Crossing Chains With Wrapped Tokens
Wrapping allows to seamlessly move crypto across multiple blockchains that would otherwise remain isolated.
When crypto just came into existence with the release of Bitcoin source code back in 2009, interoperability across blockchains was not a part of the initial plan. However, with the advancement of technology and the crypto market growth, the need to incorporate interoperability into blockchain protocols and networks arose. It has become essential to find a solution enabling users to carry on fast and seamless transactions across different blockchains at a low cost.
That bursted an idea of the possibility to use the same token on another blockchain. Bridging the interoperability gap by virtue of crypto assets wrapping was meant to make it all happen.
Here we are gonna talk about what wrapped tokens are, look at their perks and limitations, and master some wrapping mechanics. With this knowledge, you can be better prepared for future innovations that might come knocking at the door tomorrow.
What is a wrapped token?
A wrapped token is a digital replica of a crypto asset (let’s take BTC for example) that is created on another blockchain non-native for this asset. A well-known example here is Wrapped BTC (WBTC) — a Bitcoin equivalent that circulates on the Ethereum blockchain.
So a wrapped token is a kind of “mirror” of a digital asset that reflects its same amount (i.e., 1:1) and real-time price fluctuations.
In comparison with the world of traditional finance, wrapped tokens at some point resemble depository receipts — financial instruments representing a foreign company’s securities on international markets. Depository receipts (DRs) allow companies to trade their securities outside their home country. In that sense, DRs serve as a kind of bridge connecting a particular business with global capital.
Just an example here of how it works. Say, a gas company in Israel has met the New York Stock Exchange (NYSE) requirements and now wants to list its publicly traded shares on it. Unfortunately, the company can not just apply for the direct listing of its shares. The listing could be done only in the form of the American Depository Receipts (ADRs) that would proportionally represent its shares on the Exchange.
For that, besides many other actions that should be taken, the company would have to deposit its shares with an authorized custodian bank. Once this is done, the bank would inform a US authorized depository bank that the shares are received and that the ADRs can now be issued in the US. Our Israeli company would be entitled to get listed on the NYSE from that moment. The ADRs would represent its original shares, held by the depository, and can be freely traded on the NYSE like any other shares. The ADRs investors would be entitled to the same rights (like voting and dividends) as the company’s direct shareholders.
Voilà! This is how we just elegantly bridged the cross-international gap in the financial markets. 🎉
Now let’s get back to wrapped tokens. They are designed to bridge the fragmented pieces of the crypto market and solve the well-known problem of cross-chain interoperability.
Wrapping one token into another makes it possible to utilize such token on blockchain networks that are non-native to it.
Similar to depository receipts, wrapped tokens are equivalent representations of the original assets, unlocking for their holders the exposure to more markets and, therefore, more earning opportunities.
The same as a depository receipt can be converted back to a stock it represents, so does a wrapped token. Its holder can unwrap it any time and get the underlying crypto asset. In that case, the wrapped tokens would be “burnt.”
What is not a wrapped token?
There is a common misconception to extrapolate “wrapping” onto real-world assets tokenization and equate wrapped tokens to stable coins. This approach seems to bring unnecessary theoretical confusion in understanding the technologies that deal with the crypto interoperability problem.
So let’s avoid messing it all up. The technology, processes, principles, and goals behind wrapped tokens are way too different from those of stable coins and tokenized assets. We are all soon-to-become crypto PhDs here, and such incorrect oversimplification of things is just not for us. 🧐
Why do we wrap tokens?
So what’s exactly the point of going through the hassle of token wrapping?
As we mentioned above, there is a substantial practical value in it. In short, it is a great way to make your assets more liquid. Let’s take it apart here.
It’s no secret that blockchains are entirely isolated from the external world. They are also isolated from each other. Cryptocurrencies cannot just “jump” from one chain to another.
Wrapping helps enhance the utility of a token and makes it applicable in more ecosystems and networks that are originally non-native. In other words, wrapping brings new use cases for your token outside of its original scope and therefore creates more revenue-generating potential. So a wrapped token is a kind of “tuned” version of your original crypto asset.
For example, a significant amount of the DeFI ecosystem runs on the Ethereum blockchain. Therefore, it can be rather frustrating for bitcoin users, as they do not have access to these DeFi applications. By wrapping their Bitcoins into WBTC, users can easily tap this ecosystem and its applications. Also, since the liquidity of BTC is far greater than other blockchains, wrapping BTC converts this liquidity to Ethereum. With the help of wrapping, we would be able to lend our BTC out through smart contracts on DeFi platforms and earn interest on it. We can also deposit it into liquidity pools to facilitate crypto trading.
