Key Takeaways

• Utilizing wrapped tokens is a creative approach to using digital assets like Bitcoin or Dogecoin on blockchains other than the one they were designed for.
• Every wrapped token is linked to a particular asset, like Bitcoin or Dogecoin. That asset backs it at a 1:1 ratio and is kept safe in a digital vault.
• Wrapped tokens solve a big problem with blockchains: they only sometimes work well together. With wrapped tokens, you can use different blockchains together seamlessly.
• A wrapped token is like a digital copy of a cryptocurrency with the same value. Still, it’s made to work on a different blockchain.
• Wrapped tokens are handy for moving money across blockchains that don’t usually work together. They’re a crucial part of making decentralized finance work across different blockchains.
• The most well-known wrapped tokens include WBTC, WETH, WMATIC, and renBTC.

What are Wrapped Tokens?

We need to find out who originally came up with the wrapped tokens. The idea has changed, and many different people and groups have likely contributed to its development. However, “wrapped token” refers to tokens created using the Ethereum blockchain’s ERC-20 standard in 2015. A wrapped token is a digital token representing another cryptocurrency, and its value is tied to the underlying asset’s value. You can usually trade a wrapped token back for the original investment at any time. Wrapped tokens represent assets that don’t naturally exist on the blockchain they’re issued on. One well-known example is wrapped bitcoin (WBTC).

It’s like how you can’t use euros to pay for things in the US, and you can’t use Bitcoin on the Ethereum blockchain. Wrapped tokens solve this problem by allowing you to use one blockchain’s tokens on a different blockchain. Wrapping a token involves exchanging it for a different token of equal value using a smart contract. It’s like trading a dollar bill for four quarters; they’re worth the same amount, but quarters work better in a pinball machine. In a way, wrapped tokens are similar to stablecoins like USDT, which are designed to follow the US dollar price. Just like one WBTC is always worth one BTC, one USDT is always worth one dollar.

How do Wrapped Tokens Work?

Creating wrapped tokens usually involves three parties: the investor, the merchant, and the custodian. Typically, investors and merchants meet on centralized or decentralized exchanges. Investors who want wrapped tokens will ask a third-party merchant for them. The merchant will then send the tokens to a custodian, like a digital vault holding regular and wrapped tokens. To create wrapped tokens, the custodian must have an equivalent amount of the original asset in their vault. The custodian can be a merchant, a multisig wallet, a DAO, or a smart contract. When wrapped tokens are made, it’s called “minting.” And when they’re destroyed, it’s called “burning.”

Minting

There are two ways to get wrapped tokens: buy them directly or have a merchant convert your existing cryptocurrency into a wrapped token. When you go through a merchant, they will send your crypto to a custodian, who will store it in a digital vault. Once your coin is safely locked away, the custodian will create a wrapped token representing your original coin. This process of creating a wrapped token is called “minting.”

Burning

If you want to trade your wrapped token for its original cryptocurrency, you’ll need to “burn” the token. This means that the custodian will unlock the original cryptocurrency, and the wrapped token will be destroyed.

What is the Difference Between a Pegged and Wrapped Token?

Stablecoins and wrapped tokens are similar in concept, but they’re tied to different types of assets. Stablecoins are linked to traditional assets like the US dollar or gold, while wrapped tokens are tied to cryptocurrencies. Wrapped tokens are classified as “pegged currency” because custodians link them to the value of other crypto assets. However, stablecoins like Tether are not considered wrapped tokens because they’re pegged to the US dollar using off-chain cash reserves. These reserves aren’t audited through an automated protocol like wrapped tokens are.

Wrapping Tokens and DeFi

Wrapped tokens have become a popular solution among crypto enthusiasts due to their ability to enable access to multiple blockchain networks. These tokens increase the functionality of assets and provide more use cases for decentralized finance applications that may not have existed before or had limited functionality on the native blockchain network of the asset. The emergence of wrapped tokens has contributed to making crypto assets more efficient. It has helped fuel the growth of the decentralized finance industry.

