What are Wrapped Crypto Tokens?
Wrapped crypto tokens are essentially replicated copies of existing digital coins or cryptocurrencies. These digital tokens are often backed by another crypto asset on a different blockchain network or operate a different token standard.
Wrapped tokens maintain an equivalent value to the original cryptocurrency, usually on a 1:1 basis.
However, unlike the original cryptocurrency they are based on, wrapped tokens can seamlessly operate on non-native blockchain protocols. Additionally, they can be redeemed for the original digital currency.
The term ‘wrapped’ is used because these tokens are tied and simulated versions of another cryptocurrency. They serve as synthetic versions, offering enhanced functionality compared to the original cryptocurrency with rigid feature setups or restrictive applicable use cases.
Cryptocurrencies like Bitcoin, with a strong brand and market pull, were not initially compatible with DeFi protocols like Aave on the Ethereum network due to the absence of smart contract functionality.
This development allowed Bitcoin users to seamlessly utilize wBTC on smart contract-powered DeFi platforms with minimal friction.
While wrapped crypto tokens initially began with native crypto assets like Bitcoin, the concept has since been extended to include other blockchain-based assets.
How Do Wrapped Crypto Tokens Work?
Despite their presence in the cryptocurrency space for quite some time, wrapped crypto tokens remain unfamiliar to many investors. This is due to a lack of understanding regarding the intricate process of creating these digital tokens.
To shed light on the workings of wrapped tokens, let’s delve into the three key entities involved in their creation:
- Merchants/Bridges: These are decentralized entities that enable the locking of a digital coin on the Ethereum network to mint synthesized ones. Additionally, merchants have the ability to burn the wrapped tokens, which results in the release of the originally locked cryptocurrency back to the user.
- Custodians: Custodians are responsible for safeguarding wrapped tokens within the Ethereum network. Their primary function is to ensure the security of these tokens.
- Decentralized Autonomous Organizations (DAOs): These entities operate as a decentralized working group and are tasked with the responsibility of modifying the list of merchants and custodians operating in the network. Hence, they can add or remove a custodian based on a situation-by-situation basis. They utilize a multi-signature cryptocurrency wallet, which a group of elected individuals signs to make these decisions.
How to Create a Wrapped Crypto Token
Now that we’ve explained the entities involved, the process for creating a wrapped token, such as a wrapped Bitcoin, involves the following steps:
- Select a merchant from the list of options on the network.
- Transfer the required quantity of Bitcoin into the merchant’s crypto wallet to initiate a wrapping request.
- Once the digital funds are received, the merchant makes a deposit to the custodians to safeguard the funds. The transactions are then recorded on the blockchain.
- Afterward, an equivalent amount of Bitcoin is minted by the merchants and deposited into the DeFi users’ cryptocurrency wallet.
- In the event the user intends to retract their funds, the merchant burns or destroys the wrapped version of their original cryptocurrency. The digital currency is then released into the crypto wallet of the user.
While a majority of wrapped tokens are executed in a decentralized manner, some of these synthetic assets are issued by centralized groups.
However, many DeFi investors are often advised not to use these centrally run merchants due to issues around trust and liquidity access.
Types of Wrapped Crypto Tokens
Besides wBTC, there are various types of wrapped tokens in the crypto market:
- Wrapped Ether (wETH): This is the second most popular wrapped token, representing a synthetic version of the Ether coin. It exists due to its lack of compatibility with the rest of the digital assets operating in the Ethereum ecosystem. This is because Ether does not use the ERC-20 token standard even though the idea was conceived on its parent blockchain protocol. wETH was introduced to enhance its efficiency and suitability for trading and smart contract applications.
- Wrapped Matic (wMATIC): This wrapped token is linked to the Polygon’s MATIC asset. It enhances transactions on decentralized applications (dApps) on the Polygon network.
- Wrapped Fantom (wFTM): This wrapped token is the synthesized version of Fantom’s FTM token. It operates on the Fantom blockchain.
- renDOGE: Created by the Ren blockchain, renDOGE is a wrapped asset for the popular Dogecoin meme coin.
- renBTC: This is another form of wrapped Bitcoin. However, this operates on the Ren blockchain.
Each operates in multi-layered blockchain protocols, offering a utility that is lacking if it were to be used in its traditional setup.
Pros & Cons of Wrapped Crypto Tokens
|Cross-Chain Interoperability||Wrapped tokens enable cross-chain interoperability, meaning users can utilize one crypto asset across multiple blockchains. This, in turn, expands their world, making it possible for them to unlock several functionalities that would otherwise be unavailable in the native blockchain protocol.|
|Robust Passive Income Stream||Wrapped tokens can produce a more robust passive income stream network for users. A typical example is the Bitcoin asset, which users can solely earn from by either holding for the long term or actively speculating on its rise and fall. Using wrapped versions of the crypto asset allows users to earn passive income from DeFi-powered protocols, as they can lend the asset and generate a sizable yield.|
|Subject to Cyberattacks||These blockchain bridges have been the subject of malicious attacks in recent years. Impacted wrapping protocols like Wormhole have lost hundreds of millions of users’ deposited assets to bad actors due to the poor security system.|
|Centralized Risk||Another crucial demerit is the growing concern about a centralized play involved. This is because the original assets are usually kept in the care of custodians tasked with their safekeeping.
A liquidity crisis can be triggered in the event the custodian is not able to remit the burnt-wrapped token when required by the user. In the event this happens, the value of the wrapped token will significantly plummet, meaning it no longer tracks its original asset on a 1:1 basis.
|Not Widely Adopted||Wrapped tokens are still in their infancy and are not widely used across the crypto landscape due to the complexity involved in the process. Coupled with the additional costs of tying up another coin, users might be discouraged from using this medium.|
Wrapped crypto tokens are a dynamic playground for blockchain protocols to collaborate and operate. Their distinct ability to unlock additional functionality extends access to the fast-growing DeFi ecosystem.
However, wrapping assets comes with some inherent consequences.
Firstly, the process of wrapping and unwrapping entails a degree of centralized control, which is unlikely to change in the near future to ensure the integrity of all parties involved.
Moreover, wrapped tokens are often exploited by hackers for illicit fund movements, taking advantage of the security vulnerabilities in blockchain bridges. This transforms wrapped tokens into a potential minefield where substantial rewards are possible, but lurking danger persists.
Nonetheless, they play a crucial role in expanding the use cases of otherwise limited assets. In times when liquidity is king, wrapped crypto tokens provide an avenue for investors to move funds across blockchain protocols easily with little to no external sanctions.