Wrapped tokens help increase crypto liquidity and capital efficiency due to the facility to move the assets across multiple chains that would remain isolated otherwise.
How do you wrap a crypto token?
To wrap a crypto token, you deposit and lock your original tokens with a particular vault and get their crypto copies in return on another blockchain.
However, as it always happens in crypto, there are multiple nuances and ways of doing it. Every particular project dealing with wrapping brings its own methods and techniques.
You might be asking: why again multiply entities here?! We wrap because we want to beat the fragmentation problem in crypto and make it more unified and easy to use. But once again, we end up with multiple approaches and techniques that just add even more confusion!
Well, fair point 👌
The thing is that wrapping is a pretty challenging task.
Minting a copy of a token on another blockchain is not an issue. The real challenge comes from making that new-minted copy as accepted as the original token. This means coordinating several tasks simultaneously, such as:
- First, the value of the wrapped token must be the same as the original token, and the peg must be maintained over time.
- Second, the safety of the locked assets must be guaranteed, as well as the right to redeem the token at any time.
- Third, the wrapping of a token must be convenient and its utility greater than holding the original token in its native chain.
So far, there are four main designs of the wrapping process to provide these features: centralized, decentralized, hybrid, and synthetic. Let’s look at them closer.
(i) Centralized (custodial). This method relies on one or more trusted intermediaries — custodian and merchant — to maintain the wrapped token’s value. These guys are in charge of providing the so-called proof of assets (PoA). The PoA proves that the locked underlying assets are safely stored, not used in any other applications, and can be returned to a user at any time upon their “burn” request.
The most used and accepted centralized wrapped token is Wrapped Bitcoin (WBTC) — an ERC-20 token representing Bitcoin (BTC) on the Ethereum blockchain. If a user wants to wrap their BTC into WBTC, they first need to reach out to the merchant (for example, Republic Protocol) and provide it with the collateral (i.e., BTC). Then the merchant will execute KYC, deliver the collateral to a custodian (for example, BitGo), request it to mint WBTC for a user, and then provide the user with these new-minted tokens. So in the wrapping process, a merchant acts as an intermediary between a user and a custodian.
A user has to pay fees to both merchant and custodian each time they want their assets wrapped or unwrapped. This is why centralized wrapping solutions are more expensive than their alternatives.
(ii) Trustless (non-custodial). In this case, wrapped tokens minting is entirely automated and handled by a decentralized entity — a decentralized autonomous organization (DAO) that should always ensure a transparent and censorship-resistant proof of assets. The custody of tokens is solely managed by smart contracts without third-party intervention and KYC requests.
An example of a fully decentralized wrapped token is Wrapped Ether (WETH). This is actually the first wrapped token ever created. WETH is a token pegged to Ether (ETH), which is, however, not available outside of the Ethereum ecosystem.
You might be wondering: what’s the point of wrapping ETH for harnessing it only on the ETH blockchain?
Since decentralized platforms running on Ethereum use smart contracts to facilitate trades, every asset should conform to the same standardized format. This format is recognized as ERC-20. Since Ether was issued before the ERC-20 format, it is not suitable for DeFi smart contracts, and for this reason. Therefore its wrapped ERC-20 modification (i.e., WETH) was perceived as necessary.
(iii) Hybrid. This method uses both a centralized entity and smart contracts to issue wrapped tokens. A centralized entity is usually required to perform KYC functions and ensure that the smart contracts are correctly executed.
The best example of a hybrid wrapped token is RenBTC. Compared to centralized and trustless wraps, the most significant advantage of hybrid ones is that they might be interoperable upon multiple chains. Likewise, RenBTC can be available on BSC, Polygon, Solana, and Avalanche.
However, hybrids are less accepted in DeFi protocols. Main DeFi projects such as Aave, Maker, and Compound do not support tokens wrapped on RenVM.
(iv) Synthetic. Minting synthetic tokens slightly differs from the previous ones, as it does not require the lock of the original asset in a trusted vault or a smart contract. To mint a synthetic token, a user needs to lock assets of the equivalent value (or more) of the represented asset (e.g., lock USD 200 worth of SNX to mint sBTC of equivalent value). Intuitively, when users wish to burn synthetic tokens, they will not receive the represented token back but the provided assets instead.
