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What are wrapped tokens?
Wrapped tokens are cryptocurrencies created to serve on other blockchains. The problem with some cryptocurrencies is that they only exist on a particular blockchain and cannot be easily transferred to other blockchains. With wrapped tokens however, this is possible.
The best known version of a wrapped token, is the wrapped Bitcoin – WBTC, which is a version of Bitcoin on the Ethereum blockchain. In addition, there are several other wrapped tokens that are linked (1:1) to the value of gold, silver or stocks, for example:
How does the wrapping process work?
Wrapped tokens work by “wrapping” the original token in a smart contract. A corresponding form of the token, the wrapped token, is then created on the second blockchain.
These smart contracts are written or deployed by decentralized autonomous organizations (DAOs). Typically, the first letter of the wrapped token refers to the name of the DAO.
The unwrapping process takes place in the opposite direction where the trader makes a burn request to the custodian (DAO). The tokens are then ‘burnt’ and proof of this is provided to the custodian. After receiving this proof, the custodian will release the tokens from its reserves.
The (un)wrapping processes happen on-chain and are therefore fully transparent.
Advantages and disadvantages of wrapped tokens
Wrapped tokens have advantages and disadvantages. For now, the advantages outweigh the disadvantages. We can assume that in the future more and more negative features will be eliminated.
- Interoperability: Not only can you perform transactions with wrapped tokens, you can also start using them to participate in different DApps and broaden the DeFi experience.
- Liquidity: The ability to package dormant tokens and use them on other blockchains leads to increases in liquidity for these tokens.
- Transaction speed: Buying or selling a cryptocurrency can involve a large amount of transaction time, such as Bitcoin. Using wrapped Bitcoin is much faster. Something that is important in an extremely volatile world.
- Transaction cost: Wrapped tokens also have a lower transaction cost when sent on other blockchains. For example, consider Bitcoin and wrapped Bitcoin, on the Ethereum blockchain.
- Centralization: What is characteristic of the entire cryptocurrency movement is decentralization. The fact that you need a custodian to wrap tokens might be difficult for those who renounce centralization.
- Risk of dishonest custodian: Wrapped tokens can only be ‘unwrapped’ back by the custodian. The whole process depends on the custodian. If it is defective, the process will be affected.
- High ‘wrap’ costs: ‘Wrapping’ and ‘unwrapping’ tokens can require huge gas costs, leading you to pay more than the original token is worth.
Wrapped tokens are the token equivalent of cryptocurrencies that are otherwise only available on their own blockchain. Wrapped tokens can move on multiple blockchains at a faster transaction time and at a lower cost.
In addition to cryptocurrencies, we find that gold, oil or other stocks can also be wrapped and traded. The wrapped tokens help with the interoperability that characterizes the decentralized finance ecosystem.