Understanding Wrapped Tokens: The Key to Blockchain Interoperability

Basic Knowledge Required

• Definition: Wrapped tokens are representations of a cryptocurrency that operate on another blockchain network, reflecting the value of the original asset.
• Value preservation: The value of the underlying asset is maintained in the reserves at a 1:1 ratio.
• Interoperability: With their help, crypto assets originating from one network can be seamlessly used on another blockchain network, improving the mobility and liquidity of the assets.
• DeFi opportunities: They open new doors for the use of decentralized financial applications across various networks.

Why were wrapped tokens created?

One of the fundamental limitations of the cryptocurrency ecosystem is that Bitcoin cannot be directly used on the Ethereum network, or that Ethereum-based assets cannot function on the Solana chain. This isolation limits the usability of the assets. The concept of wrapped tokens provides a solution to this problem – it allows assets tied to one chain to fully function on another network.

The Principles of Wrapped Tokens

The simplest example of operation can be traced in the case of Wrapped Bitcoin (WBTC) on Ethereum. WBTC is a token that adheres to the ERC-20 standard, maintaining a 1:1 value ratio against the actual Bitcoin supply, thus allowing the full value of BTC to be utilized within the Ethereum ecosystem.

Every wrapped token requires a custodian - an organization that ensures that every issued token is backed by real collateral. This can be a trading partner, a multi-signature wallet, a decentralized autonomous organization (DAO), or a smart contract-based system. In the case of WBTC, each equivalent unit is backed by 1 real Bitcoin in reserve, which can also be verified on the blockchain.

The packaging process works like this: a trader sends Bitcoin to the custodian address. The custodian then generates an equal amount of WBTC on the Ethereum network. In the reverse direction, if someone wants to convert the wrapped token back to the original asset, they request the “burning” (burning) process, and the custodian releases the appropriate amount from the held Bitcoin reserve.

Which networks are available?

Almost every major blockchain supports various versions of wrapped tokens. Ethereum was the first where the solution spread based on the ERC-20 standard, but now BNB Chain, Solana, Avalanche, and many other networks also implement it. An interesting case on the Ethereum network is Wrapped Ether (WETH): since ETH itself is not an ERC-20 token, WETH was created to make ETH compatible with the ERC-20 protocol and to ensure seamless integration of applications.

Opportunities offered by the wrapped solution

Wrapped tokens offer numerous useful advantages:

• Advanced capital efficiency: The same asset can move across multiple chains simultaneously, allowing for multiple utilizations of the given capital.
• Interoperability between blockchain networks: New pathways are opened for collaboration, integration, and interoperability between different systems.
• Wide-ranging DeFi participation: Users can participate in lending, borrowing, liquidity provision, equity investment, and voting on platforms where the original chain is not present.
• More favorable transaction conditions: Transactions can often be conducted at a lower cost and faster than on the original network.

Challenges and Threats

Significant risks also remain alongside the benefits:

• Centralization Exposure: The assets entrusted to the custodian form a centralized point of control, which poses a potential vulnerability, as the supply is guaranteed by reliable third parties.
• Code-based Risks: The smart contracts required for packaging and unpacking processes may contain programming errors.
• Learning curve: The appropriate knowledge acquisition required for the application of technology regarding the operation of blockchain networks.
• Legal uncertainty: Different regulations apply to it in various areas of law enforcement around the world, and it is in a state of continuous transformation.
• Economic costs: High transaction fees and potential price slippage (slippage) can diminish the theoretical advantages.

Practical Application Areas

Wrapped tokens offer a variety of real-world use cases:

• Cross-chain trading: Asset swaps and value transfers between various networks.
• Liquidity service: LPs have the opportunity to place wrapped assets in liquidity pools of various networks.
• Collateral for DeFi transactions: Collateral that can be used for loan requests or yield farming on other chains.
• NFT Ecosystem: Digital collections can also be wrapped, making them accessible on multiple platforms.

Conclusion

Wrapped tokens serve as instruments in the cryptocurrency world to create a connected, open ecosystem. They increase capital efficiency, facilitate liquidity sharing between applications, and expand DeFi opportunities. However, before using them, it is important to carefully weigh the risk-reward ratio and understand the underlying technology.

Related Resources

• The principle of operation and role of a Wrapped Bitcoin (WBTC) in the Ethereum ecosystem
• Price slippage and bid-ask spread in stock trading
• The construction and operation of decentralized autonomous organizations (DAO)