Carefully! Lots of text.
Essentially, a wrapped token is a cryptocurrency whose value is tied to the value of another cryptocurrency. As the name suggests, the original asset is placed in a “wrapper,” a kind of digital storage that allows you to create wrapped tokens on another blockchain.
What is it for? Typically, different blockchains offer different capabilities and operate independently of each other. For example, the Bitcoin blockchain does not communicate with the Ethereum blockchain, so wrapped tokens are used to perform operations between them.
Introduction
Have you ever thought about the possibility of using BTC on the Ethereum blockchain? Or ETH on Binance Smart Chain? As a rule, coins tied to a specific blockchain cannot be easily transferred to another.
Wrapped tokens allow you to bypass this limitation and use non-native assets on a third-party blockchain.
What is a wrapped token?
A Wrapped token is a tokenized version of a third-party cryptocurrency. It is tied to the value of the asset it represents and in most cases can be redeemed at any time. In other words, a wrapped token represents an asset that has been moved from one blockchain to another.
At first glance, it may seem that a wrapped token is an analogue of a stablecoin, since its value is also tied to another asset. The difference is that the value of a stablecoin is usually tied to fiat currency, while the value of a wrapped token is tied to a native asset of a third-party blockchain.
However, there is no perfect way to transfer information from one blockchain to another since each is a separate system. Wrapped tokens, which provide interoperability between different blockchains, can essentially contribute to the formation of a cross-chain.
It is worth noting that the average user does not need to worry about the process of moving assets to a third-party blockchain. Trading wrapped tokens is carried out in the same way as trading any other cryptocurrency. For example, using the WBTC/BTC market on Binance.
How do wrapped tokens work?
Take, for example, Wrapped Bitcoin (WBTC), a tokenized version of Bitcoin on Ethereum. WBTC is an ERC-20 token pegged 1:1 to the value of Bitcoin, allowing BTC to be effectively used on the Ethereum network.
As a rule, to carry out operations with wrapped tokens, a custodian is required - an organization that holds an equivalent amount of the asset in the form of the sum of the value of wrapped tokens. The role of custodian can be a merchant, a multi-signature wallet, a DAO, or even a smart contract. Therefore, in the case of WBTC, the custodian holds one BTC for every WBTC created. Information about storing assets is located on the chain.
How does the process of moving an asset to a third-party blockchain work? The custodian receives a certain amount of BTC from the merchant, and then creates a similar amount of WBTC on Ethereum. If it is necessary to exchange WBTC back to BTC, the merchant sends a burning request to the custodian and withdraws BTC from the storage. It may seem that it is the custodian who carries out the process of moving the asset between blockchains. But in the case of WBTC, the functions of custodians and merchants are performed by the DAO.
Although some in the community call Tether (USDT) a wrapped token, this is not entirely true. While the value of USDT is generally equivalent to the value of USD, Tether does not hold an amount of physical USD equal to the amount of USDT held in its reserves. Instead, cash and other real-world cash equivalents, assets, and borrowings are retained. But the idea itself is very similar. Essentially, each USDT token is a kind of wrapped version of fiat USD.
Wrapped tokens on Ethereum
Wrapped tokens on Ethereum are tokens moved from other blockchains and created in accordance with the ERC-20 standard, with the help of which the assets of a third-party blockchain are used on Ethereum. At the same time, the movement of assets from one blockchain to another is paid for in gas.
The ways in which these tokens are implemented can be very different. We wrote about them in more detail in the article about tokenized Bitcoin.
An interesting example of a wrapped token on Ethereum is wrapped ether (WETH). In short, ETH (ether) is used to pay for transactions carried out on the Ethereum network, and ERC-20 is the technical standard by which tokens are created on Ethereum. For example, Basic Attention Token (BAT) and OmiseGO (OMG) are ERC-20 tokens.
However, ETH does not comply with ERC-20 due to the fact that it was developed before the standard. This is challenging because many DApps require Ether to be converted to an ERC-20 token to work with. For this reason, wrapped ether (WETH) was created, which is a wrapped version of ether that complies with the ERC-20 standard. Essentially, it is a tokenized version of Ether on Ethereum.
Wrapped tokens on Binance Smart Chain (BSC)
By analogy with wrapped tokens on Ethereum, you can purchase wrapped versions of Bitcoin and many other cryptocurrencies to work with them on Binance Smart Chain (BSC).
You can convert your crypto assets (BTC, ETH, XRP, USDT, BCH, DOT and many more) using Binance Bridge to use them on Binance Smart Chain in the form of BEP-20 tokens. Once you move your assets to BSC, you can trade them or use them to work with various profit farming applications.
Moving assets between blockchains is paid for in gas. However, it is worth noting that BSC requires much lower gas costs compared to other blockchains. You can read more about Binance Bridge in our article.
Benefits of using wrapped tokens
Although many blockchains have their own standards (ERC-20 for Ethereum or BEP-20 for BSC), they cannot be applied across multiple chains. Wrapped tokens allow the use of non-native tokens on a specific blockchain.
In addition, wrapped tokens help improve liquidity and capital efficiency for both centralized and decentralized exchanges. The ability to use idle assets on another blockchain can improve connections between networks and increase liquidity.
And finally, the use of wrapped tokens reduces the time spent on transactions and reduces the amount of commissions. Although Bitcoin has incredible properties, it is not the fastest or most cost-effective currency. However, its advantages far outweigh the disadvantages, especially since many of the difficulties can be resolved with the help of a wrapped version of Bitcoin, moved to a blockchain capable of providing fast transactions and low fees.
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Disadvantages of using wrapped tokens
Most existing methods for implementing wrapped tokens are based on trust in the custodian who has the user’s funds at his disposal. The currently available technology does not allow the use of wrapped tokens for conducting real cross-chain transactions without the participation of a custodian.
However, there are several more decentralized options currently in development that may be available in the future to create and redeem wrapped tokens based on a trustless process.
Creating tokens can also be relatively expensive due to high gas fees and may incur some slippage.
Summary
Wrapped tokens allow transactions between different blockchains and are a tokenized version of an asset that was originally tied to another blockchain.
The use of wrapped tokens helps increase compatibility between cryptocurrency and the decentralized finance (DeFi) ecosystem. Wrapped tokens open up a world of more efficient capital, where different applications can easily exchange liquidity.