What Are Wrapped Tokens?
Crypto is full of jargon and common terms that are thrown around, but do we ever stop and think about what they actually mean?
Wrapped tokens are one of these terms and are at the core of cross-chain liquidity aggregation, so we must understand what they are, their uses, and their limitations.
First, let’s start by saying that wrapped crypto is crucial to blockchain interoperability — which is vital to the long-term success of cryptocurrency.
In simple terms, a wrapped token is a synthetic version of a cryptocurrency native to a different blockchain.
There can be multiple wrapped versions of a single crypto token on one blockchain (which is a form of liquidity fragmentation), and technically speaking, the only similarity between a wrapped and original token is the price.
A blockchain is a consensus of record keeping between individuals, so to be on a blockchain, a cryptocurrency must follow that blockchain’s rules. In other words, a wrapped token must be programmed differently from the original asset.
How Do Wrapped Tokens Work?
Users must deposit their original tokens into a blockchain bridge to create the synthetic token.
The blockchain bridge will send these tokens into a smart contract, where they will be locked. In return, the bridge sends a message to the mint contract on the target chain, which mints the wrapped token and sends it to the user’s wallet.
Why Do We Use Wrapped Tokens?
There are three main reasons to use wrapped tokens, so let’s take a look at them.
Price Exposure
Sometimes, a crypto user may want to price exposure to an asset on a blockchain where they do not have a wallet set up. They may prefer not to use a centralised, custodial exchange, so instead purchase a wrapped version on a blockchain they are familiar with.
The easiest way to do this would be to swap a native asset on a blockchain for a wrapped token on a DEX or cross-chain liquidity aggregator (cough, cough). Although this would not be a cross-chain swap, we facilitate same-chain swaps as well at Magpie Protocol.
Used for DeFi Yield Farming
Due to the demand for price exposure to assets on non-native chains, there is an opportunity to earn yield too. For this reason, for many farmers, this season’s crop of choice is wBTC, harvested through DeFi liquidity pool and lending commissions.
Move liquidity cross-chain.
And finally, as everybody knows, it’s just been Arb season. During the depths of a bear market, smallcap coins on the Arbitrum network were experiencing 10’s of X’s in growth. If you wanted a piece of that Arbitrum pie, you had to bridge your ETH to Arbitrum.
Although it would still show in your Arbitrum wallet as ETH, it’s actually a wrapped version of the Ethereum cryptocurrency. The original Ethereum would be sent to a smart contract wallet until you bridge back to the main Ethereum network.
Simply put, if investors want to move assets from one chain to another to capture price movement, and take advantage of different protocols or network features, one of the easiest ways to do so is with wrapped tokens.
What Are the Limitations of Wrapped Tokens?
So, we have now discussed how wrapped tokens work and why they are used. But you may think it can’t be all rainbows and sunshine; there must be some downside. If this is you, then you’re correct.
There is one critical issue with wrapped tokens and a second issue which dramatically reduces their advantages, particularly to the broader blockchain ecosystems.
The first issue is smart contract risk. Smart contract risk and blockchain security are one of the most critical issues in crypto, which many people take for granted. This is because, most importantly, blockchain has these issues almost totally resolved.
The distributed ledger and consensus mechanisms used by major blockchains make it very difficult to hack or overrun a blockchain, but blockchain bridge smart contracts are its Achilles heel.
One smart contract holds the funds for many users, meaning if a hacker can compromise that one contract, they can steal a considerable amount of locked crypto funds. If these funds are stolen, it effectively renders the synthetic version worthless as it cannot be unwrapped.
Secondly, there can be multiple wrapped versions of a single asset on any given blockchain. In other words, it fragments liquidity and leads to all the nasty limitations which come from that.
The risks related to wrapped tokens are undeniable. But they are not undefeatable.
Magpie Protocol leverages the most secure bridge platforms, such as Wormhole and Stargate, and users can also choose whether to swap to wrapped or original assets. Moreover, as the liquidity is aggregated, it reduces fragmentation and leads to a far better user experience.
