Among all the blockchain protocols, Ethereum is the most attractive digital asset. It is because of the massive adoption of the ERC20 standard and the preference of Ethereum as the go-to blockchain technology for Decentralized Finance (DeFi) Projects. Q4 2020 saw exponential growth in the value tokenized on Ethereum. As the ecosystem’s network effects continue to grow, some more protocols will launch wrapped versions of their tokens on Ethereum in 2021.
Have you ever observed that we can’t use BTC on ETH or ETH on Binance Smart Chain?
The fact is that tokens that exist on one particular blockchain cannot be transferred to another. Wrapped tokens teach you how Bitcoin can be used on Ethereum and become an income-generating asset. In this article let’s understand in-depth about wrapped tokens.
What are wrapped tokens?
A wrapped token is a tokenized form of another cryptocurrency. It can be defined as an asset that is hosted on the Ethereum blockchain with the same price as another underlying asset, even if the asset is not on the same blockchain or any blockchain at all. Hence, it is a process of wrapping a coin that can be useful on a blockchain that is not its native blockchain, without losing its value.
For instance, Bitcoin cannot be used for transactions on the Ethereum blockchain. But when it is converted to wrapped Bitcoin which is an ERC-20 token it can be used on the Ethereum Blockchain. The same goes with ETH which cannot be used to process ERC-20 smart contracts until it is wrapped (WETH). Hence, these examples depict that wrapped tokens help to make non-Ethereum tokens compatible with the network.
A wrapped token retains the value of its original coin (1 WBTC = 1 BTC). It is also possible to unwrap the token at any time to redeem its original nature. You can think of a wrapped token to be similar to stable coins, except that they are fiat currencies and in the case of wrapped tokens they are an asset natively living on another blockchain.
How are wrapped tokens created?
The creation of wrapped tokens involves 3 parties that are the user, the merchant, and the custodian. A user is the one that needs the tokens, a merchant is a platform that distributes the wrapped token, and a custodian is a platform that holds the original assets and mints the wrapped tokens. Let’s get through the wrapped token creation process for WBTC.
- The user will communicate with the merchant to inform about his interest in the WBTC.
- The merchant will again reach out to the custodian with a request to mint WBTC.
- The custodian will later send the WBTC to the merchant’s Ethereum wallet address once an equivalent among Bitcoin is received from him. During this process, the merchant may need to go through their KYC and AML.
- Finally, the user and the merchant can swap the BTC and WBTC on exchanges like Binance, Uniswap, or Kyber.
As mentioned earlier, it is also possible to unwrap or redeem a token. To unwrap a token, the merchant needs to make a burn request to the custodian, who will release the required BTC.
Use Cases of wrapped tokens
There are various use cases for wrapped tokens:
- Asset Tokenization, which is a process of tokenizing the assets to increase the speed of transactions, enhance transparency, boost usability, and improvise scalability.
- Fiat-backed stablecoins where traders can rest assured about keeping their money in a cryptocurrency without worrying about price fluctuations.
- With the wrapped framework it is easier to represent any cryptocurrency like Bitcoin on Ethereum, hence harnessing all the Ethereum capabilities.
- Tokenization offers a mechanism to enforce policies on-chain. With on-chain policy, enforcement rules are more transparent as they do not rely on a single party to enforce them.
- Today we see that majority of the ERC20 trading in centralized exchanges is carried out with BTC and not ETH and most of the decentralized exchanges offer ETH/token and not BTC/token trading pairs. With the help of wrapped tokens, it is possible to bridge this gap and provide the required liquidity on the DEXs.
Wrapped Tokens on Ethereum
Wrapped tokens on Ethereum are tokens from other blockchains that are compliant with the ERC20 standards. It means that traders can use digital assets that are not native to Ethereum on the Ethereum platform. Wrapped Ether is an interesting example of wrapped tokens on Ethereum.
