What are wrapped crypto tokens and why are they needed

What are wrapped crypto tokens and why are they needed

The cryptocurrency and blockchain world is a very large space filled with many different ideas and projects. This large number of projects and networks is crucial to Web3 development, but there is one problem; the lack of connectivity between these networks. If you are on an Ethereum network and want to spend Bitcoins, well bad news for you, you can't.

But people have found the solution to this problem, which is called wrapped tokens. If you have looked at different crypto exchanges or other Defi platforms, you most likely have seen Wrapped Bitcoin and Wrapped Ethereum. But what are these wrapped tokens exactly, and how do they work? You are about to find out in our wrapped crypto tokens guide.

Things to Know About Wrapped Tokens

  • Wrapped tokens provide much-needed cross-chain liquidity for Defi applications
  • Wrapped tokens are similar to stablecoins, but have their own differences
  • Anyone can unwrap the wrapped token and return it to its original form
  • Wrapped tokens carry the risk of causing market contagion and liquidity crises

What Are Wrapped Tokens

Wrapped tokens are cryptocurrencies that have been tokenized on other blockchains, essentially transferring crypto from its native blockchain to another one. It is pegged to the value of the token it represents, meaning the value of the wrapped token will always be the same as the original token. Wrapped Bitcoin will always be worth the same as regular Bitcoin, but unlike regular Bitcoin, Wrapped Bitcoin is an ERC-20 or TRC-20 token operating on either the Ethereum or Tron network.

We can think of wrapped tokens as stablecoins because both of them are pegged to different assets and share their exact value. The difference here is that stablecoins are pegged to fiat currencies such as USD, while wrapped tokens are pegged to cryptocurrencies, and their value changes accordingly. 

If we wrap Bitcoin or purchase Wrapped Bitcoin, there is always a possibility of unwrapping it and turning it back into a regular Bitcoin token. But for simplicity, we can simply go to the crypto exchange and swap Wrapped Bitcoin for regular Bitcoin, without the need of unwrapping the token.

How Are Wrapped Tokens Created

When creating Wrapped tokens they are getting minted as new tokens, while unwrapping them burns these tokens. For us to wrap tokens we first need to find a custodian who will provide us with these services. For example, if we want to wrap Bitcoin, we send the amount of Bitcoin we want to wrap to the custodian, who stores these tokens in a vault, and mints new Wrapped Bitcoin. 

When it comes to unwrapping these tokens it works pretty much the same. We request the unwrapping of our Wrapped Bitcoin from the custodian and submit a burn request. Then the custodian takes our Wrapped Bitcoin and burns it, and after that our Bitcoin is released from the vault and returned to us. It also needs to be mentioned that if you want to unwrap a token, it is not required for you to be the person who wrapped it in the first place.

Importance of Wrapped Tokens

Interoperability between different blockchains is something that many people are working on. This is an important subject as there are many different blockchains such as Bitcoin, Ethereum, Solana, Binance, and more, that have huge numbers of users. But being a user of one blockchain is hardly enough if we are looking at the developments and innovations that are going on in the blockchain ecosystem. Because of this, the importance of wrapped tokens is really becoming more and more of a focus point. 

For example, Ethereum is probably the biggest cryptocurrency when it comes to Defi applications, but it has its own limitations. Most Defi applications support ERC-20 tokens built on the Ethereum network, but Ethereum itself is not an ERC-20 token. Because of this, people started to wrap Ethereum and created a new cryptocurrency called WETH. If we visit the biggest NFT marketplace, OpenSea, we will see that there are many NFTs that are priced in Wrapped Ethereum and not in standard Ethereum. There are different reasons why this is done, but the important part is that there is a need. The same can be said about Bitcoin, as it is the largest cryptocurrency in the world. Although, when it comes to Defi applications, using Bitcoin is really hard. The reason for this is that hardly any Defi apps are built on the Bitcoin blockchain, so people have to wrap Bitcoin in order to use it on these apps.

But there is one problem, fast development. The pace at which new blockchains, protocols, and other Defi apps are introduced to the world is really fast. This creates the need to have multiple versions of wrapped tokens, and this is becoming more and more complicated. But there are some developments going on that will fix this problem. One of the solutions that many consider being the best option is the creation of one central hub which connects and bridges every blockchain in one place. There are many who are working on this solution, and all that is left for us to do is wait and see where things will go from now on.

Risks of Wrapped Tokens

But being a cross-blockchain cryptocurrency it should not be surprising that there are risks associated with these tokens. One of the biggest risks that come with Wrapped tokens is market contagion, which is when a financial crisis spreads from one blockchain/protocol into another. 

Wrapped tokens bring this crisis risk, as there is a possibility of one collateral vault failing. If this happens every protocol that uses this vault will be exposed to the risk of having major liquidity issues. This contagion has already happened a few times in the crypto industry, mostly with pegged stablecoins such as USDT and UST. We are yet to see this happening to Wrapped tokens, but possibilities are there so just ignoring this fact might lead to a very huge crisis.

FAQs on Wrapped Tokens

Are Wrapped Tokens safe?

In general yes. There have not been any major problems associated with Wrapped tokens, but there is still a risk of collateral vaults failing, which will cause a liquidity crisis across all protocols using these vaults.

Is Wrapped Bitcoin the same as regular Bitcoin?

Yes and no. In essence, Wrapped Bitcoin and regular Bitcoin are the same, as both of them have the same value. But unlike regular Bitcoin which operates on the Bitcoin blockchain, Wrapped Bitcoin can work on other blockchains such as Ethereum, Solana, and more.

Are Wrapped Tokens stablecoins?

Wrapped tokens and stablecoins share similarities such as both of them are pegged 1:1 to different assets. But unlike stablecoins that are pegged to traditional fiat currencies, wrapped tokens are pegged to other cryptocurrencies, which makes them somewhat unstable.