So as we see here, a synthetic token is conceptually different from a wrapped token, although it may have the same standard (ERC-20) and generally the same price. Unlike wrapped tokens, synthetics cannot be redeemed for the original token since no original token was locked to mint the synthetic version. However, the mechanism to issue a synthetic token, such as sBTC, is similar to wrapped tokens. This is why we give it here as an example, though their acceptance is pretty scarce.
Here is a summary of the main technical differences between wrapped tokens types.
Limitations and risks of wrapped tokens
The main limitations of wraps arise out of the process of their minting.
Reliance on a trusted third party
As we discussed earlier, in the case of centralized solutions, a user has to trust a third-party — custodian that is in charge of the user’s original assets’ safety. In the case of unwrapping, a user also strongly depends on the custodian’s discretion. The latter has to approve the user’s request to “burn” the wrapped tokens and return the original assets back.
Actually, the utilization of custodians is a very debated concept in the crypto space. As a matter of fact, the whole idea of decentralization and DeFi should involve the ability of users to have complete control of their assets without involving trusted third parties and without KYC requirements.
However, custodians of crypto assets are obliged (through merchants) to request KYC from users depositing collateral. As centralized entities, custodial activity is subject to regulation and may also be ceased or censored. Thus acquiring a centralized wrapped token like WBTC means giving up the pseudonymity of BTC and its uncensorship features while operating under different security standards. If a bitcoin belonging to a black-listed user is frozen or censored by the custodian service upon request of the authority, its corresponding avatar would probably lose its value.
Decentralized projects and some hybrid ones do not require KYC for wrapping. However, their terms and conditions usually state that the projects may change their requirements to comply with the applicable laws and regulations.
The minting process of wraps is usually expensive. Each time wrapping and unwrapping, a user has to pay fees.
Other cons of wrapping tokens
Among other demerits of wrapping crypto tokens are:
- Wrapped tokens application is limited by particular ecosystems and networks, supporting them.
- As wrapping is a type of bridging, it carries the same risks. In particular,
(i) Smart contract risk — the risk of a bug in the code that can cause user funds to be lost.
(ii) Technology risk — software failure, buggy code, human error, spam, and malicious attacks can possibly disrupt user operations.
(iii) Censorship risk — bridge operators can theoretically prevent users from transferring their assets for whatever reason.
(iv) The underlying blockchain is hacked.
This is not to scare or prevent you from using wrapped tokens. It’s just useful when making an investment decision — to have a comprehensive picture of what you are dealing with in mind.
Fairly saying, if to look closer at traditional finance, one can find comparable amounts of risks of different nature, as in crypto.
Nothing is 100% safe. Where there are opportunities, so too do risks exist. This is life.
How does a user benefit from wrapped tokens?
As we already discussed, the biggest value of wrapped tokens is that they create interoperability between non-compatible cryptocurrencies and blockchains. They enable users to use their assets in more blockchain networks and ecosystems, which means greater exposure to diverse revenue-generating streams.
The particular set of perks offered by wrapped tokens can vary depending on the project. Some common ones include discounted access to a project’s services, rewards for professional help with improving an ecosystem’s functioning, and community building and evangelism incentives.
Let’s take Yellow Network as an example.
Yellow Network is a Web3 finance ecosystem that interconnects multiple stand-alone crypto exchanges in one automated non-custodial trading hub. Yellow provides a user with the aggregated crypto liquidity and infrastructure for seamless high-speed cross-chain transactions at minimal fees.
In the ecosystem of Yellow Network, along with the access to diverse crypto assets, wrapped tokens are also used for:
- getting discounts on trading fees
- creating liquidity pools and staking
- opening a state channel and getting access to the aggregated order book
- incentivizing developers for contributing to the Network’s functionality improvement
- rewarding human talent for content creation, influencing activities, etc.
The complete list of the $YELLOW tokens’ perks is given on Yellow Network website.
So as we see, the benefits of wrapped tokens can go far beyond just transactional. The sky’s the limit to how they could benefit users and the crypto industry as a whole.
Want to learn more about Yellow Network and cross-chain trading technology?
Check out OpenDAX v4 stack GitHub: https://github.com/openware/opendax
Visit the OpenDAX product page: https://www.openware.com/product/opendax
Follow Yellow Twitter: https://twitter.com/Yellow
Join the public Yellow Network Telegram: https://t.me/yellow_org
Read Yellow Network HackerNoon blog: https://hackernoon.com/u/yellownetwork
Stay tuned as Yellow Network unveils the developer tools behind Yellow Network, brokerage nodes stack, and community liquidity mining software!