DeFi 101: The Importance of Wrapped Tokens
Wrapped tokens play a crucial role in the DeFi landscape by offering a range of benefits to users, including increased capital efficiency, cross-chain liquidity, and diverse investment opportunities.
- What are Wrapped Tokens?
- Wrapped Tokens vs Stablecoins
- Why are Wrapped Tokens Essential to DeFi?
- Wrapped Token Risks and Limitations
What are Wrapped Tokens?
Firstly, to grasp the importance of wrapped tokens, we must understand what they are and how they work. Simply put, a wrapped token is a digital asset that represents the value of another cryptocurrency. It is pegged to the value of the underlying asset and can typically be unwrapped at any time using a bridge service. These bridge services are imperative to crypto as a whole because they are often used to bring assets from other blockchain platforms into a new ecosystem. This then enables cross-chain compatibility and liquidity, a bonus not only for the user but the entire DeFi space.
Wrapped Tokens vs Stablecoins
Wrapped tokens are similar to stablecoins in the sense that they both derive their value from another asset. However, while stablecoins are typically backed by fiat currency, wrapped tokens are backed by cryptocurrencies that are native to other blockchains. For example, you could wrap an asset like Bitcoin in a token that is compatible with the Ethereum blockchain. This wrapped token, known as WBTC, could then be used within DeFi applications and protocols that are built on Ethereum.
A stablecoin is designed to maintain a fixed value relative to some external reference, such as the US dollar. This in turn means that the underlying asset that they represent, such as one US dollar for every stable token issued, should stay pegged. This enables users to hold stable tokens as a reliable store of value, without worrying about the volatility that is often associated with cryptocurrencies. This however does not mean that stablecoins are 100% safe, with many losing their pegs.
Why are Wrapped Tokens Essential to DeFi?
Wrapped tokens help combat the issue of incompatibility between different blockchain platforms. Cryptocurrencies that are native to one blockchain cannot be used on another blockchain, much like how different currencies are used in different countries. Wrapped tokens enable cryptocurrencies to be used on a different blockchain by creating a new token that represents the value of the original cryptocurrency.
Each blockchain and its native token should be thought of as its own isolated system, with demand for that specific token dependent on the applications built on that network. In order to fully benefit from the growth of the DeFi industry, it is necessary to have technology that works across all blockchains.
Wrapped tokens enable this by giving native tokens utility outside of their original blockchain. This unlocks a significant amount of capital efficiency and enables diverse investment opportunities across a wide range of chains. By doing this, wrapped tokens bridge the gap between different blockchain ecosystems.
Wrapped Token Risks and Limitations
- Wrapped tokens may offer increased capital efficiency, but they also come with a higher risk of contagion. If the protocol managing collateral encounters a problem, any application using its wrapped token could be affected. In the past, credit contagion has occurred with pegged stablecoins such as USDT due to issues with their collateral requirements.
- Bridging wrapped tokens to other blockchains, such as from Ethereum to Polygon, can be expensive due to the gas fees associated with the network.
Depending on the congestion and traffic, one transaction could be more expensive than another, therefore it is always best to check beforehand.
- As wrapped tokens rely on a third party to hold and manage the underlying assets, insolvency risk becomes a real threat.
If the party responsible for managing a wrapped Bitcoin for example goes bankrupt, the token holders may not be able to redeem their tokens for the underlying Bitcoin.
- Inequivalent value can create risks for users of wrapped tokens, as they may not be able to redeem their tokens for the full value of the underlying asset.
For instance, if a wrapped token represents one Bitcoin, the value of the wrapped token may not be equal to the value of one Bitcoin. This could be due to fluctuations in the market price and the fees associated with creating and managing it. This also means that the value of the wrapped token may be slightly different from the value of the underlying Bitcoin, even though they are meant to be equal.
Wrapped tokens differ from stablecoins as they are backed by cryptocurrencies native to other blockchains, rather than fiat currency. They are essential to DeFi because they enable cross-chain compatibility and liquidity, giving users access to a wider range of assets. This ultimately increases interoperability and capital efficiency. However, wrapped tokens also come with risks, including contagion, gas fees, inequivalent value, and counterparty risk.