Wrapped tokens are a 1:1 tokenized version of a cryptocurrency that extends its functionality. For example, Bitcoin cannot work on the Ethereum blockchain, but Wrapped Bitcoin (wBTC) can. Here’s why we need them and how they work.
Why do we need wrapped tokens?
It's not uncommon to hold cryptocurrencies from other blockchains like Bitcoin and Ethereum. The issue is that there is no way to directly transfer between the blockchains as they're incompatible with each other.
Another issue is that you may want to use your cryptocurrency as collateral for a loan. But, there is no way to do this on the native blockchain, like Bitcoin, which is limiting.
Wrapped tokens solve this.
What is a wrapped token?
Wrapped tokens are a tokenized version of a cryptocurrency, making it compatible with a different blockchain. The wrapped token is pegged to the underlying crypto as they are 1:1 backed. That means the wrapped cryptocurrency is redeemable for the same amount of its unwrapped version at any point.
By wrapping your cryptocurrency, it allows the underlying asset to enjoy the advantages of another blockchain like Ethereum.
How does this all work?
The process of creating wrapped tokens depends on three factors:
- Custodians: Store the cryptocurrency used for the wrapped tokens.
- Merchants: Mint and distribute wrapped tokens to users. They also destroy wrapped tokens after redemption.
- Decentralized Autonomous Organizations (DAOs): Manage the process by adding or removing custodians and merchants. With DAO members voting for the changes using a multisig.
What about wrapped Ethereum (wETH?)
Wrapped tokens solve the issue of cross-chain compatibility. But they also make it possible for Ether (ETH) to interact with decentralized applications (Dapps). At first, this may sound odd -- why can’t ETH work on the Ethereum blockchain?
When ETH got created, it was before the Ethereum blockchain adopted the ERC-20 token standard. This was when each token had its own code. Now we have a common standard across the Ethereum blockchain. That means when we need to use ETH; it gets wrapped before interacting with Dapps.
For the average user, don’t worry about this process. It happens automatically with most dApps! Take a look at when you make your next trade on Uniswap with ETH -- you’ll see ETH get converted into wETH then exchanged for your token. Using wETH saves slightly on time and gas.
For more on this, you can head onto the Wrapped Ethereum website.
What are the benefits of wrapped tokens?
With the benefits of DeFi available on Ethereum, many users want to use their Bitcoin on the Ethereum network. We have an article on this subject that you can find here.
Using Bitcoin and other cryptocurrencies on the Ethereum blockchain offers a range of advantages that other networks can’t provide, and they are:
- Speed and cost of transactions: Using wrapped tokens on the Ethereum network is faster than sending and receiving on other networks. And with scaling solutions emerging, these transactions will be at a fraction of a penny.
- Decentralized Finance (DeFi): Wrapping cryptocurrencies allows other blockchains assets to be used as collateral for loans on DeFi protocols.
- Decentralization: Currently, most cryptocurrency trading pairs are on centralized exchanges. Using wrapped tokens on Ethereum creates the opportunity of having liquidity for non-ETH trading pairs on decentralized exchanges (DEXs). Shifting this volume to DEXs is one more step to greater decentralization.
Are there any risks with using wrapped tokens?
When using wrapped tokens, there is a risk with the tokenized cryptocurrency. As wrapped tokens use smart contracts, there is always the possibility of a bug or a hack that puts the underlying assets at risk.
There is also a risk with the custodian storing the underlying cryptocurrency. As this process relies on a trusted third party, they can make a mistake that can result in losing some if not all the stored cryptocurrency.
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