What are Wrapped Tokens

“Wrapped”, as the name suggests, is essentially a wrapped version of cryptocurrencies that can work on blockchains other than its own. The value of wrapped tokens is tied to the underlying cryptocurrency. For example, 1 BTC is equivalent to 1 Wrapped BTC. Wrapped tokens allow cryptocurrencies to be used across multiple blockchains, expanding their functionality. 

BTC can only be used on the Bitcoin blockchain, but wrapped Bitcoin can be used on the Ethereum blockchain. They are of the same value as the underlying coin, and we need them because Tokens must be interoperable across different blockchains to facilitate diversified transactions.  We know that the games we play on our phone cannot be played on our computer, but with the right software, we can play them on a computer as well. Tokens also function the same way. Bitcoin won’t work on the Ethereum blockchain unless it’s wrapped.

Most cryptocurrencies are native to their blockchains; they can’t directly interact with other chains. Wrapped tokens make it possible for Tokens like Bitcoin to be “wrapped” and used in blockchains that were not previously compatible, unlocking a new world of possibilities for decentralized finance. 

How does Wrapped Tokens work?

For a token like Bitcoin to be wrapped, there needs to be three major players:

Minting (Creating Wrapped Tokens)

 If you hold a currency, such as bitcoin, and you want to trade on the Ethereum blockchain, you send your Token to a custodian. The custodian is a set of codes that act as a bridge between you, your original token, and the wrapped token. The custodian guarantees that the value of the wrapped token is the same as the original Token.

Custodian

Once you send your tokens to be wrapped, the custodian will mint an equivalent amount in wrapped tokens. Since new tokens are created in the process, your original tokens are locked in a special kind of digital vault. 

Burning (Redeeming Wrapped tokens) :

The wrapped tokens can also be “unwrapped” and turned into the original form via the same custodian via a term called burning. To put it simply, the wrapped tokens are destroyed, and the tokens that were previously locked are released.

Wrapped Token and Native tokens

1. Native Tokens

They are the native cryptocurrencies of their respective blockchain. For example:

• Bitcoin (BTC) is the native token of the Bitcoin blockchain
• Ether (ETH) is the native token of the Ethereum blockchain.

Native tokens are important to their respective blockchains as they are used for transaction fees, network security, and governance. These tokens only work on their native networks unless they are wrapped and transferred to another blockchain.

2. Wrapped Tokens

Wrapped tokens are just a minted version of the original tokens that can be used on a different blockchain. For example, Wrapped Bitcoin (wBTC) is a Bitcoin wrapped and issued on the Ethereum blockchain. Although wBTC represents a bitcoin, it follows Ethereum’s token standard (ERC-20). This helps it to interact with the Ethereum-based applications and platforms like decentralized exchanges (DEXs)

The Future of Wrapped Tokens

Wrapped tokens diversify new opportunities for using Currencies like Bitcoin and Ether on non-native platforms. As technology evolves, we can see many advancements to be made in the field of wrapped tokens. Many new blockchains are starting to experiment with wrapped tokens to facilitate access to DeFi applications. But there are dark sides to wrapped tokens as well. It relies on a trusted custodian for the custody of underlying assets, which contradicts the decentralized nature of DeFi. If the custodian is compromised, hacked, or mismanaged, the users’ funds could be at risk. A centralized custodian could potentially freeze or seize the funds when pressured from an external source or regulatory action.

Conclusion

Wrapped tokens have removed the limitations set on cryptocurrencies and digital assets by creating a bridge between otherwise isolated blockchains. These tokens play a crucial role in connecting these chains and providing interoperability and increased liquidity. Wrapped tokens maximize the utility of their underlying assets. It’s an innovative and flexible solution. 

As decentralized finance (DeFi) continues to evolve, wrapped tokens are also evolving, and they are expanding the possibilities for decentralized trading, lending, and yield farming.

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