As blockchains (yes, in plural) rise and developers keep coming up with new projects, the cryptocurrency environment becomes more complex. In this scenario of diversification, interoperability between blockchains is hard to achieve. Wrapped tokens come as a useful tool to improve inter-chain communication.
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Wrapped tokens explained
Much like stablecoins, which hold a 1:1 ratio with a fiat currency, wrapped tokens are assets of a specific blockchain that keep an equal value to Bitcoin, Ethereum or any other coins. That way, we have a simple, fast, and easy way to move our assets in between chains without having to spend a lot of money on conversion and transaction fees.
How do wrapped tokens work?
You may be wondering what guarantees that equal value between a wrapped token and its related cryptocurrency, or how that does not collide with the fixed supply specification of some coins.
Wrapped tokens are backed by the same amount of the cryptocurrency they represent. The latter is then put out of circulation and locked in a “vault”, called wrapper (hence “wrapped tokens”). The institutions that hold these “frozen” tokens are called custodians, who must mint and burn the coins on the different blockchains as required.
That way, we can be sure that for every Wrapped Bitcoin (WBTC), an ERC-20 wrapped token, there is a native Bitcoin out of circulation. The process relies on a series of institutions, organizational roles and even smart contracts to guarantee security and prevent frauds.
Let’s explain that with a clear example: Assuming we want to send 10 BTC to the Ethereum blockchain, we must transfer those 10 BTC to a custodian. They would then lock those BTC and mint 10 WBTC on Ethereum. Similarly, when we finish operating, we should send the WBTC back to the custodian, who will burn those tokens and release the original BTC. It doesn’t matter who transferred the assets to the custodian in the first place, but who returns the wrapped tokens to them, giving these assets trading value.
By the time we’re writing this article, the amount of Wrapped Bitcoin is about 127.245, meaning that about 0.61% of the total supply of Bitcoin is circulating in its ERC-20 form.
Why are wrapped tokens useful?
Each chain has its utility, goals and plans for the future. Bitcoin seems to have moved from digital currency to a store-of-value asset. Meanwhile, Ethereum has gained fame as the go-to network for DeFi applications, and Cardano focuses on technological development and democratization for a fairer society, to name a few.
Different functionality means that you might run into trouble if you need to jump between blockchains.
For instance, you might want to put some of your BTC to work on a DeFi yield farm like Curve. One way you can do that is by swapping your BTC to ETH or any ERC-20 token. Later, you’d have to send those assets to an Ethereum wallet to connect to Curve. However, imagine that during the time you’re yield farming, Bitcoin price spikes 20%. You just lost an exceptional opportunity. On the other hand, using Wrapped Bitcoin you can easily use all DeFi applications based on Ethereum without giving up your Bitcoin.
With wrapped tokens, you can use non-native cryptocurrency on a blockchain that doesn’t support it. Also, they provide an alternative for crowded blockchains: If the Bitcoin network is slow, you can switch to WBTC to take advantage of Ethereum’s speed. Viceversa, if Ethereum fees are over the clouds, you can switch to Bitcoin BEP2 (the equivalent of WBTC on Binance Smart Chain) to save with BSC low costs for transactions.
*Even if these assets are supposed to be of equal value to their underlying cryptocurrency, they can miss the 1:1 ratio by the decimals. You can check wrapped tokens exact exchange rate with their pegged coins on The Crypto App. Download the app here.
Not everything is fun and games
Wrapped tokens are a practical solution for cross-chain communication and interoperability. They also enable faster and more accessible alternatives for transactions when a given blockchain experiences delays or high fees.
Nevertheless, there are some considerations to bear in mind. A wrapped version of a coin is not that coin. It’s another cryptocurrency entirely. Therefore, you may not have access to all of its functionality. Some passive income platforms don’t take wrapped tokens, for example, and neither do some exchanges and wallets.
Yet there is another reason to worry about: centralization. The fact that you need to trust a custodian with your assets for them to mint wrapped tokens opens the door to market bias and monopolization. You’d be giving them full control of your coins. Decentralization is one of crypto’s most significant features, and using wrapped tokens gives up that advantage.
Just like everything else in the cryptocurrency environment, there are pros and cons to using wrapped tokens. Remember to do your research, make sure you’re comfortable with the terms and conditions of the institutions and organizations involved in the process and acknowledge the risks involved in every transaction.
Keep this in mind, and there is no doubt you’ll make great use of the practical tools that are wrapped tokens.