The latest trend in the blockchain space is the pursuit of interoperability across decentralized networks. One innovation that has proven useful in accomplishing this goal is wrapped tokens. By “wrapping” one cryptocurrency in a token, they can operate in a blockchain different from their native one. But there is more!
Let us take a deep dive into the conversation of what wrapped tokens are to discover everything. We will also examine some popular examples of this asset and their use cases. Let’s dive right in.
KEY TAKEAWAYS:
- Wrapped tokens make interoperability possible across different blockchain networks.
- Creating a wrapped token involves three processes: custodian process, token minting, and token redeeming.
- The two major types of pegged tokens are cash-settled and redeemable wrapped tokens.
- Popular examples of wrapped tokens include Wrapped Bitcoin (WBTC), Wrapped Ether (WETH), and Wrapped BNB (WBNB).
How Do Wrapped Tokens Work?
Wrapped or pegged tokens are created through three major steps, and we will highlight them below:
- Custodian process: Here, a trusted custodian, usually a centralized institution or a decentralized smart contract, reserves an equivalent amount of the native or underlying assets. So, let’s say you want to create a Wrapped Bitcoin (WBTC) to be used on Ethereum. The equivalent value of the actual Bitcoin is locked up by the custodian.
- Token minting: After securing the Bitcoin, the corresponding pegged token is minted or created on Ethereum. This new pegged token represents and carries the same value as the original Bitcoin. Consequently, it can now be used on Ethereum-based applications.
- Redeeming: When you want to unwrap the WBTC or redeem your Bitcoin, the custodian permanently burns it for you to access your Bitcoin once again.
Types Of Wrapped Tokens
These tokenized assets are of two major types:
Cash-Settled
These tokens represent the value of the original assets but are not directly redeemable for it. Instead, they are backed by other liquid assets like cash that reflects the underlying assets without necessarily holding them. As such, when crypto users trade a cash-settled token, they are transacting with a tokenized version that reflects or mirrors its price.
Redeemable
They are backed 1:1 by the native asset and can be directly exchanged for it. Some refer to redeemable tokens as a true wrapped version of the original asset. Thus, they allow you to transfer assets across different blockchains while having a direct link to the underlying crypto.
What Makes Them Important?
Wrapped tokens or tokenized assets have become popular because they do the following:
- They enable liquidity: They bring more assets to decentralized exchanges’ and blockchains’ liquidity pool. As such, it is easier for traders and investors to buy and sell.
- They use different blockchain networks: Tokenized assets allow you to access decentralized applications (DApps) and decentralized finance (DeFi) protocols across different blockchains. This provides flexibility for users to lend, borrow, stake, yield farm, and participate in other DeFi activities.
- They improve efficiency and reduce costs: These assets are often faster and more scalable than their underlying blockchain. Thus, they offer lower transaction fees and faster processing times.
Read Also – A Beginner’s Guide to Investing in Decentralized Finance (DeFi)
Examples Of Wrapped Tokens
Below is a list of some popular pegged tokens:
- Wrapped Bitcoin (WBTC): This is an ERC-20 token that represents Bitcoin on the Ethereum blockchain.
- Wrapped Ether (WETH): WETH is Ethereum’s wrapped token, that allows you to use Ether in other DApps and DeFi protocols.
- Wrapped BNB (WBNB): This is a version of Binance Coin that you can use across decentralized networks that support ERC-20 or BEP-20 tokens.
- Wrapped Litecoin (WLTC): Litecoin users can use WLTC on blockchains like Ethereum and Binance Smart Chain.
- Wrapped XRP (WXRP): WXRP allows XRP traders to be a part of Ethereum-based decentralized exchanges and DApps.
Wrapped Tokens Use Cases
Tokenized assets have numerous use cases, which include:
- DeFi lending and borrowing: Tokens like WBTC can be used as collateral when lending, which allows users to borrow and earn interest on their holdings.
- Yield farming and staking: Pegged tokens can be staked and used in yield farming protocols to earn rewards.
- Multi-asset portfolios: Investors use tokenized assets to diversify their portfolios across different decentralized platforms without necessarily owning multiple wallets or exchange accounts.
Risks Associated With Them
The fact that pegged tokens have numerous benefits does not mean they do not come with some risks. Let’s check out some of their shortcomings below.
- Custodial risks: A custodial breach or failure can lead to a loss of the asset. So, you need to have a trustworthy custodian that can securely hold your funds.
- Smart contract vulnerabilities: A tokenized asset relies on smart contracts to function. If they are not properly audited, the token will be exposed to hacking and other forms of exploitation.
- Pegging issues: Maintaining the pegged value of the original assets can be challenging when the market is volatile or if there are liquidity issues.
- Centralization concerns: The fact that some pegged token protocols are partially centralized can compromise the decentralization expected with using crypto.
Conclusion
As the blockchain space keeps growing, you can expect the demand for cross-chain interoperability to increase. Thus, wrapped tokens are likely to remain a foundational tool in ensuring this. If you want to diversify your crypto portfolio, you can consider this category of tokens as a practical way to accomplish your goal.
Reference
- zerocap.com – What are Wrapped Tokens?
- cointelegraph.com – A beginner’s guide to understanding wrapped tokens and wrapped Bitcoin
- komodoplatform.com – Wrapped Tokens: Bridging the Blockchain Space
