Some of you readers who are in the cryptocurrency space might be familiar with the term “wrapped Bitcoin” or “wrapped crypto tokens.” In this article, we’ll discuss the different types of wrapped crypto tokens, their purpose, and how they could impact you as a crypto trader or investor.
While blockchains such as Bitcoin and Ethereum are independent of one another and use different protocols, they cannot communicate because their algorithms differ. While this independence protects the security of each blockchain, it also makes it difficult to exchange data and information between them.
For example, in decentralized finance (DeFi), an efficient, smooth, and fast movement of funds is essential for DeFi applications to function correctly. Other more recent blockchains were Polkadot created to overcome the interoperability issue that was holding back allows communication between early networks such as Bitcoin and Ethereum by creating wrapped tokens.
What are wrapped crypto tokens?
Wrapped crypto tokens are cryptocurrencies that are pegged to the value of another original cryptocurrency or asset, such as gold, stocks, shares, or real estate. These tokens can then be used on DeFi platforms.
Wrapping an asset essentially creates a digital vault for it and generates a new token that can be used on other platforms. This process allows non-native assets to be used on any blockchain and promotes interoperability between different networks in the cryptocurrency space.
Wrapped tokens can be redeemed for a variety of things, including but not limited to arts and collectibles, commodities, crypto assets, equity, stocks, fiat currencies, and real estate. These items must then be managed by a custodian entity in order to wrap or unwrap the asset.
We will see why cryptocurrencies are also limited in the decentralized world. Wrapped Bitcoin denominated as wBTC were the first wrapped Bitcoin tokens used in the Ethereum blockchain through smart contracts, letting investors earn a fixed income. Besides Bitcoin, the list of wrapped tokens includes other assets mainly compliant with Ethereum ERC-20 and Binance Smart Chain BEP-20.
Although it may sound curious, ERC-20 tokens are actually issued on the Ethereum platform. However, ETH is not compliant with them because it was developed before the standard was created. Therefore, just like Bitcoin, Ether needs to be wrapped in order to comply with other ERC-20 token standards. By doing this, a tokenized version of Ether is created on the Ethereum platform.
Some other popular blockchains, such as Cardano, Polkadot, and Solana are now beginning to use wrapped tokens in order to allow users access to DeFi applications.
Types of wrapped crypto and how they work
Although there is a significant distinction, stablecoins are widely considered the first type of wrapped token. For example, USDT (Tether) is backed by approximately one dollar but does not hold the same amount of physical USD for each USDT held. Tether’s reserves also include assets such as cash equivalents, investments, and receivables from loans.
There are two types of wrapped tokens: redeemable and cash-settled. Cash-settled tokens cannot be redeemed for the underlying asset, but redeemable ones can. Some other blockchains host-wrapped versions of privacy coins like Monero or ZCash.
At the request of platforms like Airswap, CoinList, 0x, AAVE, or Maker, a custodian creates reserves of original tokens. For example, if somebody wants to convert wBTC back into Bitcoin, they would request that the custodian release it from their reserve. In other words: for every wBTC that exists, there is one Bitcoin being held in reserve by a custodian.
One of the issues with crypto is that in order to create and manage wrapped tokens, you need a custodian to hold the funds. However, this goes against the idea of an open and decentralized blockchain ecosystem.
Currently, traders can’t use wrapped tokens independently for cross-chain transactions, which is why a custodian is still required. But technology is changing fast, so we might have some more decentralized options soon.
Steps in the working of a wrapped token
- A user transfers an amount of the original BTC to a custodian address on the Bitcoin blockchain.
- After that, the original BTC is locked by the custodian.
- Then, the custodian mints the real BTC equivalent amount in the ERC-20 token and holds it in custody.
- Finally, the user requests that the wrapped token be converted back into the original token.
The wBTC protocol was created in January 2019 to bring the potential and liquidity of Bitcoin to Ethereum’s network. ERC-20 tokens have increased flexibility, which allows original BTC assets to be replaced and used for DeFi transactions or decentralized applications on the Ethereum network.
The addition of a wrapped Bitcoin (wBTC) is a game-changer for the cryptocurrency world. Although its value is equal to that original Bitcoin, it can now be used for other purposes, like DeFi—enormously broadening its potential applications.
Put more simply, by connecting their wallet to a decentralized platform, a BTC holder can lend Bitcoin through smart contracts and earn fixed interest annually. Simultaneously, borrowers use cryptocurrency as collateral in case of nonpayment, which is then automatically transferred to the lender. By using this type when asset values are down, investor lenders can still receive some return on investment from financing rather than selling assets.
Wrapped tokens on Ethereum
ERC-20 tokens on Ethereum are but one use case of the blockchain. These tokens function as wrappers for other assets, making them compliant with ERC-20 standards and therefore usable on Ethereum. It’s important to note that every time you wrap or unwrap a token, it’ll cost you gas. Depending on the implementation, these wrapped tokens can vary quite a bit from each other.
An interesting example of a wrapped token on Ethereum is wrapped ether (WETH). A quick recap – ETH (ether) is required to pay for transactions on the Ethereum network, while ERC-20 is a technical standard for issuing tokens on Ethereum. For example, Basic Attention Token (BAT) and OmiseGO (OMG) are both ERC-20 tokens.
ETH isn’t compatible with the ERC-20 standard, so WETH was created as a version of ETH that is. Since many DApps need an ERC-20 token, WETH lets users have their cake and eat it too – they can use ETH and still conform to the Ethereum standards!
Benefits of using wrapped tokens
Wrapped tokens allow non-native tokens to be used on a given blockchain, which increases liquidity and capital efficiency both for centralized and decentralized exchanges. The ability to wrap idle assets and use them on another chain can create more connections between otherwise isolated liquidity pools.
Aside from its other great benefits, one awesome perk of Bitcoin is that transaction times and fees are incredibly low. Although it isn’t the fastest cryptocurrency, it more than makes up for it in other areas. And if you’re ever experiencing any problems with speed or fees, you can use a wrapped version on a blockchain that has much faster transaction times and lower fees.
The future of wrapped crypto tokens
As the number of blockchains grows, it becomes increasingly difficult to have interoperability between them. This is because exponentially more bridges are needed to connect each blockchain. However, there are solutions being developed that will enable assets to be transferred between blockchains easily and effectively.
A bridge hub is a central blockchain that all other blockchains connect to. An example of this is Darwinia, a cross-chain bridge being built on Substrate. Wrapped tokens and bridges are going to continue being part of the solution for interoperability in the near future.
Wrapped tokens assist in the construction of more bridges between various blockchains. A wrapped token is an asset that primarily exists on another blockchain but has been converted into a token.
This enhances interoperability within the cryptocurrency and Decentralized Finance (DeFi) realm. Wrapped tokens make it possible for capital to be used more effectively, and for applications to readily share liquidity with one another.