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What are wrapped tokens?

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PDAX

August 31, 2022

7 min read

IntermediateTokensDeFi

TL;DR

Wrapped tokens are cryptocurrencies that can represent another token outside of its native blockchain. This allows owners to use their tokens on platforms and applications that may not exist in their original network. Wrapped tokens were developed specifically to address the issue of interoperability between differently coded blockchain networks. 

What is a wrapped token?

There are about a dozen major Layer-1 blockchains, each one with its own set of rules or “token standards” for running its smart contracts. For those who deal in many different tokens, it can be quite a headache, especially for novice investors, to find out that their assets’ underlying blockchains are incompatible with one another.

Different token standards such as Ethereum’s “ERC-20” or Solana’s “SLP” are like different languages spoken for different blockchains. The problem is that most decentralized applications (dApps), crypto wallets, and decentralized finance (DeFi) platforms only speak one or a few of these languages. Tokens too, only operate on a specific blockchain, so you wouldn’t be able to use them on any platform or application that doesn’t speak the same token standard.

This situation in question is a matter of “interoperability” and developers are constantly making sure that crypto projects and applications maintain a level of interoperability across multiple networks in order to be useful for token holders. Fortunately, there are a number of solutions for bridging different networks together. 

One of these bridging solutions is called a “wrapped token”. A wrapped token is a utility token whose value is pegged to an existing cryptocurrency and is coded in such a way to be compatible with a different blockchain. Think of a wrapped token as a “translated version” of one token so it can be read and understood by another network. If a Bitcoin (BTC) happened to wander into the Ethereum blockchain, the latter wouldn’t be able to comprehend or transact with it. But a “wrapped Bitcoin” would be coded in the same language as Ethereum (ERC-20) but still be able to maintain its original value as a Bitcoin. 

Wrapped tokens can come in handy whenever you would want to participate in certain dApps for investment purposes, but hesitate to trade in your assets for another one. With wrapped assets, you can use your non-ERC-20 tokens as collateral to take out a loan for example, or to engage in frequent trading with other ERC-20 tokens on a decentralized exchange (DEX) like Uniswap or Sushi. Having wrapped assets also means you can virtually keep different tokens from different incompatible networks in the same wallet. 

Why does interoperability matter?

On a broader scale, interoperability is a foundational requirement for transitioning to a fully decentralized Web 3.0

Interoperability after all, is what allows us to use the Internet without much technical restraints in our current Web 2.0 setup. To use an analogy, nowadays it doesn’t really matter that much whether you are using an Apple, Windows or Android operating system (OS) to connect and interact with any website or application. Each operating system has its own pros and cons, but they are able to work with each other on the same shared network. 

But for Web 3.0 to be able to achieve the same scale of interoperability, the different major blockchains have to find means of transferring not just tokens–but any kind of data between themselves. For now, using wrapped tokens is our most practical way of bridging the gap between two blockchains. It’s basically like saving a file in a different format so it can be read by another application or OS–which just goes to show how we are still in the early stages of the shift to Web 3.0.  

In the near future however, we would more likely rely on other technologies to achieve full interoperability. Blockchains like Polkadot (DOT) for example, are currently working on developing a Layer-0 network for connecting Layer-1 networks, or a “blockchain of blockchains”.   

How are tokens wrapped?

“Wrapping” tokens is basically a process of minting new tokens. If a crypto owner wants to create a wrapped version of their Bitcoin for instance, they would have to lock their Bitcoin within a smart contract (a service which is available in a number of crypto wallets) which will then keep the assets safely away in a custodial account or a digital vault. Once that Bitcoin is locked safely in storage, the user is then entitled to receive the equivalent amount of Bitcoin in the form of newly-minted wrapped Bitcoins (WBTC).

Now, should the investor want to return their wrapped Bitcoin in exchange for their actual Bitcoin, the returned WBTC will be removed from circulation and “burned”. The stored Bitcoin will then be taken from the digital vault and given back to the original owner. This process ensures that all wrapped tokens are backed by the assets that they represent which is how they are able to maintain their value. 

Most of the time, it would be more convenient to acquire wrapped tokens on an exchange as users readily trade with the wrapped tokens as much as they would with the assets they represent. If an investor decides to sell or trade their wrapped tokens however, then the investor is also effectively selling the assets that were locked up with the custodian. The new owner of the wrapped tokens thus holds the rights to the original locked assets.

So it’s not really wrapped?

“Wrapping” a token pretty much sounds like the token is putting on a disguise or costume so that it can be recognized on a different blockchain. This terminology however was simply adopted to make the principle easier to understand though technically, the term “wrapping” is not entirely accurate to describe the process. 

In principle, a wrapped token functions more like a stablecoin, whose value is pegged to the real-time price of a fiat currency like the US dollar. Similarly, the value of wrapped tokens are pegged to the real-time value of the original cryptocurrency that they are based on and can be interchangeable for one another at a 1:1 ratio at all times. 

Simply put, a wrapped token is just a special utility token created to serve as a proxy token on another blockchain network.

Commonly used wrapped tokens

There are already dozens of wrapped tokens in circulation that now provide cross-platform compatibility and interoperability across the major token networks. Here are just a few of the most popular ones:

Wrapped Bitcoin (WBTC)

WBTC is the most popular wrapped token on the market today as it is a wrapped version of Bitcoin that allows token owners to transact on Ethereum platform and to avail of its DeFi products. As Bitcoin is the most valuable and most traded cryptocurrency, it is limited by its home network which in fact, has no smart contract capability and no dApps. Thus WBTC greatly extends the utility of Bitcoin beyond being just a store of value. 

Wrapped Ethereum (ETH)

WETH is also a popular wrapped token for the original ETH token. Surprisingly, ETH itself is not an ERC-20 token as it was launched even before the ERC-20 standard was introduced. WETH functions in the same way, allowing users to deploy their ETH holdings as WETH on DeFi platforms. 

renDOGE (RENDOGE)

RENDOGE is the ERC-20 representation of Dogecoin (DOGE) on the Ethereum blockchain. DOGE as well has its own blockchain but without any smart contract capability, which is what makes RENDOGE useful as it allows Dogecoin owners to make investments and trades on decentralized exchanges.

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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.

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