In previous blog articles, we’ve covered a broad view of cryptocurrency and profiled Bitcoin, Ethereum and several other altcoins. Despite the advances of blockchain, the problem of cross-chain interoperability between large popular early networks (such as Bitcoin and Ethereum) still exists.
👀 In this article, we’ll take a closer look at wrapped tokens, which were designed to address this issue, and provide information on what they are and how they work. Here is our brief guide to get you on a clearer path to understanding.
❓ WHAT EXACTLY IS A WRAPPED TOKEN?
👉A wrapped crypto token is a digital asset that represents a cryptocurrency or other digital asset on a different blockchain. In simpler terms, it is a token backed by an underlying asset and is pegged to its value.
💡The idea behind wrapped tokens is to allow for the transfer of assets between different blockchains without the need for a centralized exchange.
⚙️ HOW DO WRAPPED TOKENS WORK?
To create a wrapped token, an asset is locked in a smart contract📄 on its native blockchain. Then, an equivalent amount of the asset is minted on a different blockchain and represented as a wrapped token. This process is known as wrapping. The wrapped token can then be used on the new blockchain as if it were the original asset.
For example, let's say you want to use Bitcoin on the Ethereum blockchain. To do so, you would send your Bitcoin to a smart contract on the Bitcoin blockchain, which would then issue an equivalent amount of wrapped Bitcoin on the Ethereum blockchain. This wrapped Bitcoin can then be used on the Ethereum blockchain, such as in decentralized finance (DeFi) protocols.
There are two types of wrapped tokens:
- Cash-settled tokens – cannot be redeemed for the underlying asset.
- Redeemable tokens – allow investors to exchange the wrapped token with the underlying asset.
⚪ WRAPPED TOKEN EXAMPLES
Wrapped Bitcoin (WBTC) and Wrapped Ethereum (WETH) are two of the most popular wrapped tokens.
WBTC is an ERC-20 token on the Ethereum blockchain that represents Bitcoin. It is backed 1:1 by Bitcoin held in a custodial account and allows for the use of Bitcoin in Ethereum-based DeFi protocols.
WETH, on the other hand, is an ERC-20 token on the Ethereum blockchain that represents Ether. It allows for the use of Ether in Ethereum-based DeFi protocols and is often used as a base currency for trading pairs on decentralized exchanges (DEXs).
Another example of a wrapped token is renDOGE – a wrapped version of Dogecoin that can be minted using the RenBridge on the RenVM protocol.
A complete list of wrapped tokens sorted by market capitalization can be viewed here.
🌉 WRAPPED TOKEN BRIDGES
👉Wrapped token bridges are protocols that facilitate the transfer of assets between different blockchains. They allow for the minting and burning of wrapped tokens and the transfer of the underlying asset between different blockchains.
Examples of wrapped token bridges include the RenVM, which supports the creation of wrapped tokens for a variety of assets, and the Polygon bridge, which allows for the transfer of assets between the Ethereum and Polygon (formerly Matic) blockchains.
The Binance bridge allows for the wrapping of crypto assets for use on the BNB Smart Chain (BSC) in the form of BEP-20 tokens.
✔️ WRAPPED TOKEN BENEFITS
💫As mentioned earlier, the main benefit of wrapped tokens is interoperability between different blockchains. This means that assets can be used across different blockchain ecosystems, opening up new use cases and expanding the reach of existing assets.
For example, wrapped Bitcoin on the Ethereum blockchain allows for the use of Bitcoin in Ethereum-based DeFi applications, such as lending, borrowing, and trading.
💧Wrapped tokens can also provide liquidity to illiquid assets. For example, assets that are not widely traded or supported on DEXs can be wrapped and traded on a different blockchain with greater liquidity.
❌ WRAPPED TOKEN FLAWS
🙏One potential flaw of wrapped tokens is the trust required in the entity that manages the wrapped token. This entity is responsible for holding the underlying asset and issuing the wrapped token. If this entity is compromised, there is a risk that the wrapped token could lose its peg to the underlying asset.
💦Another flaw is the potential for liquidity fragmentation. If an asset is wrapped on multiple blockchains, liquidity can be fragmented across those blockchains, leading to less efficient markets and potentially higher trading fees.
🔮 WRAPPED TOKENS: FUTURE OUTLOOK
Wrapped tokens enable cross-blockchain interoperability and expansion of asset use cases, but they come with potential flaws, such as the need for trust in the wrapping entity and the risk of liquidity fragmentation.
Looking to the future, we can expect to see the continued development of wrapped token infrastructure and the expansion of the types of assets that can be wrapped. This will likely lead to greater interoperability between blockchains and more efficient markets for a wider range of assets.
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The information provided on this website does not constitute investment advice, financial advice, trading advice, or any other sort of advice and you should not treat any of the website's content as such. Bloom does not recommend that any cryptocurrency or NFTs should be bought, sold, or held by you. Do conduct your own due diligence and consult your financial advisor before making any investment decisions.