What Are Wrapped Tokens?
Wrapped tokens are assets on the Ethereum network with a value similar to an underlying asset on a different blockchain or outside a blockchain. What this primarily means is that the original asset is placed in a digital vault which allows it to be produced in a different blockchain network. Thus, making the wrapped token the same value as the underlying asset.
If you are wondering what's the point of wrapping a token in the first place, think about the fact that you can't use a specific crypto coin on just any blockchain. You can't transfer ETH to a BTC network and vice versa. This is the major reason why tokens are wrapped. By wrapping a token you can increase functionality because you can use non-native assets on any blockchain of your choice.
Now the real question is how do wrapped tokens work, what are the benefits, and limitations. Before you learn more about that, here's a more in-depth explanation of wrapped tokens
What Exactly is A Wrapped Token?
In simple terms, a wrapped token is a variation of a specific crypto coin placed inside a digital vault. It retains the value of the smart contract or asset it represents and can be unwrapped anytime. The main purpose of wrapping a token is to enable it to be functional on a blockchain network that originally doesn't support it. If you are conversant with different altcoins, then you should be familiar with stable coins.
Stablecoin gets its value from fiat currency the exact way wrapped tokens get theirs from any asset they represent. Wrapped tokens are usually used by crypto investors and gurus because they help with increasing communication between different blockchains. Although wrapped tokens can be unwrapped whenever it is required, you don't necessarily have to.
You can find exchange pairs like WETH/ETH on multiple crypto exchanges which you can trade instead of worrying about unwrapping.
Here's How Wrapped Tokens Work
Before wrapped tokens can be created, it requires a custodian or an element that has a value that is equivalent to the wrapped amount. This element can be either a smart contract, DOA, merchant, or even a multi-sig wallet.
The process of wrapping in the case of wrapped Bitcoin (WBTC) is as follows;
1.A merchant or seller sends BTC for the custodian (element) to mint
2.The element proceeds to mint BTC as WBTC on Ethereum based on the value of the BTC sent
3.Whenever an exchange of WBTC/BTC needs to be processed, the merchant puts in a burning request to the custodian
4.The custodian then proceeds to release BTC from its reserve. This, unwrapping WBTC to BTC.
Essentially, the custodian wraps and unwraps the wrapped token whenever it is needed. The proof of every transaction remains on the blockchain network after the transaction is over. It's also important to note that there are charges (gas) for wrapping and unwrapping a token.
Types Of Wrapped Tokens
There are multiple types of wrapped tokens available that you can trade on different exchange platforms. However, the focus will be on wrapped tokens on Ethereum and Binance Smart Chain.
Wrapped Tokens On Ethereum
Wrapped tokens on the Ethereum network are coins from multiple blockchains that are remade to be capitulating with the ERC-20 standard. This essentially means that tokens that are not native to the Ethereum network can be traded on Ethereum.
A common question that often comes to mind is why Ether (ETH) has to be transformed to WETH before it can function on the Ethereum network. The reason ETH isn't compliant with the ERC-20 standards is that it was created before these standards were put in place. Hence, trading usual ETH on the Ethereum network would attract a fee. However, the tokenized version wouldn't.
Wrapped Tokens On Binance Smart Chain (BSC)
Binance Smart Chain is an exchange platform where you can wrap different types of crypto coins such as BTC, ETH, XRP, USDT, DOT, etc. This platform features what is known as the Binance bridge to make this possible. Binance Smart Chain converts different cryptocurrencies to BEP-20 tokens.
By converting your assets to BEP-20 tokens, you can trade them or use them in multiple applications for profit.
Pros and Cons Of Wrapping Tokens
Like so many digital applications and processes, wrapped tokens have its benefits and limitations when you use them.
Let's take a look at the benefits of wrapping your assets on different platforms;
Wrapped tokens allow different tokens to be used across multiple blockchain networks. Although every blockchain has its standards, you can make any token compliant by wrapping it.
Wrapped tokens offer faster transaction times.
Wrapped tokens lower transaction fees. Trading Bitcoin is often more expensive compared to trading WBTC.
Wrapped tokens can improve capital efficiency and liquidity for both centralized and decentralized financial transactions. Idle assets can be wrapped and used to create a connection, which encourages more idle assets to be traded.
Even though the benefits of wrapping tokens are so exciting, there are a few limitations that you should take note of. The following are the cons of wrapping tokens and trading on an exchange platform;
Wrapped tokens cannot fully be considered a decentralized process because they usually go through a custodian. As a result, the entire process of either wrapping or unwrapping a token is built on trust. Hence, they can't be used for cross-chain transactions.
The process of minting (wrapping) a token can incur massive gas fees and sometimes slippage. Even though trading wrapped tokens can be cheaper than native coins, the minting and unwrapping process is something to think about.
Although the benefits greatly outweigh the limitations, the trust based minting process can be bothersome.
Wrapped tokens are tokenized versions of different types of cryptocurrencies or an asset that exists on a different blockchain. Wrapped tokens help with forming a connection between different blockchains. This process helps with selling more idle assets in the cryptocurrency and Decentralized Finance (DeFi) ecosystem.
It also helps with increasing capital efficiency, liquidity, transaction time, and reducing transaction fees.
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