What Are Wrapped Cryptocurrency Tokens and How Do They Work?

By November 25, 2021DeFi
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There's altcoins, stablecoins, memecoins, and then there are wrapped Bitcoin (WBTC), wrapped Ethereum (WETH), and wrapped Dogecoin (WDOGE). It turns out, almost every cryptocurrency can be "wrapped," and they are vital to the DeFi space.

So, what is a wrapped token, and how do they differ from regular cryptocurrencies?

What Are Wrapped Tokens? Why Do They Exist?

A wrapped token is a cryptocurrency whose value is pegged to the cryptocurrency that it "wraps."

Wrapped tokens exist to solve issues surrounding interoperability in the cryptocurrency space. For example, we know that Bitcoin is its own blockchain network and cannot run on Ethereum's ERC-20 blockchain because they are two entirely different networks with distinct protocols, and ERC-20 is responsible for powering hundreds of DeFi projects. So, to solve this, developers have created a "copy" of Bitcoin—wrapped Bitcoin (WBTC)—on the ERC-20 network.

Just like how the value of a stablecoin is pegged to real-life fiat currencies like the dollar, wrapped tokens derive value from the cryptocurrency they are tied to, 1:1. This means that WBTC's price is the same as actual BTC, WETH's price is the same as ETH, and so on.

How Do Wrapped Tokens Work?

To own a wrapped token, you have first to hold its original cryptocurrency. As the value of a wrapped token is tied to the original, it requires the user to have a custodian that holds the same amount of money as the wrapped token. In the world of cryptocurrency, a custodian refers to any entity that offers services to secure one's digital asset. This can be a merchant, wallet, or even a cryptocurrency exchange that provides storage services like Coinbase.

Let's say you want to wrap 1 BTC to be used on a DeFi platform powered by Ethereum:

  1. You send a "wrapping request" for 1 BTC to your custodian via your merchant.
  2. Your merchant takes over as an intermediary and performs two tasks: sending 1 BTC to the custodian for minting and sending a wrapped coin request to the DeFi platform.
  3. The DeFi platform approves the request. The custodian mints 1 WBTC because you sent 1 BTC.
  4. The custodian releases 1 WBTC to the merchant, and the merchant releases 1 WBTC to you.
  5. You can now trade 1WBTC on the DeFi platform.

The entire process is facilitated by smart contracts and is the same if you intend to "unwrap" your token, i.e., changing your 1 WBTC back to BTC. The merchant sends a burn request to the custodian that releases the original BTC back to the owner when approved.

Wrapping your tokens come at a cost—because several parties are involved in the process, there are three types of fees that you must pay: merchant fees, custodian fees, and transaction fees.

It should be noted that WBTC is not the only wrapped Bitcoin option available. Other blockchain protocols offer "wrapping services" to a cryptocurrency's holders, two notable ones being the Ren protocol and pToken protocol. So, if you see a coin like rBTC, sBTC, or pTokenBTC on an exchange or a DeFi platform, rest assured that it is a valid wrapped Bitcoin, just powered by a different protocol.

Advantages of Wrapped Tokens

The biggest advantage of wrapped tokens is the increased operability and fluidity they offer to holders, especially those using DeFi.

With wrapped tokens, DeFi users can trade quicker and with fewer restrictions, adding liquidity in a domain where price changes occur swiftly and users typically move assets across multiple blockchains.

Holders of wrapped tokens can also execute various activities on DeFi platforms, including cryptocurrency staking and yield farming. Performing transactions with a wrapped token also comes at a lower cost compared to transferring the original token.

Disadvantages of Wrapped Tokens

Like any other digital currency, wrapped tokens are open to cyberattacks on DeFi platforms where they are traded. Having your original cryptocurrencies handed over to a third-party merchant also poses a risk. Thus, you must do your due diligence before seeking out a merchant's services.

Some argue that wrapped tokens undermine decentralization, which is the very principle that forms the foundation of cryptocurrency and blockchain. The fact that users have to approach third-party custodians to wrap tokens shows that the process is still dependent on selected institutions. Even Vitalik Buterin, the creator of Ethereum, voiced his concerns over this:

https://twitter.com/vitalikbuterin/status/1263602364373745664

Although wrapped tokens bridge different cryptocurrencies on different blockchains, some users may find the token wrapping process a hassle. One has to go through a merchant and a custodian, which means potentially long wait times. Wrapped tokens promise cheaper transaction costs, but the fact that a user still has to pay three different fees for "wrapping" and "unwrapping" makes the minting process costly.

It is important to remember that wrapped tokens are not "genuine" cryptocurrencies—they are merely a representation of another cryptocurrency. This means that some basic functionalities of an original cryptocurrency cannot be executed. For example, wrapped Ethereum (WETH) cannot be used to pay gas fees on the Ethereum blockchain despite being Ethereum's native token.

Notable Wrapped Tokens

WBTC is a prime example of a wrapped token due to the very fact that it is tied to Bitcoin. It was launched on the Ethereum blockchain in January 2019 and has since been widely used on numerous DeFi platforms, including Uniswap, Pancakeswap, and Binance Smart Chain.

Other popular wrapped tokens in the cryptocurrency space include:

  • Wrapped Ethereum (WETH): The Ethereum network's native currency, Ether (ETH), was created way before the ERC-20 protocol that powers DeFi services. So, for ETH to be compatible with ERC-20, WETH was created.
  • Wrapped Zcash (WZEC): This wrapped version of the leading privacy coin debuted on the Ethereum blockchain in October 2020, meaning that on top of enhanced privacy, holders now have extra liquidity in the DeFi world.
  • RenDOGE (RENDOGE): RENDOGE is powered by the Ren Protocol, offering its own version of wrapped Bitcoin, renBTC.

Crypto, But Better?

For now, wrapped tokens are the tokens of choice for anyone who wishes to perform cross-chain transactions. If you currently hold any relatively valuable cryptocurrency, it probably already has a wrapped version. Their creation has also significantly boosted the popularity of DeFi and has allowed cryptocurrency investors to grow their portfolio by staking wrapped tokens to earn passive income.

However, questions surrounding whether or not wrapped tokens are truly decentralized are yet to be addressed. Either wrapped tokens make advancements in terms of technology to adhere to the fundamental principle of cryptocurrencies, or a true cross-chain solution is invented, and wrapped tokens are abandoned entirely.

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