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What Are Wrapped Cryptocurrencies? Are Wrapped Tokens Safe?

2022-11-24 13:05:07

What are wrapped crypto tokens?

Wrapped crypto tokens are cryptocurrency tokens minted on a different blockchain and are pegged to the value of the native token to represent the native token. Wrapped tokens were developed to solve the issue of lack of blockchain interoperability in blockchains. Wrapped tokens make it possible to transfer native blockchain assets and cryptocurrency tokens across blockchains. 

Wrapped cryptocurrencies keep the peg with the cryptocurrency asset they represent and can be used to redeem the native cryptocurrency at any time. 

For a user to send cryptocurrency tokens from its native blockchain to another blockchain, a wrapped version of that cryptocurrency must exist on the blockchain where the user is transferring the cryptocurrency tokens. 

wrapped cryptocurrency tokens

Wrapped cryptocurrency makes it possible for cryptocurrency tokens to be traded on other blockchains. Decentralized exchanges built on a blockchain have wrapped cryptocurrency tokens of other blockchains trading on it. Uniswap for example is a decentralized cryptocurrency exchange built on Ethereum, Uniswap supports BNB, BTC, and other cryptocurrencies on different blockchains in wrapped form. WBTC, WETH, and WBNB are wrapped cryptocurrency tokens for BTC, ETH, and BNB respectively. Most cryptocurrencies created have a wrapped version on other blockchains, hence making blockchains interoperable. 

The value of native tokens and their respective wrapped tokens on other blockchains must always be at a ratio of 1:1.

How do wrapped tokens work?

Wrapped tokens are made possible via smart contracts. Smart contracts are self-executing codes that run on the blockchain in an automated and decentralized manner. If a user sends BTC cryptocurrency from an address to an ERC-20 address, the smart contract locks the cryptocurrency from the sender account and mints the equivalent to the ERC-20 address as an ERC-20 token. 

This smart contract help in keeping the value of the cryptocurrency at both blockchains at an equal ratio. Unwrapping cryptocurrency tokens is the inverse of wrapping. If a user wishes to unwrap wBTC (ERC-20 BTC) and convert it to the native BTC, the wrapped token is burned (destroyed), and the locked BTC on Bitcoin blockchain is freed automatedly via smart contracts. The wrapped cryptocurrency is the collateral to unwrap it back to the native cryptocurrency. 

Wrapped cryptocurrency can be considered smart contracts that represent the native cryptocurrency asset's locked collateral on a different blockchain. Because the wrapped token's value is pegged to another cryptocurrency, it must be recognized and controlled by a custodian entity that wraps and unwraps the token. Examples of these entities are decentralized exchanges and centralized exchanges.

Several cryptocurrency blockchains offer standards for producing a cryptocurrency compatible with their blockchain. ERC-20, BEP20, TRC-20, and other standards are examples of these. The Ethereum blockchain cryptocurrency ETH was developed before ERC-20 became a standard, therefore wrapped ETH (wETH) enables ERC-20 compatibility. 

There are a lot of cryptocurrencies on other blockchains that have wrapped versions of themselves to conform to the ERC-20 standards. Examples are ERC-20 wBTC, ERC-20 USDT, ERC-20 BUSD, etc. The same applies to the BEP20 standards, TRC-20 standards, etc. 

It is important to know that the gas fee (transaction fee) differs, an ERC-20 transaction fee varies from a BEP-20 transaction fee. A wrapped cryptocurrency follows the standards of the blockchain it exists on. 

What is the purpose of wrapped tokens?

Wrapped tokens were developed to enhance the interoperability of blockchains and allow cryptocurrency tokens to be transferred from one blockchain to another. Lack of interoperability has always been an issue with blockchains prior to the development of wrapped cryptocurrencies. Blockchains existed as their world, and couldn’t communicate and share value due to different protocols before smart contracts the framework of wrapped cryptocurrency was developed to solve this problem.

Wrapped tokens make trading more accessible. Some blockchain transaction fees are costly compared to others. Trading a wrapped cryptocurrency on a cheaper blockchain makes trading easier and more convenient. For example, if the gas fee on the Ethereum blockchain (ERC-20) is too costly for a user to trade ETH comfortably, the user can trade wrapped ETH on Bep20 for other cryptocurrencies. 

How do wrapped tokens bring more liquidity to DeFi?

Wrapped tokens make it possible for decentralized finance applications to share liquidity. Wrapped cryptocurrencies aid the dispersion of liquidity across decentralized finance. Decentralized exchanges are established on blockchains, and wrapped tokens help in breaching the liquidity of tokens from other blockchains to the decentralized exchange. 

For example, Uniswap is a decentralized exchange built on the Ethereum blockchain, it supports ERC-20 tokens. Bep20 tokens can’t be traded on Uniswap in its native form. Bep20 tokens can be wrapped into ERC-20 tokens to be traded on Uniswap, hence sharing the liquidity of the Bep20 tokens on Uniswap. Thus, wrapped cryptocurrencies aid in integrating the flexibility of one blockchain with the liquidity associated with another.

Are wrapped tokens safe?

It’s widely assumed that wrapped cryptocurrencies are safe, but the safety of wrapped cryptocurrency depends on the blockchain that holds the collateral asset (wrapped asset). Unwrapping a wrapped cryptocurrency is usually safe because it is done in an autonomous and decentralized way via a smart contract which is a self-executing code. Wrapping and unwrapping a cryptocurrency can be done via a decentralized wallet, a decentralized exchange, or a centralized exchange. 

Since Bitcoin isn’t Turing Complete, it doesn’t enable smart contracts like other blockchains. To redeem a wrapped BTC, you have to trust the custodian (central authority)  that holds the underlying asset. Wrapping and Unwrapping BTC is not automated via smart contracts like other blockchains that support smart contracts. 

A centralized custodial bridge stores Bitcoin and creates ERC-20 tokens on Ethereum for anyone looking for a wrapped version of BTC. This contradicts the decentralized structure of cryptocurrencies and makes the wrapped assets vulnerable to corruption or error. If a user wishes to unwrap the wrapped BTC and the custodian refuses to disclose the native BTC, the user is left with a useless asset.

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