What are wrapped crypto assets?
Wrapped crypto assets are tokens backed one-to-one by an underlying asset, typically native to another blockchain or platform.
The concept of wrapped tokens aims to bridge the gap between different blockchains, enabling the seamless transfer of value and functionality across different blockchain networks.
You can think of a wrapped token as a tokenized version of an original token.
This additional tokenization step is taken so that a token which is native to one blockchain can be used on a different blockchain as well.
For example, bitcoin (BTC) is not natively compatible with the Ethereum blockchain. This incompatibility means that bitcoin holders cannot directly participate in decentralized finance (DeFi) protocols and earn yields on their assets.
Using wrapped tokens, however, they can now enjoy these benefits.
Use cases of wrapped crypto assets
Wrapped crypto assets have found applications in a variety of use cases, primarily centered around enhancing interoperability and expanding the utility of digital assets. Some notable use cases include
- Cross-chain trading: Wrapped tokens enable users to trade assets from multiple non-native blockchain networks on a single decentralized exchange (DEX). This functionality unlocks access to a much wider range of trading pairs and liquidity options.
- Liquidity provision: Liquidity providers can bridge their assets across different blockchains, allowing them to participate in yield farming and liquidity mining on multiple platforms.
- DeFi applications: Wrapped tokens facilitate the integration of assets from different blockchains into decentralized finance (DeFi) protocols. This integration includes using wrapped assets as collateral for loans or participating in yield farming.
- NFT interoperability: Non-fungible tokens (NFTs) can be wrapped, making them compatible with NFT marketplaces and applications on other blockchains.
- Cross-chain payments: Wrapped assets can be used for cross-chain payments and remittances, providing a fast and efficient method of transferring value across different networks.
How do wrapped crypto assets work?
There are several ways to create wrapped cryptocurrency tokens.
Crypto users can create some types of wrapped coins by simply depositing tokens into a smart contract, and receiving an equivalent amount of wrapped coins in return.
However, the original way of creating wrapped tokens like wrapped bitcoin (WBTC) typically involves three intermediaries:
- A merchant.
- A custodian.
- A decentralized autonomous organization (DAO).
Any crypto user who wishes to use wrapped tokens can interact with a merchant to swap and redeem these tokens types.
Merchants can be centralized exchanges or individual projects. However, to prevent centralization issues, merchants cannot create their own wrapped tokens at will. Instead, they must collaborate with other institutions called "custodians".
Custodians are often regulated entities that specialize in cryptocurrency storage. Merchants interact with custodians on the users' behalf.
A merchant initiates the wrapping process by sending cryptocurrency to a wrapped token smart contract. This automated computer program manages the transaction between the merchant and the custodian.
A merchant may start this process to increase their own supply of WBTC in response to rising crypto market demand.
In this example, we'll assume the merchant transfers over 100 BTC. Upon delivery, the custodian commits the original asset to its secure storage and mints 100 Wrapped Bitcoin (WBTC) tokens. To be compatible with the Ethereum blockchain, custodians mint these new tokens using the ERC-20 token standard.
You can learn more about the ERC-20 standard in our Kraken Learn Center article What is Ethereum? (ETH).
The assets held in reserve back the wrapped tokens 1:1, and ensure their prices remain accurately pegged. You can think of it as holding tokens in a digital vault until it's time to redeem them.
The custodian completes the initial part of the minting process by sending the newly created coins to the wrapped token contract. The contract then releases these coins to the merchant.
If the merchant decides to redeem their WBTC tokens for BTC held by the custodian, they must submit a "burn request". Burning is a process of permanently removing tokens from circulation. This request instructs the custodian to remove the merchant's WBTC balance from the circulating supply and release the equivalent amount of BTC from storage.
The wrapped smart contract completes the wrapping process by transferring the bitcoin from the custodian to the merchant.
A specifically created decentralized autonomous organization (DAO) manages the institutions involved with wrapping Bitcoin on the Ethereum blockchain.
This group plays an important role, as the wrapping process heavily relies on trusting centralized institutions — something that highly contradicts the decentralized foundations of cryptocurrencies like bitcoin.
The WBTC DAO consists of many merchants, custodians, and other entities. These parties can add or remove new members, and adjust contract conditions by collectively signing a multi-signature contract. This smart contract governs all activities within the DAO.
Challenges and considerations
While wrapped crypto assets offer significant benefits, they also come with certain inherent risks. The main issues being centralization, security risks, and regulatory concerns.
Users must trust the issuer of the wrapped tokens to mint and redeem native assets when requested. They must also rely on custodians to guarantee the security of assets held in reserve. These single points of failure can make wrapped tokens significantly higher risk than other asset types.
Additionally, the wrapping smart contracts used to facilitate trades between merchants and custodians may be prone to vulnerabilities and exploits.
It also remains unclear how regulatory bodies around the world view these types of tokens and what protections may be afforded to people in different jurisdictions.
Importance of wrapped crypto assets
Wrapped crypto assets have emerged as a powerful solution to bridge the gap between popular cryptocurrencies on different blockchain ecosystems. Their ability to enhance liquidity, accessibility, and blockchain interoperability holds promise for the continued evolution of decentralized finance, cross-chain interactions, and beyond.
However, it's essential to balance the benefits with the potential risks and challenges associated with centralization and security. As the blockchain space continues to mature, wrapped crypto assets are likely to play a pivotal role in shaping the future of decentralized ecosystems.
Examples of wrapped crypto assets
Since then, dozens of other projects have released their own wrapped coins.
Now, hundreds of coins that were previously incompatible with other blockchain networks can exist synthetically on non-native platforms.
- Wrapped Ether (WETH)
- Wrapped Tron (WTRX)
- Wrapped Dogecoin (WDOGE)
- Wrapped EOS (WEOS)
- Wrapped Matic (WMATIC)
- Wrapped AVAX (WAVAX)
- Wrapped Fantom (WFTM)
- Wrapped BNB (WBNB)
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