Various blockchains have different standards, making transactions across blockchains largely incompatible. Wrapped tokens solve this problem by functioning as representations connecting blockchains, allowing cryptocurrencies to thrive on non-native blockchain networks.
What Are Wrapped Tokens?
A wrapped crypto token is a converted version of a cryptocurrency or asset that functions on a network other than the original asset’s blockchain. Each wrapped token has the same value as the asset it represents and is easily interchangeable. Wrapped tokens essentially represent crypto assets on non-native blockchains. These tokens are “wrapped” because they are inserted into a wrapper or digital vault that allows the wrapped version to operate on a different blockchain.
A wrapped token is similar to a stablecoin since they both get their values from another asset. However, while many stablecoin solutions offer services that peg their values to fiat currencies, precious metals, cryptocurrencies, and several other assets, wrapped tokens can only be pegged to crypto assets native to another blockchain.
For example, Wrapped Bitcoin or WBTC is a tokenized version of Bitcoin on the Ethereum blockchain. Wrapped ERC-20 tokens like WBTC have the same value as the related asset and maintain this value through a smart contract algorithm that replicates BTC’s price in real-time and regulates WBTC supply. At all times, 1 BTC is equal to 1 BTC. Likewise, for each 1 WBTC, there is an equivalent 1 BTC locked up in an escrowed smart contract as equal collateral.
How Do Wrapped Tokens Work?
Wrapping a token generally requires a custodian that guarantees that the wrapped version maintains the same value as the original token. The custodian may be a smart contract, multisignature wallet (multisig wallet), or a DAO. Custodians hold the original token and “wrap” it through a process known as minting.
Minted wrapped tokens transfer to the applicable blockchain for their intended purpose. However, the custodian can also “unwrap” the minted token and return it to its original form through a process known as burning. Throughout the minting and burning processes, the original cryptocurrency and wrapped token both have the same value and are represented in a one-to-one fashion.
Types of Wrapped Tokens
There are two main types of wrapped crypto tokens — redeemable and cash-settled. While cash-settled tokens can't be exchanged for the underlying crypto asset, redeemable tokens can be.
Ethereum vs. Bitcoin: Wrapped Tokens on Each Blockchain
Considering Ethereum vs. Bitcoin in relation to their interoperability and functionality, wrapped tokens play a key role in bridging the two blockchains.
Wrapped tokens on Ethereum are tokens from other blockchains designed to be compliant with the ERC-20 token standard. However, Etherereum (ETH) went live before the ERC-20 standard existed, requiring many dApp users to switch between Ethereum (ETH) and ERC-20 tokens. A Wrapped ETH token then became necessary for minting and burning tokens on the Ethereum network. Wrapped Ether (WETH) is a version of ETH compliant with the ERC-20 standard. Essentially, WETH is a tokenized version of Ether on Ethereum that has usability beyond paying for transaction fees (gas).
The Bitcoin (BTC) blockchain operates differently. Since BTC can't function on the Ethereum blockchain, Wrapped Bitcoin (WBTC) replaces the original BTC on the Ethereum network. WBTC allows users to take advantage of Bitcoin on the Ethereum blockchain for transactions on a decentralized exchange or via dApps within its DeFi ecosystem.
According to CoinGecko Data, the following are the top five wrapped tokens ranked by total market capitalization as of April 2022.
- Wrapped Bitcoin (WBTC)
- renBTC (RENBTC)
- Wrapped NXM (WNXM)
- THORChain (RUNE)
- pTokens BTC (PBTC)
Benefits and Limitations of Wrapped Tokens
As with every other token, wrapped tokens have benefits and limitations. Transacting wrapped tokens requires users to understand these benefits and drawbacks, as they affect token functionality in the blockchain and DeFi space.
Benefits
- Interoperability: The primary advantage that wrapped tokens offer the crypto space is interoperability. Unlike in the early days of blockchain tech, people can now use Bitcoin on the Ethereum blockchain via wrapping. Wrapped tokens make it easy for anyone to enjoy basic interoperability while building or running DApps.
- Liquidity: Wrapped tokens significantly increase an asset’s liquidity since it can be easily traded and used on non-native networks, whether via centralized (fiat currencies) or decentralized (cryptocurrencies) systems.
- Transaction Speed: Another significant benefit is transaction speed. For instance, sending BTC on the Bitcoin blockchain takes longer than sending WBTC on the Ethereum network.
- Transaction Fees: In some cases, required costs for transacting wrapped tokens can be lower than transacting with the original assets. For example, many projects originally based on the Ethereum blockchain launched wrapped tokens on the BNB chain to significantly reduce gas fees.
Limitations
- Custodian Reliance: Wrapped tokens rely on a custodian to facilitate minting (wrapping) and burning (unwrapping). A breach or flaw in the custodian’s design will directly affect the minting or burning process.
- Centralization: The adoption of decentralized systems is a critical selling and adoption point for cryptocurrencies. Since custodians mint and burn wrapped tokens, centralization or trusting an escrowed contract is nearly inevitable.
- Wrapping Cost: There are costs to minting and wrapping tokens. These processes require gas fees which may outweigh the benefits.
Wrapped Tokens and DeFi
Many crypto enthusiasts consider wrapped tokens a much-needed solution because they allow users to access more blockchain networks. Wrapped tokens also increase asset functionality, expanding asset use cases on DeFi apps, which either might not exist or have limited functionality on the asset's native blockchain network. Wrapped tokens have made crypto assets more efficient and contributed to the growth of decentralized finance.
Try Komodo Wallet — Native Trading Across Blockchains
While wrapped tokens are a great way to represent value across various blockchain networks, they aren't the only solution for interoperability.
Komodo Wallet offers a non-custodial wallet and cross-chain decentralized exchange rolled into one app. Users can trade BTC for ETH, or vice versa, natively across the two blockchains without having to use wrapped tokens or rely upon a custodian.
Komodo Wallet also supports numerous wrapped tokens like WBTC and WETH.
