Understanding wrapped tokens
Cryptocurrency enthusiasts may have heard of wrapped Bitcoin or wrapped crypto tokens. In this article, we will learn the types of wrapped tokens that exist in the world of cryptocurrencies, the meaning of wrapped tokens, and what they mean to you as a trader, and investor in crypto.
Blockchains like Bitcoin and Ethereum have different protocols, functions, and due to the fundamental difference in their algorithms, they cannot communicate with each other. While this independence offers the sovereignty and security of individual blockchains, it also questions the existence of an interoperable ecosystem where data and information should be easily exchanged.
For example, in decentralized economics (DeFi), where efficient, smooth and fast movement of funds is crucial, wrapped tokens find a valid application.
Some more recent blockchains, such as Polkadot, were created to overcome the issue of interoperability. However, it became necessary to find a solution and allow communication between early networks such as Bitcoin and Ethereum, which is why wrapped tokens were created.
Wrapped crypto tokens
Wrapped crypto tokens are cryptocurrencies tied to the value of another entry-level crypto or some assets such as gold, stocks, and real estate and are put into operation on DeFi platforms.
The original asset is “blocked” to a digital vault and a new token is created for trading on other platforms. Wrapped tokens allow the use of non-native assets on any blockchain, build bridges between networks, and implement interoperability in the cryptocurrency space.
They can represent anything from art and collectibles, merchandise, crypto assets, stocks to fiat currencies and real estate. Since wrapped tokens are tied to other assets, they must necessarily be examined and managed by a wrap entity and he will unravel an asset. We’ll see why this also sets a limit to the decentralized world of cryptocurrencies.
The wrapped Bitcoin expressed as wBTC was among the first wrapped tokens used on the Ethereum blockchain through smart contracts, allowing investors to earn a steady income. In addition to Bitcoin, the list of wrapped tokens includes other assets that are compatible mainly with Ethereum ERC-20 and Binance Smart Chain BEP-20.
Strange as it may sound, although ERC-20 tokens are issued on the Ethereum platform, ETH is not compatible with them as it was created before them. Therefore, just like Bitcoin, Ether must be wrapped to comply with other ERC-20 token standards. This creates a version of Ether on the Ethereum platform.
Other blockchains like Cardano, Polkadot, and Solana have begun experimenting with wrapped tokens to facilitate access to DeFi applications.
Some more recent projects include bLuna, the wrapped Luna token that can be freely traded or used as collateral on other protocols on terra’s network, which is a fixed-price and growth-driven platform.
Types of wrapped tokens
It is widely accepted that stablecoins were the first type of wrapped token, despite the significant difference with more established wrapped coins. A stablecoin like USDT (Tether), for example, is backed by about a dollar. However, Tether does not hold the exact amount of physical USD for each USDT it holds, and its reserves include assets of various kinds such as: cash, cash equivalents, investments, loan receivables, etc.
There are two types of wrapped tokens, which are cash-based and can be redeemed. Cash-based tokens cannot be redeemed for the underlying asset. On the other hand, redeemable tokens allow investors to trade the wrapped token with the underlying asset. Other blockchains host wrapped tokens. Wrapped coins for privacy, for example, are hosted on the Monero or ZCash blockchains.
How do wrapped tokens work?
At the request of merchants such as Airswap, CoinList, 0x, AAVE or Maker, the custodian “mints” coins on a given platform such as Ethereum, for example, depending on the amount of the original token sent.
With a similar process, when the wrapped token needs to be converted back into the original asset or a currency like Bitcoin, the user will ask the custodian to release the token from reserves. Simply put, for every wBTC that exists, for example, there is a Bitcoin held by a custodian.
The process of creating and managing wrapped tokens represents a constraint on cryptos, as requiring a custodian to trust to hold funds defeats the purpose of an open and decentralized blockchain ecosystem.
A custodian is still required, as traders cannot independently use tokens for transactions between blockchains. However, technology is evolving rapidly and we may achieve some decentralized capabilities soon.