Have you ever wanted to transfer a cryptocurrency from one blockchain to another to make a fast transaction? If so, did you face any issues performing the task?
See, when two blockchains are separate entities, there is little communication between them. Due to the lack of communication between blockchains, interoperability is limited. Wrapped tokens came into being to resolve interoperability issues. It allows users to transfer assets between blockchains across the crypto ecosystem.
What is a wrapped token?
Wrapped tokens refer to a cryptocurrency that is pegged to assets like shares, gold or a cryptocurrency’s value and put on decentralized platforms. You can use wrapped tokens on the non-native blockchains; however, you can later even redeem them for the original cryptocurrency. Cross-trading cryptocurrencies in any blockchain are made possible with wrapped coins.
To begin trading your bitcoin on the Ethereum blockchain, you must wrap the tokens rather selling them. With wrapping, crypto users enjoy the liberty to preserve original assets by storing them securely in a digital vault. Once a token has been wrapped, the original asset is no longer accessible to its owner while the wrapped token remains in circulation.
How does a wrapped token function?
The developers mainly use the process of minting and burning when creating wrapped tokens. This minting and burning process is called wrapping and unwrapping. During the wrapping process, an underlying asset is wrapped up in a digital vault with the help of a smart contract. To better understand the operation, check the step-by-step process below.
- First, a coin is sent to the custodian for minting.
- Next, the custodian initiates a ‘burn’ request, authorizing the requested token’s release from reserves.
- A key is received by the custodians to mint wrapped tokens and remove coins from inventory.
- Custodians exchange wrapped tokens with traders by minting new tokens or delivering existing ones.
- Custodians must possess wallets as they need them to send packages tokens to respective traders.
Here’s a list of users involved in the functioning of wrapped tokens.
- Vendors: Stores a fair number of wrapped tokens in the form of buffer exchange.
- DAOs: Every dealer and custodian are, Ethereum blockchain called a decentralized autonomous organization. They are known to enter into funding after the framework conditions are established.
- Users: People who own these tokens and transfer them across the blockchain ecosystem.
- Dealer: A dealer conducts KYC processes to ensure the user is authorized.
- Traders: Custodians withdraw and mint tokens for the traders. The process of distribution of wrapped tokens is not possible without them.
What implications do wrapped tokens have on Defi?
Wrapped tokens enable the use of non-native tokens across the blockchain system. One of the significant benefits crypto users reap from this technology is achieving interoperability between blockchains. Suppose a blockchain’s slow speed is hindering a user, then wrapped tokens can help them out by allowing them to transfer assets between blockchains without any hassle.
Wrapped tokens can increase liquidity and capital efficiency for centralized and decentralized exchanges. Wrapping idle assets onto other chains can create connections between otherwise isolated liquidity pools. Besides enhancing liquidity, the wrapped tokens speed up the transaction and cost low fees.
According to a report provided by CoinDesk, wBTC has 80% of tokens wrapped in Ethereum blockchain; this indicates the increasing use of wrapped tokens. The wrapping process makes it possible for people who hold an asset not compatible with Dapps to invest in them easily.
Is there any risk of using wrapped tokens?
Though wrapped tokens offer a host of benefits to crypto users, it has certain limitations. In regards to its storage, it might prove a bit troublesome. Vitalik Buterin, the founder of Ethereum, has raised questions about the validity of coins available in the wrapped version. He rightly points out that most wrapped tokens might be sensitive to centralization.
The issue with wrapping assets such as Bitcoin and NXM is that the protocols for wrapping are not Turing complete. In other words, a smart contract on the Ethereum blockchain cannot automate the wrapping process. Instead, a central program does the wrapping instantly, which makes it open to manipulation.
Wrapped tokens are a great initiative to foster interoperability within the blockchain ecosystem. It helps crypto users to invest in Dapps even if the asset is non-compatible with crypto assets. However, certain limitations might lead to issues—and the right technical solution is required to resolve them.