One simple way to understand the dynamics and functionalities of blockchains like Ethereum and Bitcoin is when you analyse them in their separate distributed database. The hundreds of blockchains that you see on the crypto ecosystem cannot directly communicate with each other.
For example, you cannot use your Ethereum directly on the Bitcoin blockchain, and the simple reason for this is because only the Ethereum blockchain knows and understands that you hold an Ethereum token in your digital wallet.
Wrapped tokens were designed to provide a solution to this type of problem. Wrapped tokens allow you to easily move different assets between blockchains. In other words, with wrapped tokens, you can easily deploy multiple assets across different cryptocurrency ecosystems without any hassle.
Wrapped tokens offer cross-chain liquidity, enabling a wide range of investment instruments across popular blockchains and unlocking capital efficiency. Wrapped tokens like wrapped Bitcoin are assets representing locked collateral of the original Bitcoin (BTC). They are simply used to provide liquidity to any decentralized finance ecosystem.
Are there more that meet the eyes when discussing wrapped tokens? In this article, we will discuss how wrapped tokens work and highlight some benefits of wrapped tokens. Let’s dive in!
What are wrapped tokens?
In its simplest form, wrapped tokens are digital assets that let you easily transfer the value of a native cryptocurrency between blockchains. Without wrapped tokens, it will be very difficult to maintain the value of a cryptocurrency, say Bitcoin, when transferring the asset between blockchains.
During asset transfer between blockchains, the transferred asset is likely to lose value (some percentage) when it arrives at the new blockchain, but with wrapped tokens, the assets will maintain the same value across different blockchains.
Wrapped Bitcoin (WBTC), one of the most popular wrapped tokens, is pegged at 1:1 with the original Bitcoin’s price. In essence, one Wrapped Bitcoin (WBTC) will always be equal to one Bitcoin. However, unlike the original Bitcoin, WBTC is available as TRC-20 or ERC-20 tokens; meaning, it can be traded on blockchains like Tron and Ethereum.
In some ways, Wrapped tokens share some similarities with stablecoins. For instance, a stablecoin like USDT is pegged to the United States Dollars (USD). Just as the WBTC is pegged to the original Bitcoin (BTC), USDT is also pegged to USD.
Let’s get one confusion off the way: the way and manner the value of wrapped tokens is backed and maintained is what makes them “wrapped tokens,” and not because they are pegged 1:1 to another asset.
How do wrapped tokens work?
The basic knowledge we have about wrapped tokens is that they are created and destroyed through a process known as “burning” and “minting.” To create a WBTC, for instance, its original BTC would have to be sent to a custodian to safely store the token in a digital vault.
An equivalent amount of WBTC would immediately be minted once the process of locking away BTC in the digital vault is completed. In other words, the underlying asset, in this case, BTC is “wrapped up” using a smart contract in a digital vault, and a new token that can operate across blockchains is minted immediately.
You can also burn Wrapped Bitcoin (WBTC) if you follow through with the same process, although in reverse. During the burning process, Wrapped Bitcoin will be removed from circulation, while the equivalent of the original Bitcoin will then be released from the vault back into circulation. In fact, burning Wrapped Bitcoin can be considered as the process of “unwrapping” Bitcoin (BTC).
Why Do We Need Wrapped Tokens?
We all know that the simplest way to convert from one token to the other is through an exchange. For instance, if you sign up for an account on Binance, you can easily convert from Bitcoin to Avalanche without paying any fees.
Similarly, we can also convert from ETC to BTC on Binance with ease and peace of mind. The question now is: why do we need wrapped tokens since we can convert from one token to the other on centralized exchanges?
The answer to this question has to do with cryptocurrency volatility. If you want to lend crypto assets on Ethereum’s lending dApp such as AAVE and you want to use Bitcoin as your collateral since Bitcoin is one of the least volatile token. You can’t convert Bitcoin on centralized exchanges to fit into the Ethereum’s lending platform, and that’s why wrapped tokens are needed.
Earlier, we already mentioned that wrapped tokens represent a digital currency on another blockchain, making it easy to lend assets on Ethereum’s lending dApp with your Bitcoin.
Resolving Blockchain Interoperability
Every blockchain on the crypto market comes with its own set of unique features like native tokens, governance rules, smart contract formatting, and even validators. For example, while Tron (TRX) uses TRC-20 tokens, Ethereum (ETH) uses ERC-20 compliant tokens, and Binance Smart Chain (BSC) has BEP-20 tokens on its network. With all of these in mind, there are two ways to deal with the issue of blockchain interoperability, which include:
Blockchain bridges: These are smart contracts that can easily convert tokens across different blockchains. When you deposit a token into blockchain bridges, it will be locked, giving you the opportunity to withdraw new tokens that’s compatible with the blockchain you’re operating on.
This is the method that generates wrapped tokens. Also Layer 0 networks: You can cross-platforms like Cosmos and Polkadot to resolve the issue of blockchain interoperability. These platforms serve as the blockchain’s internet.
Blockchain Bridge Types
There are two types of blockchain bridges for token conversion, which include trusted or custodial bridges: These are centralized bridges that you can use to quickly create wrapped tokens or trustless bridges: These are decentralized bridges that create multiple wrapped tokens.
Is It Safe To Use Blockchain Bridges?
Yes, it is very safe to use blockchain bridges to create wrapped tokens. Even though there are reports of crypto-related hacks, causing investors to lose their hard-earned money on blockchain bridges, this method still remains the safest.