What Is a Wrapped Token?

Every year thousands of new cryptocurrencies emerge on the market. Although people can convert one cryptocurrency to another on exchanges and wallets, they face some challenges. This is because each blockchain has its native token which cannot exist on another network.
Also, the level of interoperability among blockchains is comparatively lower than expected. However, developers can now wrap some tokens so that they exist on other blockchains. In this article, we shall discuss wrapped tokens and their importance in the blockchain. We start by explaining what wrapped tokens are.

Wrapped Tokens

A wrapped token is a cryptocurrency which is converted into another type of token to enable it to exist on another blockchain. Put differently, it is a version of another cryptocurrency which is native to another blockchain network. Interestingly, wrapped tokens can exist on non-native blockchains. For example, a wrapped bitcoin can exist on networks such as Binance or Ethereum.
However, most of the wrapped tokens are in the form of ERC20 cryptocurrencies and exist on the ethereum network. The interesting thing is that people can redeem these wrapped tokens. In this case, redeeming means converting the wrapped token to the original cryptocurrency. As an example, a blockchain can convert the wrapped bitcoin (wBTC) to bitcoin.
Primarily, a wrapped token is pegged to the original cryptocurrency in a one-to-one ratio. For instance, the wBTC is rated to bitcoin at a ratio of 1:1. This is because a wrapped token maintains the value or price of the original cryptocurrency. What we are saying is that if the price of bitcoin is $50.000, the price of wBTC is also $50.000.

The Importance of Wrapped Tokens

Now that you understand wrapped tokens, let’s discuss their importance. People can use wrapped tokens on blockchains other than their native ones. As an example, traders can use wBTC on the ethereum network, creating more scenarios for the users.

Wrapped Tokens Unlock More Use Cases

Wrapped tokens have a variety of potential use cases, some of which include:

• Cross-chain interoperability: Wrapped tokens can allow for interoperability between different blockchain platforms. For example, it is possible for a user to wrap a token from one blockchain and use it on another that does not support it natively.

• Decentralized finance (DeFi): Wrapped tokens can enable the use of DeFi applications on platforms that do not natively support them. For example, a user could take a token on a platform that does not support lending and borrowing, wrap it, and then use it on a platform that does support those features.

• Tokenization of assets: Wrapped tokens can also be used to tokenize real-world assets such as real estate, companies shares, and commodities. This can make it easier to trade and invest in these assets, and can also make them more accessible to a wider range of investors.

• Hedging against volatility: By exchanging the native token for a wrapped token that is linked to a stable asset, wrapped tokens can also be used as a hedge against volatility. This can help to reduce the risk of price fluctuations for traders and investors.

There will probably be new and creative uses for wrapped tokens as the blockchain and cryptocurrency industries develop.

Enables users to enter a new ecosystem

In a nutshell, wrapped tokens enable users to access various blockchains and unlock more scenarios. As a case in point, a person may not have the chance to provide liquidity on the bitcoin network, but can do so with a wrapped BTC which exists on a platform that offers liquidity provision service. As noted, wrapped tokens increase the functionalities of a cryptocurrency.

How wrapped tokens work

Wrapping tokens requires the use of a custodian service which ensures that an equivalent amount of the original asset is kept safely in a vault. This means that an equal amount of the original cryptocurrency should be locked in a vault. If a smart contract mints 2000 wrapped tokens it means that 2000 units of the cryptocurrency are locked in the vault.
For example, to mint 1 wBTC, the smart contract should lock one original BTC in the vault. However, there are various blockchain projects which are working on developing custodian-free crypto wrapping mechanisms.
Currently, it is the custodian which mints the wrapped token. In other words, the custodian holds the original cryptocurrency and produces the wrapped version. This wrapped token migrates to the suitable blockchain. Yet, the custodian can unwrap the token. Unwrapping is the process of burning the wrapped token and unlocking the original cryptocurrency from the vault. It is important to understand that the custodian can be an escrowed smart contract, a multisignature wallet or a decentralized autonomous organization (DAO).

Examples of Wrapped Tokens

So far, in this discussion we have looked at the example of BTC and wBTC. However, there are still many other examples of wrapped tokens such as renBTC (RENBTC), Wrapped NXM (WNXM), THORChain (RUNE), and pTokens BTC (PBTC). As you can see, the list of wrapped tokens is long and they exist on different blockchains.

Wrapped BTC (wBTC)

Wrapped BTC (wBTC) was launched in January 2019 and exists on the ethereum network. In contrast to BTC, which does not function on the ethereum network, wBTC can even function with several dApps on the ethereum network. Also, the wBTC opens the possibility of deploying BTC on other DeFi platforms and performing other roles such as lending.

Wrapped ETH (wETH)

Wrapped ETH is one of the most popular wrapped tokens on the market. Despite ETH being the native token on the ethereum blockchain, it does not comply with the ERC-20 standards and as such it fails to perform other functions on the blockchain. As a result, people cannot directly trade ETH with other ethereum based tokens (ERC-20). The reason being is that Ethereum created ETH before introducing the ERC-20 tokens. Therefore, in order to make ETH compliant with other ERC-20 tokens, ethereum wrapped it, creating WETH in the process.

Advantages of Wrapped Tokens

Wrapping cryptocurrencies helps to solve the problem of interoperability. As we know, there is poor interaction among blockchains. Therefore, wrapping the tokens makes it easy for the original cryptocurrency to perform additional functions on other blockchains. Also, this increases liquidity in crypto exchanges and DeFi protocols as there is smooth movement of the assets from one blockchain to another.
In some cases, wrapping cryptocurrencies helps to increase transaction speed and lower gas fees. As a specific example, it is faster to send wBTC on the ethereum blockchain than sending BTC on the bitcoin network. In addition, it costs less to send renBTC than BTC.
Wrapping cryptocurrencies also increases their utility as they can perform more functions than before. As you can also imagine, wrapping tokens increases the supply of cryptocurrencies in the market, which opens up more opportunities.

Disadvantages of Wrapped Tokens

Probably the major disadvantage is the high processing cost of minting the wrapped tokens. Usually, the custodian requires a fee to wrap and unwrap the tokens.
In addition, since the minting and unwrapping of tokens requires an escrow smart contract, it creates centralization in the blockchain sector, thus opening up to the problem of counterparty risk: wrapped tokens are dependent on the trustworthiness of the entity or organization that is backing the token. If the entity backing the token goes bankrupt or defaults on its obligations, the value of the wrapped token may be affected.
Last but not least, the process might be too complex for an average user: wrapped tokens can be more complex to understand and use compared to native tokens, as they involve an additional layer of abstraction. Users may also need to be familiar with the underlying asset and how it is valued.

Conclusion

Wrapped tokens have created new opportunities in the blockchain sector. A wrapped token exists on a non-native blockchain. wBTC is an example of a wrapped token that exists on the ethereum blockchain and helps to increase the use cases of Bitcoin. Tokens like renBTC (RENBTC), WETH Wrapped NXM (WNXM), THORChain (RUNE), and pTokens BTC (PBTC) are other examples of wrapped tokens.
Wrapping tokens expands their utility. Probably the greatest advantage of wrapped tokens is enhanced interoperability and liquidity. Sadly, wrapping tokens creates centralization in the crypto sector due to the use of custodians. However, smart contracts can also unwrap these tokens when the need arises.