In the ever-changing world of cryptocurrencies, something new and something with new ideas keeps emerging to match the demands of the current times. One of them is the wrapped tokens. Ever heard about them? How do we even need them?
What is a Wrapped Token?
Wrapped token is a digital currency which contains another currency but on a different block chain. It’s called “wrapped” because it’s like putting one coin in a virtual wrapping so it can be spent on a block chain where it wouldn’t be able to otherwise.
How Wrapped Tokens Work
Wrapped tokens are made available through a process that is normally custodians, token issuers, and smart contracts.
Here’s a ridiculously oversimplified summary:
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Deposit Original Token: Someone hands over the original token (i.e., Bitcoin) to a custodian. The custodian may be any institution or smart contract that holds the token in safekeeping.
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Issue Wrapped Token: As compensation for holding and storing the original token, a wrapped token (e.g., WBTC) is created and forwarded to the user on another blockchain such as Ethereum.
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Redeem: If the user wishes to redeem their original Bitcoin at a later time, the wrapped token can be redeemed. The user transmits the wrapped token to the custodian, where it gets burnt and their original Bitcoin is released.
During this process, it is guaranteed that every wrapped token is secured by an underlying asset whose value is fixed and stable.
Why Wrapped Tokens are Needed in the Cryptocurrency World
Wrapped tokens may appear to be a simple idea, but they fix a gigantic issue in the crypto sphere: blockchain incompatibility.
Most blockchains are isolated islands. Bitcoin will not work on Ethereum, and Ethereum tokens won’t work on Solana, etc. This makes it restrictive, particularly in sectors such as DeFi, where users need to exchange, lend, or borrow different cryptocurrencies seamlessly and rapidly.
The following is the significance of wrapped tokens:
1. Cross-Chain Compatibility
Wrapped tokens make it possible for asset transfer from one blockchain to another. This brings about additional flexibility and use of cryptocurrencies. One of such applications is using wrapped Bitcoin within Ethereum, so that Bitcoin owners now have the chance to tap into DeFi apps, generate interest, and engage in yield farming without liquidating their BTC.
2. Liquidity and Access
Wrapped tokens make platforms more liquid. Liquidity is a term that was used to refer to how easily you’re able to sell or buy a token without affecting the cost. The greater the pool of available tokens to be used across different platforms, the easier it will be to send and sell cash.
3. More Use Cases
Wrapping makes it possible to spend tokens on fresh use cases. To illustrate, Ethereum games or NFT sites now are able to natively utilize wrapped tokens from other blockchains. This opens up new opportunities to developers and consumers.
4. Reducing Transaction Costs in Certain Situations
At times, token wrapping and making use of the token on another network can provide lower transaction charges. For example, wrapping an Ethereum token to use it on a layer-2 network or a block with high scalability can reduce the cost of gas to a colossal degree.
Are There Any Risks?
While handy, wrapped tokens are not risk-free. They depend on the custodian’s or smart contract’s trust, which holds the original token. If the custodian is hacked or is not able to maintain the original asset safe, the wrapped token will lose backing. Decentralized custodians are used in some systems to reduce the risk, but it is necessary to understand that there is still trust involved.
The other issue is regulatory uncertainty. As governments across the globe are tightening crypto regulations, wrapped tokens may be put under the radar, particularly if they are governed or issued by centralized actors.
Conclusion
Wrapped tokens are a smart solution to an actual issue in the world of crypto: that blockchains cannot communicate with each other. By establishing a way in which assets can be shared among platforms, wrapped tokens introduce a new functionality, liquidity, and efficiency level.
As the blockchain universe grows and matures, wrapped tokens will spearhead the movement to bring crypto within reach and of use to all—new users to developers and investors. Whether you are a new user of cryptocurrency or already experimenting with DeFi, you must understand how wrapped tokens work in order to realize all the potential of this groundbreaking technology.
