Wrapped tokens: What are they and how do they work?

With the continuous growth of the cryptocurrency ecosystem, several kinds of advanced tech and coins with distinctive uses are introduced every day. However, these only operate in their respective blockchains. This all changed when wrapped tokens were launched, allowing different coins to be bridged between blockchains. But what exactly are wrapped tokens and how do they work? Keep on reading to answer all your questions!

What are wrapped tokens?

The easiest way to understand wrapped tokens is by comparing them to stablecoins. Unlike the latter which are pegged to a real-world value such as the US dollar and other kinds of fiat, wrapped tokens are attached to other cryptocurrencies. Moreover, just like any other wrapper in real-life, these tokens can be ‘unwrapped’ which means redeeming the value of the original asset it’s tied to.

How do wrapped tokens work?

The reason why these assets are called this way is that the original asset they’re attached to is ‘wrapped’ inside a digital vault. This allows that coin to be created on another blockchain. 

However, how do wrapped tokens work? To help you get a better grasp on how cryptocurrencies usually work, here’s an example:

Bitcoin (BTC), the leading token in the industry, can’t operate inside the Ethereum network and vice versa. But if you wrap your BTC in ETH or the other way around, you can then use either on the opposite’s blockchain. 

Through this process, native tokens can be used in different blockchains, solving the problem of interoperability and opening up a whole new world of possibilities and advantages in the crypto world.

Custodians, minting and burning

This process is possible thanks to an entity called ‘custodians’ that are responsible for wrapping and unwrapping the different tokens. These custodians can either take the form of smart contracts, decentralised autonomous organisations (DAOs), merchants or multi-signature wallets.

To provide you with an example, let’s take a look at a situation where someone is trying to use their BTC on the Ethereum network:

The wrapping process starts with a merchant sending a certain amount of tokens to the custodian. This custodian will then proceed to mint them on the Ethereum network based on the same amount of BTC sent by the merchant. 

Once the Bitcoins have been minted on Ethereum by the custodian, they will become Wrapped Bitcoins (wBTC). wBTC is a tokenised version of BTC that works on the Ethereum network and holds a one-to-one value of the original token.

When the trader decides they want their wBTC converted back to BTC, they have to request a ‘burn’ to the custodian which causes their Bitcoins to be released from the reserves. Additionally, proof of each transaction is stored on-chain to ensure accuracy and validity.

Most famous kinds of wrapped tokens

Because wrapped tokens allow non-compatible tokens and networks to work with each other, this led to the creation of various assets on the market. Two of the most famous ones are the following:

Wrapped Bitcoin (wBTC)

The most famous kind of this token in the market today is Wrapped Bitcoin (wBTC), an ERC-20 version of Bitcoin or in other words, BTC that’s compatible with the Ethereum network. The crypto custodian responsible for securing wBTC today is BitGo. Moreover, it’s also one of the bright minds behind the creation of this token along with Kyber and Ren back in 2019.

Wrapped Bitcoin has a market capitalisation of around $10 billion, the largest in the market for wrapped tokens. They also dominate the said market by taking more than 81%.

One of the main reasons why some traders decide to have their Bitcoins wrapped is to access DeFi protocols in the Ethereum network, one of which is the different liquidity pools. By being able to access pools in DeFi protocols such as Uniswap, they can generate great returns using Bitcoin.

Wrapped Ether (wETH)

Although it doesn’t come second to wBTC in terms of market capitalisation, Wrapped Ether (wETH) is still one of the most prominent wrapped tokens. It was launched back in 2017 by Ox Labs and it currently has a market capitalisation of over $3.4 million.

Though it may sound similar to wBTC, the two have varied uses. Unlike wrapped Bitcoin whose purpose is to let BTC operate inside the Ethereum blockchain, wETH is used to trade synthetic Ether, a token authorized by the synthetic protocol. It helps in monitoring the price of ETH through price feeds provided by oracles. 

Advantages of using wrapped tokens

Aside from trading them with other coins and profiting from them, holders of wrapped tokens enjoy various benefits such as:

Increased Liquidity

As with any tradeable asset, liquidity is essential in cryptocurrency as it determines whether or not a certain token can be easily converted into cash or other crypto assets. If liquidity is low, this only means that the market is volatile which can lead to sudden spikes in the prices.

For example, Bitcoin’s network is known to have better liquidity than other networks. By using wBTC, it brings this liquidity to the Ethereum network.

Faster transactions

One of the things that Bitcoin’s blockchain can improve upon is its transaction times. With the option to wrap these tokens, users can find a blockchain that offers faster transactions and trade there.

If you were to use wBTC in Ethereum, you’ll get to enjoy the speed of the network known to be twice as fast as Bitcoin’s blockchain.

Lower fees

Another benefit that comes with wrapped tokens is lower fees. If a certain blockchain network requires you to pay expensive gas fees, a great option for you is to wrap your assets and find another network that charges far less.

Should you invest in wrapped tokens?

Wrapped tokens made it possible for crypto investors to use their native tokens on other blockchain networks. This opened up several opportunities and benefits which include increased liquidity and most importantly, a better transaction experience. 

If you’re looking to buy wrapped tokens, you can either buy them traditionally through different centralised/decentralised exchanges or wrap them through different merchants.