A wrapped token is a cryptocurrency token pegged to the value of another cryptocurrency but exists on a different blockchain. The main purpose of wrapped tokens is to enable interoperability between different blockchain networks. This means you can use a token from one blockchain (like Bitcoin or Ether) on another blockchain (like Ethereum or Binance Smart Chain) by “wrapping” it.
How Wrapped Tokens Work:
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Pegging and Wrapping:
- To create a wrapped token, the original cryptocurrency (e.g., Bitcoin) is “wrapped” in a digital contract.
- A custodian (which could be a smart contract, decentralized autonomous organization (DAO), or centralized entity) holds the original token in reserve.
- In exchange, a corresponding amount of the wrapped token is minted on the target blockchain. This wrapped token is pegged 1:1 to the original cryptocurrency.
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Example: Wrapped Bitcoin (WBTC):
- Bitcoin operates on its own blockchain, making it difficult to use on Ethereum-based decentralized finance (DeFi) applications.
- WBTC is an ERC-20 token on the Ethereum blockchain that represents Bitcoin. For each WBTC in existence, there is an equivalent Bitcoin held in reserve by a custodian.
- When you want to convert WBTC back to Bitcoin, the WBTC is burned (destroyed), and the equivalent amount of Bitcoin is released to the user’s wallet.
Use Cases:
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Interoperability in DeFi:
- Wrapped tokens enable users to leverage the liquidity of a cryptocurrency like Bitcoin on Ethereum’s DeFi ecosystem. This means Bitcoin holders can participate in lending, borrowing, and yield farming on Ethereum-based platforms.
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Liquidity Pools:
- Wrapped tokens contribute to liquidity pools on decentralized exchanges (DEXs) like Uniswap or SushiSwap. By providing liquidity in the form of WBTC, users can earn fees or rewards.
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Cross-Chain Transactions:
- Wrapped tokens allow for seamless cross-chain transactions. For instance, you could use a tokenized version of Bitcoin on Ethereum without needing to convert or sell your Bitcoin.
Custodianship Models:
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Centralized Custodians:
- Some wrapped tokens are managed by centralized entities. For example, BitGo, a centralized custodian, holds Bitcoin in reserve for WBTC.
- While centralized custodians can offer security and trust, they may also introduce risks like custodial control and the need for trust in the entity.
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Decentralized Custodians:
- Some protocols are exploring decentralized methods of wrapping tokens, where the original assets are held in a decentralized manner, reducing reliance on a single entity.
- This can be achieved through smart contracts or DAOs, ensuring that no single party controls the wrapped assets.
Benefits of Wrapped Tokens:
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Access to Other Blockchains:
- Wrapped tokens allow users to utilize their assets across different blockchain networks without selling them.
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Increased Utility:
- For instance, by wrapping Bitcoin into WBTC, Bitcoin holders can use their BTC in Ethereum’s DeFi applications, increasing its utility.
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Liquidity and Market Efficiency:
- Wrapped tokens help in increasing the liquidity of various decentralized platforms, leading to better market efficiency and tighter spreads.
Risks and Considerations:
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Custodial Risk:
- If the custodian managing the wrapped token is compromised, the original asset may be at risk.
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Smart Contract Risk:
- Wrapped tokens often rely on smart contracts, which can be vulnerable to bugs or exploits.
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Regulatory Risk:
- Regulatory scrutiny may arise, especially with centralized custodians, as governments may require oversight on the wrapping process.
Popular Wrapped Tokens:
- Wrapped Bitcoin (WBTC): An ERC-20 token on Ethereum backed by Bitcoin.
- renBTC: Another token representing Bitcoin on Ethereum, managed by Ren Protocol.
- Wrapped Ether (WETH): A token that represents Ether on the Ethereum blockchain, used to conform to the ERC-20 standard.
Wrapped tokens are a powerful innovation in the crypto space, bridging the gap between different blockchains and expanding the use cases of existing cryptocurrencies. They enhance liquidity, enable interoperability, and open up new possibilities in decentralized finance, but users must be aware of the associated risks, especially concerning custodianship and smart contracts.