Interoperability has become a primary concern in the cryptocurrency ecosystem. It’s bothersome that we are unable to spend tokens from one blockchain on another. Furthermore, the rise of decentralized finance (DeFi) demands a greater need for interoperable solutions. Wrapped tokens are one emerging answer for this concern.
Wrapped Token: Definition
A wrapped token is a blockchain-based asset whose worth is linked to the value of an underlying cryptocurrency. The original crypto is stored in a secure vault while the wrapped version is published on a host blockchain. Wrapped tokens exist natively on a blockchain that is different from its source. These tokens act as a link between blockchain networks.
Wrapped tokens are similar to stablecoins. Their value is derived from another asset. A fiat currency, for example, backs stablecoins. In the case of a wrapped token, the asset is usually a native cryptocurrency of another blockchain network. For instance, wBTC is a wrapped token of Bitcoin on Ethereum. It allows users to enter the DeFi market while still owning Bitcoin.
These tokens improve interoperability between blockchains by allowing the underlying tokens to move cross-chain. Users can trade these wrapped tokens precisely like any other cryptocurrency.
How do wrapped tokens work?
Wrapped tokens typically require the services of a custodian. These are entities that own an equivalent amount of the blockchain-based asset as the wrapped amount. The presence of a custodian is crucial while handling the problem of double-spending. A merchant, a multi-sig wallet, a DAO, or even a smart contract can serve as the custodian.
To demonstrate how wrapped tokens function, let’s take an example of Wrapped Bitcoin (wBTC). wBTC is an Ethereum-based tokenized version of Bitcoin. It is an ERC-20 token designed to be pegged to the value of Bitcoin. wBTC enables holders to use Bitcoin on the Ethereum network. For every wBTC in existence, a Bitcoin is held inside a custodian. The proof of which can be found on the Ethereum network.
Benefits of wrapped tokens
Non-native tokens can be used on any other blockchain. Every network has its own token standards that define the creation of new tokens. These standards are not compatible with other blockchains. Wrapped tokens enable the use of non-native tokens on another network.
1. Increased liquidity
Wrapped tokens have the potential to improve liquidity and financial efficiency for both centralized and decentralized exchanges. The ability to wrap unused assets and utilize them on another blockchain can help increase a platform’s liquidity.
2. Faster transaction times and reduced fees
Transaction times and fees are a significant advantage in the blockchain ecosystem. While Bitcoin and Ethereum have some excellent attributes, they aren’t the fastest. They can also be costly to use at times. Users can avoid these disadvantages by adopting a wrapped version of the same token on other fast and efficient blockchains. As an example, Solana or Binance Smart Chain can offer faster transaction speed and cheaper fees.
Limitations of wrapped tokens
1. Centralization
Decentralization is a defining characteristic of the cryptocurrency revolution as a whole. The requirement for a custodian to wrap tokens makes it difficult for individuals who oppose centralization.
2. Custodian vulnerability
Only the custodian can ‘unwrap’ wrapped tokens. It is in charge of the entire procedure. Users can do nothing if the custodian has a vulnerability in the code or locks the tokens.
3. Expensive
Wrapping and unwrapping tokens might incur significant transformation costs. It can result in a higher payment amount than the original token’s value.
Bottom line
Wrapped tokens assist the development of linking blockchain networks. This facilitates interoperability throughout the cryptocurrency and DeFi ecosystems. Wrapped tokens usher in a new era in which capital is much more efficient, and apps can readily share liquidity.
If you like this article or wants to learn more about cryptocurrencies and blockchain, check out our other articles!
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