Wrapped Tokens

At the inception of blockchain and dApps, users were concerned that they would not be able to move their tokens between blockchains. BTC or ETH could not be used outside of their blockchains and users could not tap the potential of other blockchains. To overcome this limitation, wrapped tokens were introduced.

A wrapped token is similar to a stable coin, in that its value mirrors another asset. In the case of a stable coin, the other asset is usually a fiat currency. In the case of a wrapped token, it is usually an asset operating on another blockchain.

Wrapped tokens have risen in prominence with the growth of DeFi, where you can invest in lending, derivatives and other types of financial applications. The demand for using BTC as an underlying asset in DeFi was such that it had to be converted to an ERC-20 compliant token in order to plug it into all blockchains and their DeFi worlds.

Where to get wrapped tokens?

There are two ways

1. Users can buy the cryptocurrency and wrap it via a dApp. For example, if you want to wrap BTC, the merchant will pass your BTC to a smart contract that will mint new wBTC in exchange for your BTC. These are safely stored in the smart contract at the merchant. When you wish to receive back your BTC, the merchant will burn your wBTC and return your BTC to you. The mint and burn method ensures that there is one BTC for every wBTC, thus maintaining a 1:1 peg.

2. You can buy wrapped tokens on Centralized Exchange (CEX) or Decentralized Exchange (DEX).

The advantages with respect to liquidity and transactional flexibility are attractive. However, investors need to be aware that token wrapping allows for some centralization in the supposedly decentralized crypto world. Namely, you trust a third party to hold your original cryptocurrency while you hold their wrapped token. That being said, wrapping is a great way to move tokens between different blockchains without the need to convert them into stable coins, for example.

Example of a wrapped token

Wrapped BTC (wBTC)

This is a tokenized version of bitcoin on the Ethereum blockchain. This ERC-20 token is pegged 1:1 to the value of bitcoin. This allows users to use the Ethereum blockchain without selling the corresponding amount of bitcoin they hold.

Not everything that is wrapped is good

Wrapped tokens carry inherent risk because they require a certain level of trust on the part of the holder. Users need to trust the developers that they have written the smart contract code correctly and that the wrapping and unwrapping will go smoothly. While holding a wrapped asset should entitle the holder to a 1:1 ratio, the protocol can be hacked and your cryptocurrencies stolen. Then the price of the wrapped token may not stay at a 1:1 ratio.

PROs

• Interoperability - wrapped tokens enable cryptocurrency transactions on non-native blockchains, which can be faster or cheaper than their native blockchains
• Liquidity - wrapped tokens increase capital efficiency by allowing tokens to be used in different ways on non-native blockchains

CONs

• Fee - the wrapping process itself is subject to a fee
• Volatility - wrapped tokens may not be worth as much as the original token in a volatile market