What is a wrapped token?
Imagine you’re watching a space thriller. The astronauts are going through an asteroid field and their ship is taking the damage. They need to get out there to repair the ship and the bravest astronaut volunteers for the job.
So, what do they do? The really important thing here is to put on a spacesuit. People are usually best suited to be on earth, breathing some crisp pure earth air, not dying in a vacuum of space. To phrase this somewhat oddly, they wrap themselves up to be able to survive in a different environment. Exactly like a wrapped token.
Definition
The many different layers and situations can make this concept confusing, but at its most basic, a wrapped token is just an asset in disguise. You take an asset, wrap it up, and then you can use it on a different blockchain.
To understand this, we first have to understand how tokens work. You can check my post on tokens X coins, but basically what you have to know is that each blockchain has its own coin, but developers on that blockchain can create their own tokens.
The problem is that tokens are tough to use on different blockchains. For example, let’s say you want to deposit some bitcoin on a popular blockchain application called Aave. It is an application that allows you to earn an interest rate by lending out your crypto.
However, Aave is only available on the ethereum network. You can’t use your bitcoins on it. So, what do you do? You can wrap up your bitcoin and make it a token on the ethereum network called Wrapped bitcoin.
What you’re doing is locking up your true bitcoin and then you simply get a wrapped bitcoin as a token on ethereum to use. Then you have that token you can use on the ethereum network, but it is a representation of your original bitcoin.
The point of all this is that some blockchains can do things that other blockchains can’t, and some coins aren’t even available. So what did the early developers do? They made representations and called them wrapped tokens, so that you can essentially have the main coin, but use it on any other network. A good way to think about using wrapped tokens is collateral.
Similar to collateral
Imagine you’re trying to buy a house and you don’t have enough money for it. So you get what is called a mortgage. If you have something else that has value, you can take a loan on it, because the bank or party loaning the money knows that you have something valuable they can take if you don’t pay them.
A wrapped token is similar to this. They are pretty similar to stablecoins or cryptocurrencies that are pegged to a fiat currency’s value. A wrapped token, like Wbtc, retains the value of the wrapped asset, and in this case, it would be bitcoin.
So one Wbtc always equals one bitcoin. Stablecoins pretty much do the same thing. They are wrapped fiat currencies used for improved transaction efficiency. How do they do this? Well, if you own one wrapped bitcoin, you can turn it into a real bitcoin at any time. So wrapped bitcoins are 100% backed by a real asset that they are representing.
This way traders are incentivized to keep the price of the wraps token the same as the real coin. Now, depending on which coin you have, and which blockchain you want to use, the benefits of wrapped tokens can vary. But if you have an asset with a slow blockchain, and want to make the transaction done faster, wrapped tokens can be an advantage.
Going faster
A blockchain like ethereum clears blocks quicker than bitcoin, which of course provides a speed advantage to users of the chain. Polygon is even faster than ethereum, and the native coin is Matic.
So many users use wrapped ethereum called wETH on the polygon blockchain to do things they would normally do on the ethereum blockchain, but much quicker and with much lower fees.
It’s wrapped! Then, what?
Great, so we have a cool new shiny tool to use crypto more effectively, but doesn’t this create other problems? What happened to that wrapped tokens when it’s done being used? Does creating another asset of the same value mean you’re just doubling your money out of thin air?
First, wrapping a token does not mean you are any richer than before. It’s kind of like if you write a check from your checking account. Writing the check doesn’t create a new asset, it’s still tied to your original asset that has value.
Security with custodian
Also because of the security or double-spending issues that could potentially arise from this, there of course has to be what is called a custodian.
This custodian is a third party that could be a smart contract, another person, a DAO, or many other things. The point is that you have to have a way to verify that you have a certain amount of the currency that you say that you have. This way nobody could create a wrapped token based on coins that they do not have.
A custodian verifies that the person creating the wrapped token has the original valuable collateral coin. In short, someone has to initially take your real bitcoin, and then give you the corresponding amount of wrapped bitcoin. Then, if someone else comes to the custodian with a wrapped bitcoin, the custodian can give them a real bitcoin.
Normally this is all done with code, it’s not a real person. So we don’t have to trust that someone won’t run away with all our real coins or print a ton of fake tokens.
Wrapped supply
Can there be more wrapped tokens than real coins? The short answer is no. In the same way that there can only ever be 21 million bitcoins, there could only ever be 21 million wrapped bitcoins, because you have to verify that you own the asset first to mint a wrapped token. Once you wrap your bitcoin, trade it, and then the transaction is over, the wrapped bitcoin is given to the person you sold it to.
Eventually, that person might come back to the custodian and say “I want a real bitcoin!”. The custodian will take their wrapped bitcoin and give them a real bitcoin, and then destroy the wrapped bitcoin forever.
Useful cases
Lastly, who even uses wrapped tokens? Well, the example that I’ve been working with so far is a simple one: wrapped bitcoin. So we can understand the underlying concept. This is a great use case, and the share of bitcoin being used for wrapped bitcoin is over 1% and increasing every day.
This is of course not a massive amount, but it is steadily increasing, as the demand for the ethereum network and Dapps increase over time. It seems to be the case that as DeFi grows, the demand for wrapping all kinds of coins to use on ethereum is also growing. For example, a lot of people are using wrapped bitcoins to interact with decentralized applications to earn an interest rate, or even create leveraged positions.
Ren
A company called Ren has expanded blockchain interoperability using what they call the RenVM protocol. This lets users create wrapped tokens on ethereum, like wrapped bitcoin, wrapped zcash, wrapped bitcoin cash, and many other tokens.
Conclusion
Summing it all up, wrapped tokens may seem like a simple idea that just lets people improve how they make transactions, but the problem that it solves is much bigger.
Interoperability, or the ability to easily move between blockchains, is becoming a very important and recurring problem to solve, as the entire DeFi landscape expands. Whether the eventual solution to this problem is wrapped tokens or maybe something else, they are certainly a viable solution that is only becoming more popular.
If you have any other questions about wrapped tokens, please stop by the KogeFarm Telegram or Discord communities, where you’ll always find someone willing to help you out.
