The Beginner’s Guide
A wrapped token is a cryptocurrency token indexed to the value of another crypto. It is called a wrapped token because the original asset is placed (wrapped) in a kind of digital vault that allows wrapped versions to be created on another blockchain.
What is the purpose in doing this? Different blockchains offer different functions, but these blockchains cannot talk to each other. The Bitcoin blockchain cannot know what is happening on the Ethereum blockchain. But with wrapped tokens, more bridges can be built between different blockchains.
Does it bother you that BTC cannot be used on Ethereum? Or the unavailability of ETH on Binance Smart Chain? It is not possible to transfer coins on a particular blockchain to other blockchains.
Wrapped tokens offer a way to circumvent this limitation. It achieves this by allowing assets that have not been issued on a particular blockchain to be used on that chain.
Wrapped token is a tokenized version of another cryptocurrency. It is indexed to the value of the asset it represents and can be exchanged at any time over this value. Moreover, these tokens often represent an asset located outside of the local blockchain on which it is mined.
You can think of a wrapped token similarly to stablecoins in that it gets its value from another asset. The value of stablecoins is usually indexed to a fiat currency. Wrapped tokens value is indexed to an asset mined on another blockchain.
Since blockchains are separate systems, there is no effective way to transfer information between different blockchains. On the other hand, wrapped tokens increase the interoperability of different blockchains. Basically, underlying tokens become cross-chain movable.
It’s also important to note that if you’re a standard user, you don’t have to mess with wrapped token generation processes. You can buy and sell these wrapped tokens like any other coin. For example, you can trade in the WBTC / BTC market on Binance.
How do Wrapped tokens work?
Let’s proceed with the example of Wrapped Bitcoin (WBTC), which is the Ethereum-tokenized version of Bitcoin. WBTC is an ERC-20 token and is indexed one-to-one to Bitcoin’s value, allowing you to use BTC on the Ethereum network.
Wrapped tokens usually require the presence of a custodian. A custodian is a unit that keeps the amount indexed from the asset. This can be a custodian, multi-signature wallet, DAO, or smart contract. In the WBTC example, the custodian is required to hold 1 BTC for every 1 WBTC issued. The proof of this reserve is on the chain.
So how does this wrapping process work? The vendor sends BTC to the custodian to create the wrapped token. The custodian then issues WBTC on Ethereum for the amount of BTC sent. When WBTC needs to be converted back to BTC, the seller requests a burn from the custodian and the BTCs in reserve are released. You can think of the depository as the unit that performs the wrapping and takes it back. In the WBTC example, the addition and removal of custodians and vendors is handled by a DAO.
Although some members of the community consider Tether (USDT) a wrapped token, this is not exactly true. Although USDT is usually traded one-on-one with the USD, Tether does not physically hold the exact equivalent amount of USD in reserve for each USDT in circulation. Instead, this reserve consists of cash and other real-world cash equivalents, assets and loan receivables. But the underlying idea is very similar. Each USDT token acts as a type of wrapped version of the fiat currency USD.
Wrapped tokens in Ethereum
Wrapped tokens in Ethereum are tokens of other blockchains that have been aligned with the ERC-20 standard. This means you can use assets that have not been mined on Ethereum on this chain. As you can imagine, gas has to be paid on Ethereum to wrap the tokens and return them to their original state.
Many different applications can be made with these tokens.
An interesting example of wrapped tokens in Ethereum is Wrapped Ether (WETH). Just a quick reminder, ETH (ether) must be paid for transactions on the Ethereum network. ERC-20 is a technical standard for issuing tokens on Ethereum. For example, Basic Attention Token (BAT) and OmiseGO (OMG) are ERC-20 tokens.
However, since ETH was developed before the ERC-20 standard, it is not compatible with this standard. This incompatibility is a problem as many DApps have to convert between ether and an ERC-20 token. This is why wrapped ether (WETH) was created. WETH is a wrapped version of ether to comply with the ERC-20 standard. So it’s actually a tokenized version of ether on Ethereum!
Wrapped tokens in Binance Smart Chain (BSC)
Similar to wrapped tokens in Ethereum, you can wrap Bitcoin and many other crypto to be compatible with Binance Smart Chain (BSC).
Binance Bridge allows you to wrap your crypto assets (BTC, ETH, XRP, USDT, BCH, DOT, and many others) for use in the form of BEP-20 tokens on Binance Smart Chain. You can then use your assets that you moved to BSC for various yield farming applications or for trading.
Gas is required to wrap and revert the tokens to their original form, but the gas fees in BSC are very low compared to other blockchains.
Advantages of using Wrapped tokens
While many blockchains have their own token standard (ERC-20 for Ethereum or BEP-20 for BSC), it is not possible to use these standards on multiple chains. With Wrapped tokens, a token becomes available on a blockchain on which it is not mined.
In addition, wrapped tokens can increase liquidity and capital efficiency for both centralized and decentralized exchanges. Being able to wrap idle assets and use them on another chain may allow more links to be established between liquidities that would otherwise remain more isolated.
Finally, one of the most important advantages is transaction times and fees. Although Bitcoin has some great features, it is not one of the fastest chains, and sometimes it can be quite expensive to use. Therefore, there may be difficulties while trading. Using wrapped versions on a blockchain with faster transaction times and lower transaction fees allows avoiding these problems.
Disadvantages of using Wrapped tokens
The vast majority of current implementations of wrapped tokens require trust in the custodian holding the funds. With today’s technology, it is not possible to use wrapped tokens for true cross-chain transactions. These tokens usually have to go through a custodian.
But work on more decentralized options is ongoing, and these options may allow future wrapped tokens to be issued and reverted to their original form in a completely non-trusting manner.
Apart from that, the token issuance process can cause price slippage and can become quite costly due to high gas fees.
Wrapped tokens help build more bridges between different blockchains. A wrapped token is a tokenized version of another blockchain’s local entity.
Wrapped tokens contribute to interoperability in cryptocurrency and Decentralized Finance (DeFi) ecosystems. Wrapped tokens can open the door to a world where capital is more efficient and applications can easily share liquidity with each other.
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