What Is Wrapped Tokens and How Do They Work? Everything you need to know

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What Is Wrapped Tokens and How Do They Work? Everything you need to know

Decentralized finance (DeFi) is rapidly disrupting the financial sector by offering trustless banking. However, it also faces multiple challenges that challenge its mass adoption. At the moment, one of the most significant obstacles is insufficient liquidity.

What Is Wrapped Tokens

With DeFi relying on users to provide liquidity, it is imperative to have cross-chain interoperability, a necessity that has proven a tough nut to crack. Thus far, efforts to make blockchain networks interoperable have seen developers create wrapped tokens. These tokens can function on different blockchain networks, introducing some aspect of cross-chain interoperability.

Also Read: What is Crypto Phishing Attacks

In this article we discuss what is wrapped token?, How Do Wrapped Tokens Work?, Benefits of Using Wrapped Tokens, few example of wrapped tokens, Why do we need wrapped tokens?, Limitations of using wrapped tokens.

What is a Wrapped Token?

A wrapped tokens is a cryptocurrency pegged to another cryptocurrency in a 1:1 ratio. Simply put, the price of the wrapped token always equals that of the underlying coin or token. To this end, wrapped token holders can redeem them for the original asset at any given time.

The wrapped token and the original token run on different blockchains, with the prior running on blockchains that support DeFi. This feature ensures that wrapped tokens create a bridge between incompatible blockchain networks. Consequently, this interoperability helps introduce more liquidity to DeFi protocols, boosting the utility of cryptocurrencies.

How Do Wrapped Tokens Work?

To get wrapped tokens, users can create them by wrapping them on their own or purchasing them from centralized or decentralized crypto exchanges.

Wrapping tokens involves finding merchants for a specific token and transferring the tokens to them. The merchants then transfer the digital assets to a custodian who mints their wrapped versions in a 1:1 ratio and stores the underlying tokens in a digital vault.

After putting their wrapped tokens to use, a user can redeem them by requesting the merchant to send the custodian a burning request for a given amount of the tokens. Finally, the custodian destroys the wrapped tokens and returns the original assets to the user. The custodian records all minting and burning transactions on-chain for transparency, ensuring that wrapped tokens always maintain their 1:1 peg to the underlying asset.

Also Read: What Is Blockchain Trilemma

Benefits of Using Wrapped Tokens

Wrapped tokens increase the utility of cryptocurrencies by expanding the number of blockchains they can run on. As utility increases, the value of crypto networks rises, helping to expedite the maturity of the nascent asset class.

Through wrapped tokens, crypto holders can put their digital assets to use by lending them out through DeFi protocols to earn interest. Crypto holders can also stake the tokens and provide the DeFi sector with liquidity. In return, DeFi protocols offer stakers high yields.

Wrapped tokens also help minimize the transaction costs and times. For instance, using a wrapped version of BTC on a scalable blockchain network would significantly cut costs and ensure faster transaction times. For example, it can be said that the wrapped version of Bitcoin i.e. WBTC can easily be transacted on another blockchain such as Polygon or Solana in much less time than the fees and transaction time of the Bitcoin network.

Wrapped cryptocurrencies have improved liquidity and supercharged the cross-chain flow of assets, particularly benefitting Ethereum’s DeFi ecosystem. These assets have enhanced the much-needed interconnection between the blockchain community’s many ecosystems, making new forms of composability and collaboration possible.

Examples of Wrapped Tokens

The need to bridge the Bitcoin and Ethereum networks saw developers team up to create wrapped Bitcoin (wBTC), an ERC-20 version of BTC. wBTC is the most popular wrapped token and is currently the 18th-largest cryptocurrency by Market capitalization, with a market cap of over $5 billion. Needless to say, wBTC is the largest wrapped token.

The second largest wrapped token is renBTC, an ERC-20 token, which is part of the Ren Protocol. renBTC has a market cap of over $80 million. renBTC serves the same purpose as wBTC.

Wrapped NXM (wNXM) is the third-largest wrapped token by market capitalization. The token allows users to trade NXM, the native token of the Nexus Mutual platform, outside the protocol.

There are over 20 wrapped tokens in the crypto market, and they have a market cap of $5.31 billion.

Several tokenized representations of bitcoin exist in t4e crypto market. Wrapped bitcoin (wBTC or WBTC), jointly created by Bitgo, Kyber, and Ren, was launched in 2019. To obtain wBTC. You can swap your bitcoin for wBTC with the merchant via a centralized exchange (CEX), decentralized exchange (DEX), or atomic swap. Only merchants can redeem wBTC for BTC.

