What is wrapped tokens?
What is wrapped tokens?
Simple language explanation of wrapped tokens
What is wrapped tokens?
Wrapped crypto tokens are cryptocurrencies used on the DeFi platforms that are pegged to the value of another original cryptocurrency or other assets like gold, stocks, shares, and real estate.
A newly minted token is created to conduct transactions on other platforms, and the original asset is "wrapped" into a digital vault. Wrapped tokens create bridges between networks, enable interoperability in the cryptocurrency industry, and enable the use of non-native assets on any blockchain.
They can stand in for anything, including fiat money, real estate, equity, commodities, arts and collectibles, and crypto assets. Wrapped tokens must be treated and managed by a custodian entity that will wrap and unwrap the asset because they are tied to another asset.
Wrapped Bitcoin denominated as wBTC were the first wrapped Bitcoin tokens used in the Ethereum blockchain through smart contracts, letting investors earn a fixed income. In addition to Bitcoin, the list of wrapped tokens also includes other assets, mostly those that adhere to Binance Smart Chain BEP-20 and Ethereum ERC-20.
Although ERC-20 tokens are created on the Ethereum platform, ETH was created before they were, so it is not compatible with them. Ether must be wrapped in order to adhere to other ERC-20 token standards, just like Bitcoin. This results in the creation of an Ethereum platform tokenized version of ether.
Other blockchains like Cardano, Polkadot, and Solana have started to experiment with wrapped tokens to facilitate access to DeFi applications.
Various types of wrapped tokens
There are two types of wrapped tokens:
Cash-settled.
Redeemable.
Cash-settled tokens are not redeemable for the underlying asset. On the other side, redeemable tokens allow investors to exchange the wrapped token with the underlying asset. Other blockchains host wrapped tokens. In the blockchains of Monero or ZCash, for instance, are wrapped privacy currencies hosted.
How does it work?
The custodian mints the specified amount of the original token supplied on a certain platform, like Ethereum, for instance, in response to requests from merchants like Airswap, CoinList, 0x, AAVE, or Maker.
By using a similar procedure, the user will ask the custodian to release the wrapped token from the reserves when it has to be changed back into the original asset or a coin like Bitcoin. Simply put, for every wBTC that exists, for example, there is a Bitcoin that a custodian is holding.
The process of creating and managing wrapped tokens represents a limitation in crypto as the requirement of a custodian to trust for holding the funds defeats the purpose of an open and decentralized blockchain ecosystem.
A constraint of cryptocurrencies is the process of producing and managing wrapped tokens, as it defies the goal of an open and decentralized blockchain environment to require a custodian to store the assets.
Since traders cannot independently use wrapped tokens for cross-chain transactions, a custodian is still necessary. Though technology is developing quickly, decentralized options might be available shortly.
What is wrapped Bitcoin?
The world of cryptocurrencies has benefited greatly from the introduction of the wrapped Bitcoin. Although the wBTC has the same value as the original Bitcoin, its increased functionality makes it more likely that Bitcoin will be used for other use cases, such as DeFi.
By simply connecting their wallet to a decentralized network, Bitcoin owners may lend their currency using smart contracts and receive a set annual interest rate. Borrowers also utilize their cryptocurrency as collateral, which automatically belongs to the lender in the event of default.
By using this type of financing, investor lenders can still get some returns even in bear markets when the value of the asset drops.
How does wrapped Bitcoin work?
The main players in the development and administration of the wBTC protocol are three:
The DAO (Decentralized Autonomous Organization) comprises 17 members from the DeFi space who will hold a multi-sig (multi-signature) contract to add or remove wBTC merchants and custodians.
The merchants. The minting process is started by the merchants, who are administrators who submit a particular quantity of Bitcoin to the custodian and ask them to mint an equivalent amount of wrapped tokens in response to investor and trader demands.
The custodians act as wBTC's equivalent of vaults, ensuring its dependability and security as well as the full backing and verification of all wBTC through on-chain proof of reserves. They create BTC and return to the merchant the exact same amount of wBTC (pegged one to one to the value of BTC).
With the expansion of DeFi, which is now valued billions of dollars and used in loans, options, derivatives, and other forms of financial applications, the demand for such a token emerged. In order to participate in the ecosystem, which was primarily built on Ethereum, BTC had to be turned into an ERC-20 compatible token due to the desire for using it as an underlying asset in DeFi.
Does it safe?
From a technical perspective, a wrapped Bitcoin token is safe. It will likely be in custody in safe platforms like Ethereum or Binance Smart Chain, and once converted into an ERC-20 or BEP-20 token, it will hold the security of the related network.
The necessity of having faith in the custodian who retains the underlying asset is one of the major drawbacks of wrapped BTC tokens. The owners of the wrapped Bitcoin tokens that are ERC-20 compatible would be left holding a useless asset if the custodian unlocked and released the real Bitcoin to someone else.
Are wrapped tokens a wise financial decision?
In the cryptocurrency era, where decentralized finance will unquestionably play a key part, wrapped tokens are becoming more and more considered as a wise investment. The industry's current capitalization can be inferred from the approximately $800 million worth of Bitcoin that was converted into wBTC in a little more than a year.
Wrapped tokens enable the movement of assets across various chains that would otherwise remain isolated, increasing liquidity and capital efficiency for both centralized and decentralized exchanges.
Another benefit is that wrapped tokens are especially helpful for slow blockchains like Bitcoin or Ethereum since they enable quick transaction times and cheaper fees.
In contrast with other assets, wrapped tokens also offer fractionalized ownership that allows owners to buy and hold a tiny fraction of the asset.