Wrapped Token - Definition

Wrapped tokens are cryptocurrency tokens that represent another asset or cryptocurrency on a different blockchain. This wrapping process allows assets to be used across various blockchain networks. It enhances interoperability and liquidity within decentralized finance (DeFi) ecosystems.

Wrapped tokens function by pegging to an underlying asset at a 1:1 ratio. The original asset is locked in a secure vault. A trusted custodian or a decentralized autonomous organization (DAO) manages this vault. Once secured, an equivalent amount of wrapped tokens is created on the target blockchain.

For example, when Bitcoin (BTC) is wrapped into Wrapped Bitcoin (WBTC) on the Ethereum blockchain, each WBTC is backed by one BTC held in reserve. Users can exchange their wrapped tokens by burning them. This action releases the original asset from the vault.

Wrapped Tokens vs Native Tokens

Native tokens are the original cryptocurrencies on their blockchains, such as Bitcoin on the Bitcoin network or Ether on Ethereum. In contrast, wrapped tokens represent these native tokens on different blockchains.

While native tokens are essential for their respective networks, they do not support interoperability. Wrapped tokens bridge this gap. They allow native assets to be used in multiple blockchain ecosystems, expanding their functionality and use cases.

Benefits of Wrapped Tokens

Wrapped tokens offer several advantages:

• Interoperability: They allow assets from one blockchain to be used on another, facilitating cross-chain compatibility.
• Liquidity Enhancement: By making major assets available on multiple platforms, wrapped tokens increase liquidity within DeFi markets.
• Access to DeFi: Users can participate in lending, borrowing, and trading on decentralized platforms without selling their original assets.
• Efficiency: Wrapped tokens often operate on blockchains with faster transaction speeds and lower fees than native networks.

Common Examples of Wrapped Tokens

• Wrapped Bitcoin (WBTC): Represents Bitcoin on the Ethereum blockchain. This allows BTC holders to engage with Ethereum-based DeFi applications.
• Wrapped Ether (WETH): A tokenized version of Ether that conforms to the ERC-20 standard. It enables ETH to interact with smart contracts on Ethereum.
• Wrapped BNB (WBNB): Represents Binance Coin on the Binance Smart Chain. This facilitates its use in BEP-20-compatible applications.

Security and Risks

While wrapped tokens enhance interoperability, they introduce certain risks:

• Centralization Risk: Relying on custodians or trusted entities to hold the original assets can create single points of failure.
• Smart Contract Vulnerabilities: Wrapped tokens depend on smart contracts, which may have bugs and can be exploited.
• Regulatory Concerns: The custodial nature of wrapped tokens may attract regulatory scrutiny. This could impact their adoption and functionality.

Things to Remember

• Interoperability: Wrapped tokens allow assets to move seamlessly between different blockchain networks. This enhances cross-chain compatibility and expands the functionality of native assets.
• Liquidity Enhancement: By making major cryptocurrencies available on multiple platforms, wrapped tokens significantly increase liquidity within decentralized finance markets. This facilitates smoother trading and investment activities.
• Access to DeFi: Users can engage with a wide range of DeFi applications such as lending, borrowing, and trading without needing to sell their original assets. This maintains their investment positions while leveraging additional financial opportunities.
• Security and Risks: While wrapped tokens offer numerous benefits, they also introduce risks like centralization vulnerabilities, smart contract exploits, and potential regulatory challenges. Users should carefully consider these risks when utilizing wrapped tokens.