Crypto exchange Huobi Global launched its own version of wrapped bitcoin, Huobi BTC (HBTC), in 2020. Every HBTC is backed by one BTC. You can obtain HBTC by first depositing BTC into your Huobi Global exchange account and then withdrawing HBTC, both wBTC and HBTC are fairly centralized systems for wrapping bitcoin.

Ren, launched in 2020, offers a more decentralized alternative to wBTC and HBTC with its renBTC. To obtain renBTC, you must send bitcoin to Ren’s protocol, which will lock it up in a smart contract. The protocol then verifies the details of the transaction and returns a minting signature, which allows you to mint renBTC, an ERC-20 token representing bitcoin. Ren also lets you burn your renBTC to redeem the bitcoin you locked up.

There are a variety of other wrapped bitcoin tokens in addition to those mentioned above, including:

  • Synthetix’s sBTC
  • Keep Network’s tBTC
  • Tokenlon’s imBTC
  • BoringDAO’s oBTC
  • pNetwork’s pBTC

At another layer of abstraction, PieDAO’s BTC++, ACoconut’s acBTC, and mStable’s mBTC are all backed by a basket of ERC-20 token representations of bitcoin. In other words, they are backed by multiple wrapped versions of bitcoin. For example, acBTC is backed by sBTC, wBTC, pBTC, and imBTC

Also Read: What Is Crypto Fear and Greed Index

Wrapped Tokens on Ethereum

An interesting example of a wrapped token on Ethereum is wrapped Ethereum (wETH). Although creating a wrapped version of ETH seems to defy logic, it is worth noting ETH arrived before the network introduced the ERC-20 standard for issuing tokens. As such, ETH is not ERC-20 compliant.

To this end, developers created wrapped Ethereum (wETH) to simplify using ETH in DeFi. With the bulk of DeFi activity being on Ethereum, most dApps require users to swap ETH with ERC-20 tokens, and wETH streamlines this process.

Other wrapped tokens on Ethereum include wBTC, wNXM, wDGLD, and wCRO, among other ERC-20-compliant tokens that run on blockchains other than Ethereum.

Why do we need wrapped tokens?

Wrapped tokens such as WBTC offer interoperability between blockchains so that people can move assets easily and take advantage of features and applications on other blockchains. Those advantages might be faster transaction times, lower fees, or yield farming opportunities.

How to Deposit, Withdraw & Trade Wrapped Tokens?

Deposit and withdrawal functions are available from exchanges that support the wrapped tokens. For instance, exchange like binance, Kucoin, Huobi etc supports some wrapped tokens deposit and withdrawal, such as WBTC.

​​In general, a wrapped token may not have a separate trading pair. For the purpose of consolidating liquidity, centralized exchanges will credit tokens based on different blockchains as its native token, similar to USDT on Tron and Ethereum are both credited as USDT. However, there are exceptions like WBTC, which has separate trading pairs like WBTC/BTC or WBTC/USDT.

Are wrapped tokens safe?

Wrapped cryptocurrencies enable crypto assets to be used on blockchains to which they are not native. This interoperability hack has brought bitcoin (BTC) and other popular cryptocurrencies to smart contract platforms, including the Ethereum ecosystem.

The security of the wrapped token depends on the blockchain it is wrapped on. For example it can be said that Bitcoin is wrapped on the Solana blockchain but if any issue is detected in the Solana blockchain or there is a hacking attack then that WBTC will be the victim. It’s can definitely said that the native blockchain of a token always safety than any wrapped version of the particular token or coin.

Limitations of using wrapped tokens

Most of the current implementations of wrapped tokens require trust in the custodian holding the funds. As for the currently available technology, wrapped tokens can’t be used for true cross-chain transactions – they usually need to go through a custodian.

However, some more decentralized options are in the works and may be available in the future for completely trustless wrapped token minting and redemption. The minting process can also be relatively costly thanks to high gas fees and can incur some slippage.

Conclusion

Wrapped tokens play a significant role in creating bridges between different blockchains. This interoperability helps provide DeFi and the broader crypto space with ample liquidity because networks can easily share the amount of capital locked in them. Although wrapped tokens currently run on the centralized models, which require users to trust merchants and custodians, the future might present completely trustless options, helping the crypto space put the power back in users’ hands.

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