In this video we talk about what Wrapped Tokens are exactly, why wrapped tokens are being utilized and what the limitations are.
Video guide
What is a Wrapped Token?
A Wrapped Token is a tokenized version of an asset which makes it possible for the asset to exist on a different blockchain.
Simply put, the point of wrapping a token is to make it available on other blockchains so to have the same benefits of that specific blockchain.
A Wrapped token is also pegged to the value of the asset they represent.
The original asset, in the form of a native token on a blockchain, is placed in a wrapper (think of the wrapper like a digital vault), so that the wrapped version can be minted on a different blockchain.
The interesting part is that you can redeem them whenever you want via a process called unwrapping.
To help you understand this better, think about how a stablecoin gets its value.
Stablecoins have a derivative value from fiat currencies, for example, USDT is pegged to the value of the US dollar.
When it comes to wrapped tokens, the asset is usually a native token of a particular blockchain existing on another blockchain.
Imagine being able to use Ether currency on Binance Smart Chain with much lower fees compared to the more expensive gas fees on Ethereum.
It goes without saying that interoperability is a challenge with trading cryptocurrencies. Wrapped tokens provide the long-desired solution of native tokens being able to be used cross-chain.
Why are Wrapped Tokens used?
Wrapped tokens are a bridge for native tokens to exist on different blockchains. Hence, increasing interoperability in the Decentralized Finance and Cryptocurrency Ecosystem.
You should know that there are token standards for various blockchains such as BEP-20 for Binance Smart Chain and ERC-20 for Ethereum. It is, however, impossible to use these standards across different blockchains.
But with wrapped tokens, you can peg the value of an asset so that it can be freely used on other blockchains.
Another benefit of a wrapped token is how much they increase capital efficiency and liquidity for both decentralized and centralized exchanges.
What does that mean exactly?
Well, it means that the ability to wrap idle tokens and engage them on a different chain makes it possible to create more connections between isolated liquidity with the benefits of its original token. For example, lower transaction fees and shorter transaction times.
It goes without an argument that Bitcoin has lots of outstanding features. However, Bitcoin transactions can be quite expensive and sometimes, not the fastest to use, especially when network usage increases due to global adoption.
These deficiencies might not mean a lot but can be quite unpleasant at some critical moment. These issues can be mitigated by using a wrapped token on another blockchain that has lower transaction fees and faster times.
How do Wrapped Tokens work?
For wrapped tokens to work, there has to be a custodian to hold an equivalent amount of the cryptocurrency you want to wrap.
The custodian can be a smart contract, a multi-currency wallet, a Decentralized Autonomous Organization or a merchant.
Let’s take WBTC as our example; before you can mint 1 WBTC on the Ethereum blockchain, the custodian must have received 1 BTC to place on hold.
Remember that the wrapped token is pegged to the value of the asset, which is why the custodian holds the equivalent asset to mint the wrapped token.
The wrapping process is as follows.
You send a certain amount of BTC to the custodian. According to the amount sent, the custodian mints an equivalent amount of WBTC on the Ethereum blockchain and you get your wrapped BTC, in this case WBTC.
What about the unwrapping process?
When you ask to change the WBTC back to BTC, it gets to the custodian as a burn request. The wrapped token gets burnt and your BTC is released back to you.
In short, the custodian fulfills the duty of the wrapper and the unwrapper.
Where are Wrapped tokens used?
Wrapped tokens are used on other blockchains to the original blockchain of the native token that is being pegged.
For example, a Wrapped BTC is simply a tokenized version of BTC existing on the Ethereum blockchain. The ERC-20 token WBTC is pegged to the value of BTC.
This means Bitcoin can be used on the ERC-20 network effortlessly in the form of WBTC.
Wrapped tokens used on the Ethereum Blockchain
These are tokens that are native to their blockchain, being brought to the Ethereum blockchain. They are made to comply with the ERC-20 standard and so become usable there.
As expected, there are gas fees for wrapping and unwrapping on Ethereum, which can be quite expensive due to the Proof-of-Work mechanism.
Wrapped tokens used on Binance Smart Chain
Another network where wrapped tokens are used is the Binance Smart Chain. Just like those on Ethereum, you can use whichever wrapped token you want on the Binance Smart Chain.
You will be able to use the wrapped tokens in the form of BEP-20 tokens and in this case, the Binance Bridge helps you in wrapping and unwrapping the tokens.
You can use them in different yield farming applications or trade them as you want.
There’s also a gas fee for wrapping on BSC, but this is much lower than other blockchains.
Some limitations you need to consider
We talked about the need for a custodian as the means to get the wrapping and unwrapping to work.
You can’t get any wrapped token for cross-chain transactions without going through a custodian.
It is, therefore, required that the custodian with the funds is trustworthy for the implementation of any wrapped token.
You should know that there are more decentralized options that are still a work in progress. In the nearest future, we hope to have a completely trustless minting and redemption of wrapped tokens.
Another demerit is the expensive gas fees, hence, making the minting process quite costly with the addition of slippage.
Nonetheless, with wrapped tokens, applications can share liquidity more conveniently and capital becomes more efficient.
Side note
A common misconception is to think that Tether, or USDT, is a wrapped token. This is not the case however.
Unlike wrapped tokens, USDT does not hold an equivalent amount of US dollars to mint Tether.
The reserve is made up of assets, receivables from loans, and other real-world cash equivalents. It’s true that they share similar ideas but not the same process.
Afterword
Hopefully we made the meaning and process of Wrapped Tokens clear to you.
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