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Have you ever wondered why you can't use Bitcoin on Ethereum? Vice versa? Different blockchains have different functionalities and they cannot communicate with each other. The Ethereum blockchain doesn't interact with or know what's going on with the Bitcoin blockchain. Wrapped tokens are a way to circumvent the blockchain limitation and use non-native assets on a blockchain.
I am not sponsored by anyone or anything mentioned in this article.
This is not financial advice. I am not a financial advisor.
Please do your own research before making any decisions before investing.
This article is meant for educational purposes only.
A wrapped token is a tokenized version of another cryptocurrency that is pegged to the value of the asset it represents and typically can be redeemed for it (called "unwrapped") at any time. It represents an asset that doesn't natively live on the blockchain where it's issued on. With blockchains each being their own unique and distinct systems, there really isn't good way to move information between them. This is why wrapped tokens are essential to going cross-chain with your assets.
Wrapped tokens typically require a custodian. A custodian is an entity that holds an equivalent amount of the asset as the wrapped amount. Custodians can either be a smart contract, merchant, DAO, or a multisig wallet. Below, you will find a brief overview on how the wrapping of tokens (specifically Bitcoin) unfolds.
- Merchant sends BTC for the custodian to mint
- Custodian mints Wrapped Bitcoin (WBTC) on Ethereum according to amount sent
- To unwrap, the merchant puts in a burn request to the custodian
- BTC is released from the reserves
You can now use your once BTC (now WBTC) on the Ethereum blockchain to interact with smart contracts and decentralized applications (dApps)!
As mentioned previously, a key benefit of using wrapped tokens is the ability to transfer non-native tokens to be used on a given blockchain. Wrapped tokens can actually increase liquidity and capital efficiency both for centralized and decentralized exchanges. If you keep a close eye on transaction times and fees, then you're probably familiar with this benefit of wrapped tokens. While both Bitcoin and Ethereum have great blockchain properties, sometimes one blockchain is faster and less expensive to use. These problems can be mitigated by using wrapped tokens on a blockchain with faster transaction speeds and lower fees.
Pushing back on the idea of trustless and decentralization, a limitation to using wrapped tokens requires trust in the custodian that's holding the funds. With current technological advances, we still cannot use wrapped tokens for a true cross-chain transaction... since they need to go through a custodian for the wrapping and unwrapping of the token. Due to high gas fees, the minting process can be relatively costly and can also incur some slippage.
There's advantages and disadvantages to everything... especially in different markets both traditional and crypto. Regardless, wrapped tokens help interoperability in the crypto and decentralized finance (DeFi) ecosystem. They open an entirely new door where capital has the potential to be more efficient and applications can easily share liquidity with each other.
Have you ever used wrapped tokens?
Let us know in the comments down below!
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