What Are Wrapped Tokens?

Learn what wrapped tokens are and how they can be used in the crypto market.

Wrapped tokens come with many benefits and a few downsides, which we’ll list in the following text. You’ll also find out what are the main types of wrapped tokens and what is a wrapped Bitcoin.

What Is a Wrapped Token?

A wrapped token is a term that describes digital assets that are usable on a blockchain that is not native to them. The goal of wrapped tokens is to enable the interoperability of different blockchains. In this way, they are similar to stablecoins. However, instead of being pegged to fiat or precious metals, wrapped tokens are pegged to another cryptocurrency.

The value of the wrapped token is the same as the value of its original cryptocurrency.

We use the term “wrapped” because the original asset is placed in a wrapper. A wrapper is a digital vault that allows the creation of a wrapped version of a particular asset on another blockchain.

Best examples of wrapped tokens include:

• Wrapped Bitcoin (WBTC)
• Wrapped Ethereum (WETH)
• Wrapped Dogecoin (wDoge)

How Do Wrapped Tokens Work?

Wrapped tokens are created by minting. If you want to mint a wrapped token, you’ll have to send its underlying asset to a custodian who will store it in a digital vault. Custodians can be both centralized and decentralized entities. However, you should avoid using centralized entities as custodians since they can tamper with your assets.

Once the underlying asset is locked, its equivalent amount will be minted in the form of wrapped tokens. Keep in mind that the custodian’s treasury must have a reserve greater than the number of issued wrapped tokens.

This process is also called wrapping since the underlying asset gets wrapped in a digital vault via smart contracts. Just as tokens can be wrapped by minting, they can also be unwrapped or destroyed. On that note, you can remove wrapped tokens from circulation by burning them.

That said, a technical standard called proof of reserve is used to ensure transparency between users and custodians. Proof of reserve is an automated, trustless system that guarantees that all wrapped tokens from the reserve are backed by their pegged assets.

Types of Wrapped Tokens

Stablecoins are considered the first type of wrapped tokens. However, unlike wrapped tokens, stablecoins are pegged to traditional assets, like gold or fiat. On the other hand, wrapped tokens are pegged to cryptocurrencies.

As such, they are divided into redeemable and cash-settled tokens. Redeemable tokens can be exchanged with their underlying assets, while this is not the case with cash-settled tokens.

Pros and Cons of Wrapped Tokens

Pros

The main advantages of wrapped tokens include interoperability, enhanced liquidity, improved security, reduced transaction fees, and faster transactions.

Interoperability

Wrapped tokens are like bridges that connect multiple blockchains. For example, a wrapped BTC can function on the ETH network. This enables traders to access a wide range of dApps and DeFi services. Moreover, wrapped tokens will simplify transactions between chains.

Enhanced Liquidity

Wrapped tokens can increase the liquidity and efficiency of decentralized and centralized assets by making them more accessible. Enhanced liquidity will also reduce price slippage.

Improved Security

Wrapping tokens increases their security. On the one hand, users who use wrapped tokens will have more control over their private keys. On the other hand, custodians who mint-wrapped tokens will make the transactions more secure by using smart contracts.

Reduced Transaction Fees

Wrapped tokens can also reduce transactional fees. For example, many crypto projects that run on the Ethereum network launch wrapped tokens on other blockchains to reduce gas fees.

Faster Transactions

Wrapped tokens provide faster transactions. For example, traders will send wrapped BTC to the ETH network much faster compared to sending it on the Bitcoin blockchain.

Cons

On the other hand, wrapped tokens come with certain limitations, such as custodian dependency, wrapping costs, and centralization issues.

Custodian Dependency

Only custodians can mint and burn wrapped tokens. This means that any flaws in the design will affect the burning and the minting process.

Wrapping Costs

Wrapping tokens comes with gas fees that can cause price slippage.

Centralization Issues

As mentioned above, only custodians can mint and burn wrapped tokens, which can lead to the risk of centralization. Moreover, if the custodian encounters certain problems, it can affect the usefulness and value of the wrapped token.

Are Wrapped Tokens Safe?

Wrapped tokens are considered relatively safe. When users convert their digital assets into wrapped tokens, the chance that they will lose their funds is very small.

However, wrapped tokens may lose their peg, especially when the crypto market is in fear sentiment. Furthermore, wrapped tokens depend on custodians, which is why they are more prone to dishonest practices. In addition to that, the bridges that connect blockchains are often the target of cyber attacks. Likewise, a greater number of connected blockchains equals greater risk.

What Is a Wrapped Bitcoin?

Wrapped Bitcoin or WBTC is a BTC that has been converted so that it can be used on the ETH network. WBTC launched in January 2019, and today it is an integral part of many dApps and DeFi services. On that note, the WBTC token is built according to the ERC-20 token standards. This means it can be staked and used as collateral on lending platforms.

The goal of WBTC is to bring greater liquidity to decentralized exchanges and DeFi apps that run on the ETH network. WBTC is pegged to BTC on a 1:1 basis, which means that it has the same value as BTC. At the time of writing, there are currently 158,479 WBTCs in circulation.

The WBTC protocol is under the control of a decentralized autonomous organization. As such, it goes through regular audits. On that note, all on-chain transactions are published, meaning that users can verify their validity.

Conclusion

So, what are wrapped tokens and what is their purpose?

The main goal of wrapped tokens is to provide interoperability between different networks. On that note, they allow traders to use their cryptocurrency on blockchains that are not their native.

Their benefits include enhanced liquidity, improved security, faster transactions, and lower fees.

That said, wrapped tokens are generally safe, although they come with certain limitations, such as dependence on a custodian, gas fees, and centralization issues. The most popular wrapped tokens include WBTC, WETH, and wDoge.

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