Wrapped Tokens Explained: What Are Wrapped Tokens and How They Work
Ever wondered whether you can perform operations with cryptocurrency outside of its native blockchain? Unfortunately, you can't, at least not directly. This inability to migrate crypto assets from one blockchain to another can be considered by some among the most frustrating problems facing the crypto community. And while there currently is no direct way that would allow using Bitcoin on the Ethereum blockchain, a wrapped crypto token is the next best thing to a completely seamless transition between blockchains.
Wrapped tokens explained
Wrapped tokens are designed to allow the use of cryptocurrencies across blockchains, without forcing users to resort to selling crypto assets when they wish to trade on a platform utilizing a different blockchain. Essentially, a wrapped crypto token is a special cryptocurrency the value of which is tied to the value of another currency (similarly to stablecoins, the value of which is tied to fiat money like USD). The token is best imagined as a stand-in for a currency that is non-native to some blockchain. Using wrapped tokens allows the holder to preserve their original assets by securing them in a special digital vault. The original asset, however, remains inaccessible to the original owner while the token is in circulation. Though one can still retrieve their original assets, this will require a special notification to be given, which would pull the token out of circulation and destroy it. After this is done, the original crypto asset is released from the vault and given back to the holder.To explain in more detail, let’s look at the process of how wrapped tokens operate. In order for a wrapped token to be created, it requires a custodian – someone or something holding a certain amount of crypto assets. The value of the created wrapped tokens needs to be equivalent to the value of these assets. A custodian is usually a merchant, a multisig wallet (a type of wallet that requires several signatures for access), a DAO (Decentralized Autonomous Organization – an automated and crowd-sourced investment organization, which operates similarly to a venture fund), or a smart contract. A custodian receives a certain amount of crypto, let's say 1 BTC, from someone who wants to trade on an Ethereum-based platform. The transferred BTC is then placed to a digital vault, “wrapped”, while an equal amount – 1 WBTC – is minted on the Ethereum blockchain. The value of the WBTC is tied to the value of BTC and changes in real time accordingly thanks to a smart contract algorithm. In case the client wants to exchange WBTC back to BTC, or “unwrap” it, he or she issues a request to the custodian, who burns the WBTC and releases the BTC back from the vault. Proof of the transactions is stored on the blockchain. It is important to note that there is a fee (gas) involved in wrapping and unwrapping the cryptocurrency.
Wrapped tokens on Ethereum and the Binance Smart Chain (BSC)
You can use wrapped tokens on both Ethereum and Binance Smart Chain. In the case of Ethereum, such tokens can be utilized instead of non-native Ethereum assets – tokens that originate on other platforms – in order for them to be compatible with ERC-20 (the standard that is used on Ethereum to issue tokens). Similarly, on Binance Smart Chain various cryptocurrencies such as Bitcoin (BTC), Ether (ETH), USDT, and others can be wrapped with the help of Binance Bridge into BEP-20 tokens. They can then be bought or sold, or used for different purposes, such as yield farming (lending your funds in exchange or fees in crypto).Interestingly enough, ETH (or Ether), which is needed to pay for transactions on the Ethereum blockchain, predates the ERC-20 standard. This means that Ether needs to be converted into the ERC-20 token, despite being native to the blockchain. To do so, you need to wrap Ether (ETH) into wETH, thus creating a tokenized version of Ether.
Pros and cons of using wrapped tokens
The most obvious advantage of wrapped tokens is based on the fact that various standards differ across various blockchains, and these standards aren’t compatible with one another. Wrapped tokens help overcome this problem, allowing you to use tokens on a blockchain without them being originally non-native to it.Secondly, wrapped tokens help build connections and contribute to increasing liquidity. Capital efficiency is increased by the proliferation of wrapped tokens as idle and disconnected assets are “put to work”: tokens allow for more assets to potentially become traded and utilized in transactions, while also building bridges between different platforms.Finally, wrapped tokens can help avoid extra fees and increase transaction speed.However, as with everything else, wrapped tokens are not without disadvantages. Tokens do not allow genuine blockchain-to-blockchain migration, and therefore require the presence of a trustworthy third party. This, of course, means extra fees to pay for the user.Conclusively, while wrapped tokens are not ideal and do not allow for true blockchain-to-blockchain transactions, they nevertheless help connect different blockchains to one another bridging the gaps in decentralized finance and making crypto-capital more efficient.