ETH tokens are required to pay for transactions on the Ethereum network and ERC-20 is the technical standard for issuing tokens on Ethereum. ETH was created before the evolution of the ERC-20 standard, so ETH is not compliant with the ERC-20 standards. Hence, it creates a problem, as many dApps will require their traders to convert between ether and ERC-20 token. A wrapped version of the Ether is compliant with the ERC-20 standard. It can be a tokenized version of ether on Ethereum.
Wrapped Tokens on Binance Smart Chain (BSC)
Just as the previous one, it is possible to wrap Bitcoin and other cryptocurrencies for use on Binance Smart Chain (BSC). In BSC, there is a Binance bridge that allows the wrapping of crypto assets like BTC, ETH, XRP, USDT, BCH, DOT, etc for use on the Binance Smart Chain in the form of BEP-20 tokens.
After bringing the digital assets to the BSC platform, traders can trade these assets on various yield farming applications. Wrapping and unwrapping tokens on the Binance Smart Chain will cost a gas fee, but it is significantly less when compared to other blockchains.
Types of Wrapped Tokens
Wrapped tokens are categorized into three categories:
In this category, you need to deposit your BTC or any other assets in a centralized third-party exchange platform. This exchange will act as an intermediary to lock your assets in the smart contracts, later mint a new ERC20 token and send it to you. One of the best examples of a firm offering such a kind of service is BitGo. One limitation of this platform is that you need to fully depend on this intermediary to keep its own end of the bargain.
You can use the decentralized method to wrap your bitcoins. The custodial responsibilities are handled by smart contracts. The tokens are completely secure as they are locked in smart contracts that cannot be changed without the user’s approval.
In this category, you need to lock your tokens into smart contracts and in return, your will receive synthetic asset with the equivalent value. The synthetic asset is backed by native tokens of the platform.
Benefits of wrapped tokens
There are various benefits of wrapped tokens:
While the Ethereum ecosystem is quite big, there are chances that various DEXs and other platforms may lack the liquidity to support their operations. Low liquidity is not good because traders cannot easily trade their tokens at their targeted prices. But wrapped tokens bring the necessary liquidity to the crypto market.
Wrapped tokens offer faster and cheaper transactions when compared to normal tokens. Wrapped bitcoins exist on the Ethereum blockchain rather than directly on the Bitcoin network. WBTC transactions are faster and cheaper when compared to those involving BTC.
Wrapped tokens offer more functionalities than standard tokens. For example, WBTC can leverage smart contracts deployed on the Ethereum blockchain. Smart contracts existed after the emergence of Ethereum. With smart contracts, you can self-execute computer programs when the conditions are met.
With yield farming, you can earn interest in cryptocurrencies that you lend out. WBTC allows you to participate in yield farming by lending your crypto and earning interest on it.
Staking is a process of locking your assets in smart contracts for a certain period of time to earn rewards. Native cryptocurrencies cannot do this, so you need to wrap your tokens to enjoy the benefits of staking.
Limitations of wrapped tokens
Implementing wrapped tokens will require trust in the custodian holding the funds. Wrapped tokens cannot be used for cross-chain transactions as they need to go through a custodian. The minting process can be costly, there are high gas fees, and can also incur some slippage.
Future of Wrapped Tokens
Wrapped tokens have a bright future as they aim to improvise interoperability between blockchains. Various DEXs and protocols like Compound, Bitgo, Ren, Uniswap, Gnosis, and Kyber have already adopted wrapped tokens and doing pretty well in the crypto market.
With time, the concept of the wrapped token is most likely to flourish as the equity markets may adopt it. It will enable the wrapping of corporate bonds and municipal debt and their placement on the blockchain. Hence, bringing lots of buyers and boosting the liquidity of the blockchain. The future is all about minting and redemptions of wrapped tokens to become decentralized.
Wrapped tokens create bridges between various blockchain networks. A wrapped token is a tokenized form of an asset that lives on another blockchain. Wrapped tokens offer a world where capital is more efficient, and applications can easily share liquidity with each other.