One leading problem blockchains face is that they can’t easily communicate with each other. They’re separate chains so inter-communication is hard. You can’t use your Bitcoin directly on the Ethereum blockchain, because only the Bitcoin blockchain “knows” that you hold Bitcoin. What’s the solution, then? Wrapped tokens.
What Are Wrapped Tokens?
A wrapped token is basically swapping one asset for another that has the same value. This is done through a smart contract or a blockchain that can store and send funds. It’s like you exchanging one dollar bill for four quarters. They’re not the same, but they hold the same value.
Some confuse these with stablecoins. While the two are similar, stablecoins’ value is linked to an external, and more traditional asset, like the US dollar or gold. Whereas cryptocurrency backs the value of wrapped coins.
How Do Wrapped Tokens Work?
The merchant sends the token to a custodian which triggers the minting of the wrapped token. The custodian then sends the original token to a custodian address, and the latter locks it. Once locked, the address mints the equivalent amount of the original token. Then, they send the wrapped coin to the merchant.
If you choose to get your original token back, you have to burn the wrapped one.
Types of Wrapped Tokens
There are two types:
- Cash-settled tokens: Holders can’t redeem the original asset
- Redeemable tokens: Investors can exchange the wrapped token with the underlying asset.
Are they useful?
Yes. These tokens are actually useful and investors often use them nowadays. But, just like almost anything, they do have their disadvantages.
Wrapped tokens are still in circulation because they do have benefits. Matter of fact, the main benefit they have is allowing interoperability between blockchains. As we already mentioned, blockchains can’t interact with each other.
So, you can’t use Bitcoin on the Ethereum blockchain. But, what you can do is use a wrapped bitcoin on the Ethereum blockchain. Therefore, thanks to these assets, blockchains can interact with one another. This, in turn, improves liquidity because tokens can circulate on non-native blockchains.
Moreover, these tokens are also used in NFT renting. In order to rent an NFT and enjoy all its benefits without the original owner losing it, you get a wrapped one instead.
It’s not all sunshine and rainbows, wrapped tokens do have some limitations.
- Added fees: You can use wrapped tokens on non-native blockchains that have lower transaction fees. However, the actual minting process of these wrapped assets may trigger fees.
- Inequivalent value: Even though generally wrapped tokens and the original assets have the same value, it might not always be the case. In times of high volatility, the wrapped asset can have a lower value than the original one.
- Financial Contagion: Because these assets can be used across blockchains, this can cause a financial crisis on one blockchain to affect the other.
Examples of Wrapped Tokens
There are multiple examples:
- WBTC: This project wraps Bitcoin so investors can use them across the Ethereum blockchain.
- WETH: This is a wrapped ERC-20 version of Ethereum that can be used as an asset on DeFi protocols.
- renDOGE: Wrapped version of Dogecoin.
So, wrapped tokens are like Christmas presents except you know what’s inside and sometimes it’s actually yours. They are however very useful to use on non-native blockchains. But, this increases the interaction between blockchains that usually don’t interact. Does that increase the risk of hacks? Wait, can you even hack a blockchain?