What Are Wrapped Tokens and How Do They Work?

2022/07/29 08:15:53

Decentralized finance (DeFi) is rapidly disrupting the financial sector by offering trustless banking. However, it also faces multiple challenges that hinder its mass adoption. At the moment, one of the most significant obstacles is insufficient liquidity.

For instance, Bitcoin (BTC) has the largest market cap in the crypto market - (around $420 billion). However, its blockchain does not support smart contracts and hence does not support DeFi. On the other hand, the Ethereum blockchain supports the highest number of DeFi protocols. Nonetheless, the market cap of its native token, ETH, currently sits at $186 billion.

With DeFi relying on users to provide liquidity, it is imperative to have cross-chain interoperability, a necessity that has proven a tough nut to crack.

Thus far, efforts to make blockchain networks interoperable have seen developers create wrapped tokens. These tokens can function on different blockchain networks, introducing some aspect of cross-chain interoperability.

What is a Wrapped Token?

A wrapped token is a cryptocurrency pegged to another cryptocurrency in a 1:1 ratio. Simply put, the price of the wrapped token always equals that of the underlying coin. To this end, wrapped token holders can redeem them for the original asset at any given time.

The wrapped token and the original token run on different blockchains, with the prior running on blockchains that support DeFi. This feature ensures that wrapped tokens create a bridge between incompatible blockchain networks. Consequently, this interoperability helps introduce more liquidity to DeFi protocols, boosting the utility of cryptocurrencies.

How Do Wrapped Tokens Work?

To get wrapped tokens, users can create them by wrapping them on their own or purchasing them from centralized or decentralized crypto exchanges.

Wrapping tokens involves finding merchants for a specific token and transferring the tokens to them. The merchants then transfer the digital assets to a custodian who mints their wrapped versions in a 1:1 ratio and stores the underlying tokens in a digital vault.

After putting their wrapped tokens to use, a user can redeem them by requesting the merchant to send the custodian a burning request for a given amount of the tokens. Finally, the custodian destroys the wrapped tokens and returns the original assets to the user.

The custodian records all minting and burning transactions on-chain for transparency, ensuring that wrapped tokens always maintain their 1:1 peg to the underlying asset.

Examples of Wrapped Tokens

The need to bridge the Bitcoin and Ethereum networks saw developers team up to create wrapped Bitcoin (wBTC), an ERC-20 version of BTC. wBTC is the most popular wrapped token and is currently the 18th-largest cryptocurrency by capitalization, with a market cap of over $5 billion. Needless to say, wBTC is the largest wrapped token.

The second largest wrapped token is renBTC, an ERC-20 token, which is part of the Ren Protocol. renBTC has a market cap of over $80 million. renBTC serves the same purpose as wBTC.

Wrapped NXM (wNXM) is the third-largest wrapped token by market capitalization. The token allows users to trade NXM, the native token of the Nexus Mutual platform, outside the protocol.

There are over 20 wrapped tokens in the crypto market, and they have a market cap of $5.31 billion.

Wrapped Tokens on Ethereum

An interesting example of a wrapped token on Ethereum is wrapped Ethereum (wETH). Although creating a wrapped version of ETH seems to defy logic, it is worth noting ETH arrived before the network introduced the ERC-20 standard for issuing tokens. As such, ETH is not ERC-20 compliant.

To this end, developers created wrapped Ethereum (wETH) to simplify using ETH in DeFi. With the bulk of DeFi activity being on Ethereum, most dApps require users to swap ETH with ERC-20 tokens, and wETH streamlines this process.

Other wrapped tokens on Ethereum include wBTC, wNXM, wDGLD, and wCRO, among other ERC-20-compliant tokens that run on blockchains other than Ethereum.

Benefits of Using Wrapped Tokens

Wrapped tokens increase the utility of cryptocurrencies by expanding the number of blockchains they can run on. As utility increases, the value of crypto networks rises, helping to expedite the maturity of the nascent asset class.

Through wrapped tokens, crypto holders can put their digital assets to use by lending them out through DeFi protocols to earn interest. Crypto holders can also stake the tokens and provide the DeFi sector with liquidity. In return, DeFi protocols offer stakers high yields.

Wrapped tokens also help minimize the transaction costs and times. For instance, using a wrapped version of BTC on a scalable blockchain network would significantly cut costs and ensure faster transaction times.

How to Deposit, Withdraw & Trade Wrapped Tokens

Deposit and withdrawal functions are available from exchanges that support the wrapped tokens. For instance, KuCoin supports some wrapped tokens deposit and withdrawal, such as WBTC.

In general, a wrapped token may not have a separate trading pair. For the purpose of consolidating liquidity, centralized exchanges will credit tokens based on different blockchains as its native token, similar to USDT on Tron and Ethereum are both credited as USDT. However, there are exceptions like WBTC, which has separate trading pairs like WBTC/BTC.

Closing Thoughts

Wrapped tokens play a significant role in creating bridges between various blockchains. Furthermore, this interoperability helps provide DeFi and the broader crypto space with ample liquidity because networks can easily share the amount of capital locked in them.

Although wrapped tokens currently run on the centralized models, which require users to trust merchants and custodians, the future might present completely trustless options, helping the crypto space put the power back in users’ hands.