What is a Wrapped Token?

A wrapped token is a digital asset that allows the use of tokens from one blockchain on another, offering interoperability between normally incompatible ecosystems. Here, we will explore the features of wrapped tokens and how they function.

Understanding Wrapped Tokens

The concept of wrapped tokens is based on tokenization, which allows an asset to be “wrapped” in a compatible format to be used on a different blockchain.

For example, an individual holding Bitcoin (BTC) and wishing to use it on the Ethereum blockchain, which doesn’t natively support BTC, would exchange their BTC for a tokenized equivalent, Wrapped Bitcoin (WBTC), created on the Ethereum blockchain. Each WBTC is equivalent to one BTC, enabling Bitcoin holders to use their funds within the Ethereum ecosystem despite the initial incompatibility.

Importance of Wrapped Tokens

Wrapped tokens are crucial because they enable interoperability between blockchains. Each blockchain operates according to its own standards and protocols, making direct communication challenging. Wrapped tokens provide a gateway to transfer value between different networks.

Thus, they allow cryptocurrencies to be utilized beyond their original blockchain, offering new possibilities and enhancing the user experience.

How Do Wrapped Tokens Work?

Wrapped tokens operate primarily through two key mechanisms: wrapping and minting/burning.

The Wrapping Mechanism

Wrapping a token involves converting an asset into another “wrapped” asset to make it compatible with a different blockchain. For instance, Bitcoin (BTC), which is not natively compatible with the Ethereum blockchain, can be wrapped into Wrapped Bitcoin (WBTC), an ERC-20 token on Ethereum.

The process begins when a BTC holder sends their bitcoins to a custodian. Currently, the only authorized custodian for WBTC is the platform BitGo, resulting in a high degree of centralization. The custodian secures the bitcoins in a digital vault and issues an equivalent amount of WBTC. Each issued WBTC is directly tied to and backed by a real BTC, ensuring that WBTC can always be exchanged back for BTC.

The role of custodians is essential in this process. They are responsible for the security of the original tokens and the proper issuance of the wrapped tokens. These entities maintain parity between the underlying asset and its wrapped version, ensuring trust and stability in the wrapped token system.

The Minting and Burning Mechanism

The control of wrapped token circulation is managed by minting and burning processes.

Minting is the creation of new wrapped tokens. When an original asset is deposited with a custodian, new wrapped tokens are minted, ensuring that the number of tokens in circulation always matches the amount of original assets held in reserve. For example, for each Bitcoin deposited, one WBTC is minted.

Burning, on the other hand, involves destroying wrapped tokens. When a user wants to retrieve their original asset, the corresponding wrapped tokens are burned. This reduces the number of tokens in circulation and ensures the withdrawal of the original asset from the custodian. This mechanism prevents the creation of unsupported tokens and helps maintain the balance between underlying assets and their wrapped equivalents.

These minting and burning processes are fundamental to regulating the supply of wrapped tokens and ensuring their integrity and transparency.

Benefits of Wrapped Tokens

Accessibility and Liquidity

Wrapped tokens play a vital role in increasing accessibility and liquidity across different blockchains. They allow users to transfer and use tokens more freely throughout the blockchain ecosystem, enhancing the fluidity of exchanges.

Additionally, wrapped tokens contribute to increased liquidity by unlocking assets that would otherwise be confined to their native blockchain. Bridges between different blockchains also play a crucial role in releasing assets that would be isolated on their native chain, thereby increasing their utility and availability. This interconnectivity significantly boosts overall liquidity and the efficiency of exchanges within the cryptocurrency ecosystem.

Utilization in DeFi Protocols

In the development of decentralized finance (DeFi), wrapped tokens allow users to access various protocols on different blockchains. Decentralized applications (Dapps) on blockchains like Ethereum often require tokens that adhere to specific standards, such as ERC-20, to participate in activities. Wrapped tokens convert non-ERC-20 assets, like Bitcoin, into compatible formats, facilitating their integration into the DeFi ecosystem. This capability greatly expands opportunities for users and investors. For instance, BTC holders can obtain WBTC, which is accepted by protocols like Aave and Compound.

Reduced Transaction Fees and Times

Wrapped tokens can also help reduce transaction fees and times compared to native transactions on their original blockchains. For example, transferring Bitcoin can become expensive and slow, especially during network congestion. Using WBTC on Ethereum allows users to benefit from the speed and potentially lower transaction fees of Ethereum’s smart contracts. Moreover, users can take advantage of Ethereum’s scalability innovations, such as staking and layer 2 solutions, which can further reduce costs and improve processing times.

Risks and Limitations of Wrapped Tokens

Despite the numerous advantages of wrapped tokens in terms of interoperability and blockchain liquidity, they also present certain risks and limitations that need to be considered.

Dependence on Trusted Third Parties

One of the primary drawbacks of wrapped tokens is their reliance on trusted third parties for storing the original assets. Custodians play a crucial role in securing the assets; however, this dependence creates a vulnerability, as it relies on the custodian’s reliability and integrity to maintain the equivalence between original assets and wrapped tokens. If the custodian fails to securely manage these assets, it could lead to significant losses for users, damage the credibility of wrapped tokens, and potentially destabilize the original asset.

For example, in the case of WBTC, the only authorized custodian is the platform BitGo. This results in extreme centralization, with the system’s operation hinging on a single entity, making it very fragile.

Security Issues

Wrapped tokens are also exposed to specific security risks, as demonstrated by the Wormhole vulnerability incident. In this example, a security flaw allowed an attacker to siphon millions of dollars in wETH (Wrapped Ether) on the Solana blockchain after exploiting a vulnerability in the Wormhole bridge.

Regulatory Considerations

Regulatory considerations represent another major challenge for the adoption and development of wrapped tokens. Regulators worldwide are increasingly scrutinizing blockchain-based financial products, and wrapped tokens are no exception. Future laws and regulations could significantly impact how these tokens are issued, managed, and traded. For example, increased compliance and disclosure requirements could impose additional constraints on custodians and other stakeholders involved in the wrapping process, making their use less attractive or more complex.

Future Prospects of Wrapped Tokens

As the blockchain sector continues to evolve, wrapped tokens are likely to play an increasingly central role. However, the current reliance on trusted third parties and associated security challenges are driving the search for more decentralized and secure solutions.

Projects like Cosmos, Polkadot, and Chainlink, which complement wrapped tokens, offer innovative mechanisms for interoperability between blockchains without the need for wrapped tokens.

These innovations, alongside wrapped tokens, could provide safer and equally effective alternatives, representing a natural evolution in the quest for more robust and decentralized cross-chain solutions.