Despite its uniqueness and functionality, blockchain technology has limitations in terms of interoperability within the ecosystem. As a result, Bitcoin and Ethereum are built on different blockchain protocols and functionalities. This means they can’t communicate with one another because their algorithms are fundamentally different; data and information cannot be easily exchanged.
Because different blockchain networks cannot communicate with one another –the Bitcoin blockchain is unaware of the Ethereum blockchain’s activities, and vice versa– a bridge is required to allow users to enjoy the functionality and usability of one network while holding tokens from another.
However, wrapped tokens were introduced to solve the problem of communication between networks and enable interoperability while also benefiting the sovereignty and security of each blockchain.
Now, let’s look at what wrapped tokens are and how they work, what issues they tend to solve, and why you need them as a crypto user. Continue reading!
What Are Wrapped Tokens?
Wrapped tokens are tokenized versions of other crypto assets representing another blockchain and having the same value as the original cryptocurrency. They are tokens typically tied to a specific cryptocurrency but can function on another blockchain network. Also, the wrapped token can be used on non-native blockchains and later converted (unwrapped) for the original cryptocurrency.
Wrapped tokens are 1:1 backed by their underlying crypto asset, kept in a digital vault. As a result, they are considered a possible solution to the problem of blockchain interoperability. Wrapped tokens also improve the usability, utility, and liquidity of well-known decentralized finance (DeFi) applications.
However, because wrapped tokens are pegged to another asset, they must be regarded and managed by a custodian entity that holds an equivalent amount of the asset as the wrapped amount and unwraps the asset to the initial amount.
Also, wrapped tokens can be traded just like any other assets as it seeks to address the limitations of two blockchains’ lack of cross-chain interoperability. As a result, you can trade a wrapped token of a blockchain network on another different network.
How does Wrapped Token Work?
To purchase a wrapped token, you must first have an actual crypto-asset because the wrapped token’s value is linked and pegged to the original token. As a result, wrapped tokens track the value of the original token asset they represent and can be wrapped and unwrapped easily using a custodian digital vault holding the equivalent amount of the token.
Consider the first and most popular wrapped token – Wrapped BTC (wBTC) to better understand this. wBTC is an Ethereum blockchain-based tokenized version of bitcoin. It is an ERC-20 token with a 1:1 correlation to the value of bitcoin. This allows users to benefit from Ethereum’s second-generation blockchain while enjoying bitcoin’s price movement and security.
Wrapped tokens are created through a process known as “minting.” However, to mint a wrapped token like WBTC, the corresponding crypto asset, BTC, is sent to a custodian who stores it in a digital vault. Once the BTC has been secured, an equivalent amount of WBTC can be minted. This procedure is also known as “wrapping.” A smart contract is used to “wrap up” the BTC in a digital vault, and a newly wrapped asset –wBTC– is minted for use on another blockchain.
Similarly, the same procedure is used to “unwrap” a wrapped token, and the wBTC is destroyed through a process known as “burning.” Therefore, the procedure would be followed in reverse to burn a wrapped token. The wBTC is taken out of circulation, and an equivalent amount of BTC is released from the digital vault and returned to the market.
wBTC enables you to participate in the Ethereum ecosystem, particularly the DeFi protocol. You can earn interest as a lender and token rewards by staking and providing liquidity using wBTC. This flexibility enables users to seamlessly switch between wBTC and BTC to suit their investment strategy.
Conversely, to ensure transparency within the ecosystem, wBTC makes its entire order book available to the public. You can see how much BTC has been stored within the digital vault and the equivalent wBTC in circulation.
Benefits of Wrapped Tokens:
Although many blockchain networks have their own token standards, such as Ethereum’s ERC-20, these tokens cannot be used across multiple chains. On the other hand, wrapped tokens allow the use of non-native tokens across any given blockchain. Among the other advantages are:
Wrapped tokens enable cross-chain interoperability, allowing users to quickly move assets and access features and applications on other blockchains.
Greater liquidity is another significant advantage that wBTC brings to the market. The Ethereum ecosystem is vast and diverse. This distribution of funds may result in DEXs (decentralized exchanges) and other platforms lacking the liquidity required to function optimally. As a result, decentralized exchanges and other platforms may lack the liquidity needed for optimal functionality.
Lower Transaction Fee:
Transactions involving a wrapped token are frequently less expensive than transferring the original token. In addition, wrapped token transactions are faster because they take advantage of the blockchain’s functionality and programmability.
Limitations of Wrapped Tokens:
Trusting the custodian who holds the underlying asset is one of the significant flaws in wrapped BTC tokens. As a result, wrapped tokens can’t be used for cross-chain transactions and are not entirely decentralized because they need to go through a third party. Also, the minting process can be costly due to the custodian’s high gas prices and transaction costs for wrapping and unwrapping the token.
A wrapped token is a tokenized cryptocurrency backed by the original coin. However, wrapped tokens are not “ideal” cryptocurrencies; they represent other cryptocurrencies. As a result, they cannot perform some of their original asset’s functions.
Also, wrapped token creation has boosted DeFi’s popularity, Ethereum’s DeFi ecosystem in particular, and allows cryptocurrency investors to diversify their crypto portfolio.
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