TL;DR
A wrapped token is a cryptocurrency token pegged to the value of another crypto. Itâs called a wrapped token because the original asset is put in a wrapper, a kind of digital vault that allows the wrapped version to be created on another blockchain.
Whatâs the point? Well, different blockchains offer different functionality. And they canât talk to each other. The Bitcoin blockchain doesnât know whatâs happening on the Ethereum blockchain. However, with wrapped tokens, there can be more bridges between different blockchains.
Introduction
Ever found it frustrating that you canât use BTC on Ethereum? ETH on BNB Smart Chain (BSC)? Coins that exist on a given blockchain canât be simply transferred to another.
Wrapped tokens are a way to circumvent this limitation and use non-native assets on a blockchain.
What Is a Liquidity Pool?
A wrapped token is a tokenized version of another cryptocurrency. Itâs pegged to the value of the asset it represents and typically can be redeemed for it (unwrapped) at any point. It usually represents an asset that doesnât natively live on the blockchain that itâs issued on.
You could think of a wrapped token as being similar to a stablecoin in that it derives its value from another asset. In a stablecoin's case, thatâs usually fiat currency. In a wrapped tokenâs case, itâs usually an asset natively living on another blockchain.
As blockchains are distinct systems, there isnât a good way to move information between them. Wrapped tokens increase interoperability between different blockchains â the underlying tokens can, in essence, go cross-chain.
Itâs worth noting that if youâre an ordinary user, you donât have to worry about the wrapping and unwrapping process; you can just trade these wrapped tokens like any other cryptocurrency. For example, this is the WBTC/BTC market on Binance.
How Do Wrapped Tokens Work?
Letâs use Wrapped Bitcoin (WBTC) as our example, a tokenized version of Bitcoin on Ethereum. WBTC is an ERC-20 token thatâs supposed to hold a one-to-one peg to the value of Bitcoin, allowing you to effectively use BTC on the Ethereum network.
Wrapped tokens typically require a custodian â an entity that holds an equivalent amount of the asset as the wrapped amount. This custodian can be a merchant, a multisig wallet, a DAO, or even a smart contract. So, in WBTCâs case, the custodian needs to hold 1 BTC for each 1 WBTC that is minted. Proof of this reserve exists on-chain.Â
But how does the wrapping process work? A merchant sends BTC for the custodian to mint. The custodian then mints WBTC on Ethereum according to the amount of BTC sent. When the WBTC needs to be exchanged back to BTC, the merchant puts in a burn request to the custodian, and the BTC is released from the reserves. You can think of the custodian as the wrapper and unwrapper. In WBTCâs case, adding and removing custodians and merchants is performed by a DAO.
While some in the community may refer to Tether (USDT) as a wrapped token, this isnât exactly the case. While USDT generally trades one-for-one with USD, Tether does not hold the exact amount of physical USD for each USDT circulating in their reserves. Instead, this reserve is made up of cash and other real-world cash equivalents, assets, and receivables from loans. However, the idea is very similar. Each USDT token acts as a kind of wrapped version of a fiat USD.
Wrapped Tokens on Ethereum
Wrapped tokens on Ethereum are tokens from other blockchains that are made to be compliant with the ERC-20 standard. This means that you can use assets that are not native to Ethereum on Ethereum. As youâd expect, wrapping and unwrapping tokens on Ethereum costs gas.
The implementations of these tokens can be very different. We wrote about them in more detail in our tokenized Bitcoin article.
An interesting example of a wrapped token on Ethereum is wrapped ether (WETH). A quick recap â ETH (ether) is required to pay for transactions on the Ethereum network, while 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 isnât compliant with it. This creates a problem, as many DApps require you to convert between ether and an ERC-20 token. This is why wrapped ether (WETH) was created. Itâs a wrapped version of ether that is compliant with the ERC-20 standard. Itâs basically a tokenized version of ether on Ethereum!
Wrapped Tokens on BNB Smart Chain (BSC)
Just like wrapped tokens on Ethereum, you can wrap Bitcoin and many other cryptos for use on the BNB Chain.
The Binance Bridge allows you to wrap your crypto assets (BTC, ETH, XRP, USDT, BCH, DOT, and many more) for use on the BNB Smart Chain in the form of BEP-20 tokens. Once youâve brought your assets to BSC, you can trade them or use them in various yield farming applications.
The wrapping and unwrapping cost gas; however, as far as BSC is concerned, you can expect significantly lower gas costs than other blockchains. You can read more about Binance Bridge in our detailed article.
Benefits of Using Wrapped Tokens
Even though many blockchains have their own token standards (ERC-20 for Ethereum or BEP-20 for BSC), these standards canât be used across multiple chains. Wrapped tokens allow non-native tokens to be used on a given blockchain.
In addition, wrapped tokens can increase liquidity and capital efficiency both for centralized and decentralized exchanges. The ability to wrap idle assets and use them on another chain can create more connection between otherwise isolated liquidity.
And lastly, a great benefit is transaction times and fees. While Bitcoin has some fantastic properties, it isnât the fastest and can sometimes be expensive to use. While thatâs fine for what it is, it can cause some headaches sometimes. These issues can be mitigated by using a wrapped version on a blockchain with faster transaction times and lower fees.
Limitations of Using Wrapped Tokens
Most of the current implementations of wrapped tokens require trust in the custodian holding the funds. As for the currently available technology, wrapped tokens canât be used for true cross-chain transactions â they usually need to go through a custodian.Â
However, some more decentralized options are in the works and may be available in the future for completely trustless wrapped token minting and redemption.
The minting process can also be relatively costly thanks to high gas fees and can incur some slippage.
Closing Thoughts
Wrapped tokens help with creating more bridges between different blockchains. A wrapped token is a tokenized form of an asset that natively lives on another blockchain.
This helps interoperability in the cryptocurrency and Decentralized Finance (DeFi) ecosystem. Wrapped tokens open up a world where capital is more efficient, and applications can easily share liquidity with each other.
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