Types of Wrapped Tokens

Wrapped tokens can be classified based on how they are created and converted back to their original version. Two categories are cash-settled and redeemable wrapped tokens. Cash-settled wrapped tokens cannot be exchanged for the original cryptocurrency asset. On the other hand, redeemable, wrapped tokens are exchangeable for the same amount as the original asset.

Wrapped Bitcoin

The most popular type of wrapped token is called wrapped bitcoin (wBTC). It is a digital asset that represents Bitcoin on the Ethereum blockchain. wBTC allows Bitcoin holders to participate in decentralized finance (DeFi) applications previously only available to Ethereum holders. With wBTC, bitcoin investors can lend, borrow, or trade their bitcoin on DeFi platforms. To get wBTC, investors can send their Bitcoin to a wBTC merchant. The merchant then sends the bitcoin to a custodian, who mints an equivalent amount of wBTC and holds the bitcoin in a secure digital vault. To redeem their bitcoin, investors can return their wBTC to the merchant, who will request that the custodian burn the wBTC and release the equivalent amount of bitcoin. This minting and burning process ensures that the value of wBTC is permanently pegged to the value of Bitcoin. This system is similar to how stablecoins maintain their peg to the US dollar.

Wrapped Ethereum

Wrapped ether (wETH) is a popular token that allows users to trade synthetic ether directly on the Ethereum blockchain. This is because the native token of Ethereum, ether (ETH), is not compliant with decentralized finance protocols. Instead, wETH converts ETH into an ERC-20 token that conforms to the protocol. ERC-20 tokens have rules they must follow to ensure they’re compatible with other Ethereum-based services and platforms. Unlike wrapped bitcoin (wBTC), you don’t have to wrap ETH to acquire wETH. You can simply trade ETH for wETH through a smart contract. As a result, holders of ETH may now directly transact with other cryptocurrencies based on Ethereum and donate money to DeFi protocols, opening up an entirely novel network of decentralized finance for them.

Bridges

Wrapped tokens are one of many ways to transfer assets between blockchains. Bridges like Polygon, Arbitrum, and Optimism let you move assets from Ethereum and trade them on other networks at faster speeds and lower costs. Larger bridges like Wormhole support many blockchains, such as Ethereum, Solana, Terra, Binance Smart Chain, Polygon, and NFTs. Unfortunately, in February 2022, Wormhole was exploited, which resulted in the loss of 120,000 wETH, worth more than $326 million at the time. Bridges are becoming more popular in the DeFi market, making it easier to trade wrapped tokens in one place rather than individually wrapped cryptocurrencies. However, selling tokens across blockchains may be so seamless that you won’t need bridges or wrapped tokens in the future.

Are Wrapped Tokens a Good Investment?

Investors in the cryptocurrency world increasingly view wrapped tokens as a sound investment, especially with the growing importance of decentralized finance. In just over a year, roughly $800 million of Bitcoin has been converted into wrapped Bitcoin (wBTC), indicating the industry’s current market capitalization. In 2021, there will be 189,000 Bitcoins held on the Ethereum blockchain, as predicted by Arcane Research. More than 1% of the 18.73 million Bitcoins in circulation are currently thought to be used in DeFi using wrapped Bitcoin tokens. This makes them a good investment if you are interested in them.

Benefits of Wrapped Tokens

Lower Fees

When using the Ethereum network, you may face high transaction fees, especially during busy periods. However, wrapped ether (wETH) allows you to use Ethereum tokens, including ETH, to conduct transactions on other blockchains with lower fees. This way, you can avoid high costs when transferring assets across blockchains.

Faster Transaction Speed

Transferring tokens between blockchains can be complex and time-consuming, often involving multiple transactions. However, with the help of wrapping, a native token from one blockchain can be easily used on another. Wrapping allows for the seamless transfer of cryptocurrencies within the same blockchain, eliminating the need for multiple transactions across different networks.

