What is a wrapped token? A comprehensive guide to wrapped tokens
A wrapped token is a cryptocurrency tied to the value of an underlying asset. The underlying asset is typically a base coin such as BTC, ETH, NEAR, etc.,
Hello everyone,
Surely everyone knows that each blockchain provides different functionalities and they cannot directly interact with each other. For example, Bitcoin blockchain cannot interact with Ethereum blockchain. So, how can you trade BTC on Ethereum blockchain?
Thanks to wrapped tokens - tokens that allow the transfer and exchange of assets between different blockchains. We will delve deeper into this topic in this article!
And I'm Neo — Admin — Community Manager of Optimus Finance and Growth Marketing of LECLE Vietnam. Let's get started!
1. What is a wrapped token?
A wrapped token is a cryptocurrency tied to the value of an underlying asset. The underlying asset is typically a base coin such as BTC, ETH, NEAR, etc., but sometimes it can be gold, stocks, shares, or real estate.
The original asset is 'wrapped' in a digital vault to ensure its value. Subsequently, a type of wrapped token is created for trading on different platforms. In this context, the original asset is like collateral, and the wrapped token is the voucher you receive for trading after pledging your original asset.
In simple terms, wrapped tokens operate similarly to stablecoins like USDT and USDC because stablecoins are based on the value of a fiat currency. With wrapped tokens, the underlying asset is typically the native coins of a different blockchain.
So, to put it plainly, a wrapped token is a type of token that represents a cryptocurrency following the standards of another blockchain and holds an equivalent value to the original cryptocurrency. Wrapped tokens can be used on a different blockchain and converted back to the original cryptocurrency.
For example, to trade Bitcoin on the Ethereum network, you need to convert BTC to wBTC.
2. Classifying wrapped tokens
Wrapped tokens come in two types: Cash-settled and Redeemable.
2.1. Cash-settled
With cash-settled wrapped tokens, the wrapped token cannot be directly converted back to the original asset.
For example, when stocks are tokenized based on the real stock quantity and listed on a cryptocurrency exchange, they can only be traded in pairs like BUSD or USDT on that exchange, and you cannot exchange them for actual stocks on the stock exchange.
2.2. Redeemable
For redeemable wrapped tokens, you can exchange them for their original assets, held by a trustworthy custodian.
For example, wETH can be redeemed for ETH, and wBTC can be redeemed for BTC at an equivalent value (1:1) with transaction fees.
3. How do wrapped tokens work?
You can understand this process as the process of collateralizing assets in a bank. This process involves 3 parties:
Merchant: Users exchange their original assets for wrapped tokens.
The asset redeemer: Users exchange wrapped tokens for the original assets.
The third party (custodian): This party receives the original assets from users and mints wrapped tokens based on the value of the sent original assets, or it receives wrapped tokens from users, burns them, and returns the original assets to users. This custodian can be a merchant, multi-signature wallet, DAO, or a smart contract.
The conversion ratio between wrapped tokens and the original assets is 1:1, meaning that a specific amount of wrapped tokens corresponds to an equivalent amount of the original assets.
For example, in the operation process of wrapped Bitcoin (wBTC):
Users send their original BTC to the custodian's address on the blockchain.
The initial BTC is locked by the custodian.
The custodian mints a corresponding amount of wBTC following the ERC-20 standard (on the Ethereum blockchain) in relation to the initial amount of BTC sent.
Users request the conversion of wBTC back to the original amount of BTC.
4. Some fundamental wrapped tokens
Wrapped Bitcoin (wBTC): An ERC-20 version of Bitcoin, wBTC holds 81% of the wrapped token market and is backed by the cryptocurrency custodian company BitGo. wBTC enables users to participate in the DeFi ecosystem.
Wrapped Ethereum (wETH): An ERC-20 version of ETH, compatible with decentralized protocols (as ETH, the original token of Ethereum, does not adhere to the ERC-20 standard). wETH is supervised by 0x Labs. Unlike wBTC, you don't actually 'wrap' ETH; you simply swap ETH for wETH through smart contracts or on wallets like MetaMask.
Bridge: A blockchain bridge that facilitates the transfer of tokens or data between two different blockchain ecosystems. Some well-known bridges include Binance Bridge, Avalanche Bridge, Wormhole, Sollet, Allbridge, Anyswap, Polygon POS Bridge, and more.
However, Ethereum is not the only network that supports wrapped tokens. BNB Chain (formerly known as BSC) is another blockchain where wrapped tokens like wBTC and wETH can operate.
These wrapped tokens on the BNB Chain need to comply with the BEP-20 token standard. The mentioned tokens can be wrapped through the Binance Bridge, which is one of the safest methods to mint new wrapped tokens and deploy them on the BNB Chain.
5. Benefits and limitations of wrapped tokens
5.1. Benefits
5.1.1. Increasing Interoperability
Wrapped tokens enable the original tokens to increase their interoperability and exchange value with other tokens.
Each blockchain has its own standards like Ethereum's ERC-20 and BNB Chain's BEP-20. These standards cannot be directly applied to different blockchains. For instance, the Bitcoin blockchain cannot run smart contracts or be compatible with DApps on the Ethereum blockchain. However, wBTC can operate on various different blockchains.
5.1.2. Increasing liquidity
The ability to wrap assets for use on a different blockchain helps increase liquidity and capital efficiency for exchanges.
For example, BTC has much higher liquidity compared to other blockchains, so wrapping BTC (wBTC) transfers this liquidity to Ethereum.
5.1.3. Saving time and transaction fees
The first-generation Bitcoin blockchain has slower transaction processing speeds and higher gas fees compared to second-generation blockchains like Ethereum. Wrapped BTC (wBTC) allows users to enjoy faster transaction speeds with lower transaction fees without the need to switch to a different token.
5.1.4. Generating income for users
The decentralized finance (DeFi) ecosystem primarily operates on the Ethereum blockchain. By wrapping BTC into wBTC, Bitcoin users can earn passive income by participating in the DeFi ecosystem through activities such as yield farming, lending, staking, and more.
5.2. Limitations
5.2.1. Non- decentralized
With current technology, the token wrapping process still requires the involvement of a third party - the custodian. This reduces the decentralization aspect of cryptocurrencies and also demands that users have trust in the custodian.
5.2.2. The token wrapping fees are relatively high
The token wrapping cost depends on the blockchain's gas fees. If gas fees increase, the wrapping cost will also rise accordingly.
6. Is it advisable to invest in wrapped tokens?
Wrapped tokens are considered a more user-friendly bridge to use across various platforms and different blockchains. In the past year, the total market capitalization of wBTC has significantly increased, and it is now consistently among the top 20 cryptocurrencies by market capitalization (according to CoinMarketCap).
For this reason, many investors today choose to hold wrapped tokens instead of native platform coins. From my perspective, if you frequently trade and interact with various blockchains and different DApps, it's advisable to hold wrapped tokens. On the other hand, for holders who primarily trade on centralized exchanges or prefer to HODL coins, it's better to stick with native platform coins.
7. Closing thoughts
Wrapped tokens have made cryptocurrencies significantly more efficient and useful. DApps benefit from various types of wrapped tokens on different blockchains. Therefore, they may even have more potential than before and can have a positive impact on the crypto world if they continue to develop at their current pace.
Since the inception of wrapped tokens, they have enhanced the efficiency of cryptocurrencies
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