A wrapped token is a cryptocurrency whose value is pegged to that of another. It is called a wrapped token because the original cryptocurrency is wrapped so that its wrapped version can be created on another blockchain. A wrapped token is much similar to a stablecoin. A stablecoin derives its value from another asset, usually fiat currency. In the case of a wrapped token, it derives its value from an asset created on another blockchain.
Wrapping tokens is a way of creating bridges between tokens issued on different blockchains. Wrapping tokens enhances interoperability. Interoperability is the concept that allows compatibility between different blockchains. Imagine if someone who uses the Chrome browser could not send an email to another who uses a different browser such as Internet Explorer or Safari.
There are different types of wrapped tokens, the same way that there are different kinds of stablecoins.
Different Types of Wrapped Tokens
The different models of wrapping are nothing more than different routes taken to get to the same destination.
Centralized
This method relies on using a firm to maintain the value of your assets. You deposit your BTC into a centralized third-party. The intermediary locks up your crypto assets in a smart contract, mints a new ERC-20 token, and sends it to you. BitGo is an example of a firm offering this kind of service. However, the downside is that you are fully dependent on this intermediary to keep its own end of the bargain.
Trustless
You can wrap your bitcoins using a decentralized method. The custodial responsibilities are managed by smart contracts. Your bitcoins are locked in a network contract that cannot be altered without your approval.
Synthetic assets
This model is slightly different from the two discussed above. You lock your BTC into a smart contract and in return, you get a synthetic asset with equal value. However, your synthetic asset is not backed by BTC directly. It is backed by native tokens of the platform.
How Wrapped Tokens Work
Let us use Wrapped Bitcoin (WBTC) as an example. The same logic applies to how other wrapped tokens work. WBTC is an ERC-20 token that is pegged on a 1:1 basis against the value of Bitcoin, allowing you to use Bitcoin on the Ethereum network.
Wrapped tokens typically require a custodian to hold an equivalent amount of the wrapped token. The custodian can take many forms such as a DAO, a multisig wallet, a merchant, or a smart contract. In the case of this example, the custodian needs to have 1 BTC for each minted wrapped bitcoin. There is proof of reserve on-chain to ensure that the custodian can account for the minted wrapped tokens.
In order for this to work, a process must be followed.
A BTC is sent to the custodian for minting. The custodian mints bitcoins on the Ethereum network based on the amount of BTC sent. When the BTC needs to be redeemed for WBTC, the merchant sends a burn request to the custodian. The reserved BTC is released when the unwrapped token has been burned. It’s a back and forth process of wrapping and unwrapping.
Benefits of wrapped tokens
What is the benefit of using a wrapped token instead of the original crypto asset? There are several benefits for this, but the primary reason is to allow other tokens to be used on the Ethereum ecosystem. This is because Ethereum is the most used blockchain. The benefits of wrapping tokens are:
Liquidity
Wrapped tokens bring much-needed liquidity to the market. The Ethereum ecosystem is very big and diverse. This creates a situation where decentralized exchanges (DEXs) and several platforms lack the necessary liquidity to support their operations. Low liquidity is bad for exchanges as traders cannot easily trade their tokens quickly and at their targeted prices. Wrapped Bitcoin brings the liquidity of BTC to the Ethereum ecosystem.
Scalability
Wrapped bitcoin tokens exist on the Ethereum blockchain rather than directly on the Bitcoin network. WBTC transactions are quicker and cheaper than those involving BTC.
New Functionality
Wrapped Bitcoin provides users with more functionality than what standard BTC offers. WBTC can leverage smart contracts deployed on the Ethereum blockchain. Smart contracts are computer programs that self-execute when predetermined conditions are met. Smart contracts have become an important part of the blockchain ecosystem. However, they came into the fold with the emergence of Ethereum. The Bitcoin network does not fully support smart contacts in its true form.
Yield Farming
Yield farming has gained traction in the DeFi space even though it is different from staking. Farming protocols allow users to earn interest on cryptocurrencies that they lend out. WBTC allows users to participate in yield farming by lending out their crypto and earning interest on it.
Staking
Staking is very popular within the DeFi community. In order to stack their funds, users have to lock their crypto assets in smart contracts for a designated period of time and earn rewards. BTC in its native form cannot do this. You have to wrap your BTC for you to enjoy the benefits of staking your Bitcoin.
Summary
Wrapping provides a way for you to use tokens on non-native tokens. Wrapped tokens are used for different reasons, and they are not created the same. There are different methods of minting wrapped tokens. Each has its own pros and cons, but in the end, they all serve the same purpose.
So what happens when an asset is ‘wrapped’?
A ‘Wrapped Token’ is where you ‘wrap’ or ‘transform’ an existing crypto asset or Token (ETH, ERC20, BTC) into a new Wrapped Token with additional functionality, converting an asset to an ERC-20 compatible token.
An ERC-20 token represents another asset that has the same value recorded by a smart contract.