Capital Efficiency

Sophisticated borrowing systems on decentralized finance (DeFi) lending platforms require access to multiple blockchains to enable a broad settlement network.

Limitations of Wrapped Tokens

Currently, wrapped tokens have limitations that require trust in the fund custodian. In other words, you need to trust a third party to hold the wrapped tokens. Also, the technology behind wrapped tokens have some limitations – they can only be used for genuine cross-chain transactions if they go through a custodian. However, decentralized options are in development that may allow for future trustless token minting and redemption. Additionally, other limitations exist with wrapped tokens that should be considered. There are several limitations to consider when it comes to wrapped tokens:

• Fees: One of the potential benefits of wrapped tokens is that they can allow you to use a token on a different blockchain with lower transaction fees. However, there may be fees involved in the minting process itself.
• Inequivalent value: While a wrapped token should theoretically have the same value as the original cryptocurrency, in times of high volatility, the value of a wrapped token may be lower than the actual coin.
• Contagion: The spread of a financial crisis from one cryptocurrency to another is called contagion. Wrapped tokens can increase the risk of contagion by increasing interdependence among currencies.

How to Secure Wrapped Tokens

Wrapped tokens are digital assets, much like physical assets in the real world, and protecting them from potential threats is essential. Hardware wallets such as Ledger Nano S Plus, Nano X, and Stax offer the most robust security for your assets. Ledger wallets ensure the safety of your private keys and seed phrases by keeping them offline at all times, making it nearly impossible for anyone to access or manipulate your wrapped tokens. You can easily access various DeFi protocols online through Ledger Live. This mobile and desktop application connects with your Ledger wallet while keeping your wrapped tokens safe and secure. This combination of top-notch security and flexibility makes Ledger wallets an excellent choice for those who prioritize protecting their digital assets.

What are the Components of Wrapped Tokens?

There are five fundamental parts of a wrapped token. These components are listed and explained below:

An Underlying Asset

Wrapped tokens are digital representations of another asset, which can be anything from a cryptocurrency to a traditional asset to a unique digital item known as a non-fungible token (NFT). The value of a wrapped token is determined by the asset it represents, meaning that the underlying asset provides the foundation and worth for the wrapped token.

Smart Contracts

These are used to create wrapped tokens, and programmable digital assets with rules and regulations written directly into their code. Smart contracts specify the parameters for the wrapped token, including how it can be created, transferred, and destroyed. These self-executing contracts manage the entire lifecycle of wrapped tokens, ensuring that all transactions are executed correctly and transparently without intermediaries.

Blockchain Platform

Wrapped tokens can be generated on blockchain platforms, including Ethereum and Binance Smart Chain. The wrapped token’s functionalities and capabilities can vary depending on the blockchain platform.

Token Standard

Most wrapped tokens adhere to a particular token standard, like the widely-used ERC-20 standard on Ethereum. This standard outlines a wrapped token’s specific rules and requirements, including how it can be created, moved, and removed.

Digital Asset Exchange

You can buy and sell wrapped tokens on digital asset exchanges, where you can trade and easily access them. The choice of exchange you use can affect how easy it is to buy or sell a wrapped token and how quickly you can trade it for other assets. The more exchanges that list a wrapped token, the higher the liquidity, which means you’ll be able to buy or sell the token more quickly and efficiently.

Final Thoughts on What Wrapped Tokens Are

Wrapped tokens have the power to revolutionize interoperability in the blockchain world. They enable diverse blockchain assets in a single ecosystem, paving the way for cross-chain communication and collaboration. As the need for wrapped tokens increases, we can anticipate more projects embracing this innovative approach to interoperability. The impact of wrapped tokens on the future of the cryptocurrency industry is exciting to observe, and they may even change our perception of cryptocurrency as a whole.