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The Beginner's Guide to Wrapped Tokens

Wrapped Tokens: What They Are, How They Work and Benefits
CryptoCounsel
Mar 1, 20235 min read195 views

Key takeaways

  • Wrapped tokens are digital assets representing the value of an underlying asset or cryptocurrency, stored in a digital vault and created to be compatible with another blockchain.
  • Wrapped tokens increase interoperability between blockchains, allowing for more opportunities for trading and investing.
  • Wrapped tokens offer a way for users to use assets not native to the blockchain they are using and can provide users with access to more liquidity.
  • Wrapped tokens require a custodian or a trusted third party to hold the original asset, which may limit their use in the decentralized world of cryptocurrencies.
  • Wrapped tokens are a relatively new concept in the crypto space. Still, they are an exciting development, and we can expect to see more of them as blockchain technology evolves.

Abstract

One of the greatest challenges facing the blockchain and cryptocurrency space is interoperability among blockchains and their respective assets. This means a cryptocurrency based on chain X cannot be directly transferred to chain Y and used there, as blockchains cannot enable cross-chain digital asset support by design. However, supporting assets cross-chain has become crucial with the rise of decentralized finance (DeFi) and the need for efficient, smooth, and fast movement of funds. This is where wrapped crypto tokens have found a valid application. While early blockchains like Bitcoin and Ethereum have different protocols and functionalities, and cannot communicate with each other due to the fundamental difference in their algorithms, wrapped tokens allow for effective asset movement between blockchains and the seamless use of assets across the crypto ecosystem.

This article will explore wrapped tokens, how they work, and their significance in crypto.

What are Wrapped Tokens?

A wrapped token is a digital asset representing the value of an underlying asset or cryptocurrency. The original asset is stored in a digital vault, and a new token is created to represent its value on another blockchain. The process of creating a wrapped token is known as "wrapping."

Wrapped tokens allow users to transact with assets not native to the blockchain they are using. For example, Bitcoin (BTC) is a cryptocurrency native to the Bitcoin blockchain. However, if users want to use BTC on the Ethereum blockchain, they can "wrap" their BTC in a digital vault and receive a new token called Wrapped Bitcoin (WBTC), which is compatible with the Ethereum blockchain.

Wrapped tokens are typically pegged to the value of the underlying asset, meaning that the value of the wrapped token will rise and fall with the value of the original asset. This makes wrapped tokens attractive for traders and investors who want to hold different assets on various blockchains.

How Do Wrapped Tokens Work?

Creating a wrapped token involves a custodian or a trusted third party who holds the original asset and creates the wrapped token. The custodian then issues the wrapped token on another blockchain, making it available for use on that blockchain.

The custodian ensures that the original asset always backs the wrapped token. This means the custodian must hold an equivalent amount of the original asset for every wrapped token in circulation.

When users want to "unwrap" their wrapped token and receive the original asset, they can return it to the custodian. The custodian then burns the wrapped token and returns the original asset to the user.

What Are the Benefits of Wrapped Tokens?

Wrapped tokens have several benefits for users in the crypto space. First and foremost, wrapped tokens increase interoperability between different blockchains. Since different blockchains cannot communicate, wrapped tokens allow assets to be transferred between blockchains, creating more opportunities for trading and investing.

Wrapped tokens also offer a way for users to use assets not native to their blockchain. This opens up new possibilities for decentralized applications and smart contracts requiring different asset types.

Finally, wrapped tokens can provide users with access to more liquidity. Since wrapped tokens can be traded on various decentralized exchanges, users can easily convert their assets into other cryptocurrencies or fiat currencies.

Conclusion

Wrapped tokens are a relatively new concept in the crypto space, but they offer several benefits for users looking to transact with assets on different blockchains. By wrapping an asset in a digital vault and creating a new token, users can gain access to new opportunities and increase their liquidity.

However, it's important to note that wrapped tokens require a custodian or a trusted third party to hold the original asset. This may limit their use in the decentralized world of cryptocurrencies, where trustlessness is a key feature.

Overall, wrapped tokens are an exciting development in the crypto space, and we can expect to see more of them as blockchain technology continues to evolve.

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