear that there are a host of vulnerabilities associated with them. Poorly written contracts and bugs can pose significant security risks.
Examples of Wrapped Tokens
We have already familiarized ourselves with what wrapped tokens are, why it is used, and what their advantages and limitations are.
Now let’s see some of the most popular wrapped tokens and how they function:
1. Wrapped Bitcoin (WBTC)
WBTC is one of the first wrapped tokens created to enable the interchain usage of Bitcoin and Ethereum. It is an Ether-based ERC-20 token. Users can wrap Bitcoin and receive WBTC, to enjoy the features that the Ethereum blockchain can offer. The token is also popular on major centralized and decentralized exchanges.
2. Wrapped Ethereum (WETH)
WETH is an ERC-20 token based on the Ethereum blockchain. It makes it easier for Ethereum to be used in ERC-20-supported blockchains such as Ethereum, Avalanche, and more. The ERC-20 is a standard guideline for tokens created by Ethereum. However, the native token of Ethereum ETH was created pre-ERC-20 and it does not follow the guidelines which is why you need to wrap ETH to use them in dApps, and DeFi platforms on the Ethereum.
3. Wrapped BNB (WBNB)
This token represents the DeFi-compatible, ERC-20 version of the BNB coin of Binance. BNB and WBNB are pegged in a 1:1 ratio, and the custodian stores BNB for every WBNB in circulation. This serves as the bridge between Binanace and Ethereum.
Is it Safe to Wrap Tokens?
Yes, wrapping, is found to be safe in technical regards and from an investment standpoint. Wrap tokens have better liquidity, and often provide most opportunities for users to find lucrative opportunities. According to statistics, the number of wrapped Bitcoins has only increased since the launch of WBTC.
However, it is worth noting that the original token is only as secure as the smart contract or your custodian is. Any vulnerabilities in the smart contract can result in the loss of your cryptocurrency. So ensure that you are using a credible and trustworthy custodian that is backed by insurance and guarantees in case an attack happens. This intervention of a third party goes against decentralization. Bridging, which makes interoperability of blockchains without a third-party intervention can be much safer.
Difference Between a Bridge and a Wrapped Token
Since bridges and wrapped tokens are both used for facilitating interoperability between two blockchains, they are often mistaken for the other. Let’s understand the difference between the two concepts before further engaging with the exploration of wrapped tokens.
The major difference between a bridge and a wrap is the way how each facilitates interoperability. While in the case of wrapping, the original coin is pegged in a 1:1 ratio with a token that is operational on another blockchain, the bridge locks the coin on the source blockchain, while creating an equivalent asset on the destination.
Bridging is a bit more complicated and slower process than wrapping. However, it allows users to transfer the cryptocurrency onto another blockchain to enjoy its positive aspects, without having to trust a third-party custodian.
Conclusion
Wrapped tokens are a type of cryptocurrency token used to represent a cryptocurrency of a blockchain on another independent blockchain. The wrapped token is pegged in a 1:1 ratio with the original cryptocurrency.
It allows interoperability between blockchains, allowing the users to enjoy the perks of both worlds. In this article, we have explored wrapped tokens in detail. We have also verified if it is safe to wrap a cryptocurrency.
