Over the last couple years, wrapped tokens have gained significant popularity on the cryptocurrency market. Their ability to solve the issue of cross-chain transactions has played a major role in that.
But how exactly do they work? And what are their benefits?
This is what we will discuss in this article. We will understand why wrapped tokens attract investors and traders & look at the risks involved. Whether you are a seasoned investor or just starting to explore the world of cryptocurrency – this article will provide a good understanding of wrapped tokens.
So, let’s start with the basics! 👇
What are Wrapped Tokens?
Wrapped tokens, sometimes called synthetic or wrapped assets, are a kind of cryptocurrency that users can trade for other assets, such as commodities, equities, or other tokens. The tokenization of these assets makes them tradable and usable on different networks, such as the Ethereum network.
This provides a new level of convenience and security for managing and transferring cryptocurrencies, opening a wider range of opportunities for those wanting to invest, trade, or use them in decentralized applications.
In other words, wrapped tokens are assets that enable the transfer of native asset value from one blockchain to another. Wrapped Bitcoin, also known as wBTC (ticker WBTC) is a famous example of a wrapped token.
One wBTC will always be equal to the value of one BTC due to the 1:1 peg between the two currencies. Unlike Bitcoin, however, wBTC may only be obtained as either an ERC-20 or a TRC-20 token, making it usable and tradable on the Ethereum and Tron networks.
Wrapped tokens are comparable to stablecoins like USDT in terms of their value generation. One wBTC is tied to the price of one BTC, while one USDT is fixed to the price of one dollar.
However, the fact that a token is tied at a 1:1 ratio to the price of another asset is not the only defining characteristic of a wrapped token. Its backing and stability in value are due to the technology that underpins them.
How do Wrapped Tokens Work?
To understand how wrapped tokens function, we first have to understand how they are created. To create or destroy a wrapped token, the underlying asset that it represents, has to be “minted” or “burned”. Let’s look at what this means exactly.
wBTC minting process.
What is token minting and token wrapping? 🪙
Minting refers to transferring the underlying asset, such as BTC, to a digital vault for safekeeping. The holder of the digital vault then creates an equal quantity of a wrapped token, such as wBTC, that users can trade on other blockchain platforms.
The process through which an underlying cryptocurrency is safely stored in a digital vault using smart contracts is called wrapping.
What is token burning and token unwrapping? 🔥
When the wrapped token is no longer required, the procedure is reversed.
Burning refers to taking the wrapped token out of circulation, after which the underlying token is unlocked and released back into circulation.
Unlocking an underlying cryptocurrency from the vault and releasing it back into circulation using smart contracts is called unwrapping.
How is wrapped token price ensured?
Each wrapped token is backed by an equal quantity of its underlying currency. This implies that the owner of the digital vault stores the corresponding amount of the underlying asset for each wrapped token that is issued. If someone creates 100 renDOGE tokens, for instance, they will have to store 100 Dogecoins to support the value of the wrapped token.
Wrapped tokens are a practical and safe approach to represent existing assets across many blockchain networks. Wrapped tokens have the same purchasing power as the currency they represent because of the smart contract used in their minting and burning.
Benefits of Wrapped Tokens 👍
Wrapped tokens provide a range of benefits compared to regular crypto tokens. Let’s address the most important ones.
1. Interoperability
One of the critical advantages of wrapped tokens is their versatility and interoperability. For example, being backed by an equivalent amount of Bitcoin, wrapped Bitcoin allows investors to essentially hold and trade Bitcoin on the ERC-20 network.
This may come in handy for both investors and traders alike. Interoperability has potential to reduce transaction costs as well as increase transaction speed.
2. Security
Another advantage of wrapped tokens is their security. Due to the usage of smart contracts in their creation, wrapped tokens allow for a higher security than traditional financial systems.
In addition, the value of wrapped tokens does not depend on any one project or company. Instead, it only relies on the value of the asset backing it, which may provide investors additional stability.
3. Liquidity
Wrapped tokens allow for assets to be used on different decentralized platforms, including exchanges and dApps. For instance, since wBTC is an ERC-20 token, it can be used in Ethereum network-based applications and interact with other ERC-20 tokens.
Drawbacks of Wrapped Tokens 👎
Now let’s look at some drawbacks associated with wrapped tokens:
1. Fees
There may be financial advantages to using wrapped tokens, particularly if wrapping a token permits its usage on a blockchain with cheaper transaction costs. However, the minting process itself may impose fees.
2. Inequivalent value
Wrapped tokens should be worth the same as the underlying cryptocurrency they represent. However, during periods of extreme market volatility, the value of wrapped tokens may fall below that of the underlying coin.
3. Contagion
An economic crisis may move from one cryptocurrency to another via a process known as contagion. Wrapped tokens raise the possibility of a currency crisis by making it more likely that one currency will affect another.
So, if the value of Ethereum (ETH) suddenly drops, the users of wrapped Ethereum (WETH) will be directly affected by that as the value of their wrapped assets drops as well.
Wrapped Tokens Examples: wBTC & beyond?
The first wrapped Bitcoin (wBTC) protocol was released in January 2019 to bring Bitcoin’s potential and liquidity to the Ethereum network via a flexible ERC-20 token.
The world of cryptocurrencies has benefited significantly from the introduction of the wrapped Bitcoin. Its increased functionality allows it to put Bitcoin to use in other contexts, such as DeFi.
And since the appearance of wBTC, multiple other wrapped tokens have been created to expand the functionality of existing cryptocurrencies. Let’s have a brief look at the most popular ones:
Examples of wrapped tokens include:
- WBTC – The WBTC DAO oversees this project, which Kyber, Ren, and BitGo jointly established. It wraps Bitcoin for usage on the Ethereum network.
- RENBTC – another version of wrapped Bitcoin created by Ren Project. It serves the purpose of value movement between blockchain networks, along with other wrapped tokens supported by Ren (Ethereum, Solana, USDT etc.).
- WMATIC – Most people are familiar with Polygon (MATIC). It’s an Ethereum scaling solution that operates on top of the Ethereum network. However, Polygon has its own Layer 2 blockchain, and WMATIC is a version of MATIC that can be used on Polygon network.
- WETH – also known as wrapped ETH, is an ERC-20 version of Ethereum coin that owners may use as an asset on DeFi protocols. Several 0x labs-managed projects developed it.
- RENDOGE – Wrapped Dogecoin that users can mint over the RenBridge on the RenVM protocol.
The Takeaway
Wrapped tokens provide a solid utility for investors and traders alike, letting them use cryptocurrencies of their choice in exchanges and applications they could not use them in before. They also allow for the value transfer between different blockchain networks, improving liquidity, interoperability and security.
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