What are Wrapped Tokens and How Do They Work?

Wrapped crypto tokens are used to transfer assets from one blockchain to the other. Let’s discuss how Wrapped Tokens work, their benefits, risks, and their possible future.

Blockchains like BTC and ETH are all based on separate databases, and that’s why they can’t effectively communicate with each other.

For example, a user with ETH can’t use his Ethereum on the Bitcoin blockchain, as only the ETH blockchain knows that he owns Ethereum.

This problem is solved with the help of wrapped tokens. These tokens allow the transfer and use of crypto assets across the blockchain ecosystem.

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What are Wrapped Tokens?

Wrapped Tokens allow users to transfer the native asset of a blockchain to another blockchain. Wrapped Tokens are always pegged 1:1 to the price of the original token. For example, Wrapped Bitcoin (WBTC) has the same price per coin as Bitcoin.

Since WBTC is available as an ERC-20 token, it can be transferred to and traded on the Ethereum blockchain.

Just like stablecoins like USDC and USDT are pegged to the price of USD, wrapped tokens are pegged to the price of the original token. However, it isn’t the peg of Wrapped Tokens which makes them special, it’s the technology and algorithm behind it which allows the blockchain ecosystem to retain the value of Wrapped Tokens while they’re being transferred across blockchains.

How Do They Work?

Wrapped Tokens are created through the minting process, and are destroyed through the burning process. To mint a Wrapped Token, the underlying crypto is sent to a third party, who acts as the custodian, and locks away that crypto to release/ mint an equal amount of Wrapped Token.

This process is also known as wrapping and includes the storage of the underlying asset in a secure vault with the help of a smart contract. Wrapped Tokens are always minted to transfer and use the asset on another blockchain.

When the Wrapped Token has done its job, can be burned by reversing the minting process. The Wrapped Token is sent back to the custodian, who removes it from circulation, and releases and locked the underlying asset.

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Benefits of Wrapped Tokens

There are lots of different cryptocurrencies with their wrapped tokens available in the crypto market. These Wrapped Tokens are used as a transfer of value between different blockchains, such as Ethereum, Solana, Polygon, and others.

Wrapping a token doesn’t require the users to send the underlying asset to a centralized blockchain. Instead, users can remain inside the decentralized financial system to wrap their cryptocurrency and transfer it across multiple blockchains.

Blockchains like Ethereum are programmed in such a way that the transaction cost increases with increasing congestion on the blockchain. However, wrapping a token and transferring it to another blockchain which is not as busy as the native blockchain helps make transactions with low transaction fees.

Since Wrapped Tokens can be transferred to faster blockchains, they provide users with high transaction speed as well.

Risks Associated with Wrapped Tokens

Any type of failure can cause market contagion, and can thus result in a significant loss of value for Wrapped Token holders. The whole market can get affected through a fatal chain reaction.

Custodian dependency is one of the major risks which raises trust issues.

Custodians have been caught lying about the actual size of their original reserves in the past. If the custodian gives away the underlying asset to someone else, they’ll leave the Wrapped Token owners with zero value.

The process of Wrapping and Unwrapping cryptocurrency and assets depends on custodians and is hence considered centralized.

Future of Wrapped Tokens

Blockchain interoperability is one of the biggest issues for the current blockchain ecosystem. Since the number of blockchains is increasing with every passing day, the need to make more bridges to ensure smooth interoperability will increase accordingly.

The future of Wrapped Tokens and Bridges seems to be bright, as they’re of extreme importance for blockchain technology if it is to become interoperable.

Author: Isacco Genovesi

Isacco writes news articles, reviews and guides about cryptocurrencies including technical analysis, blockchain events, coin prices marketcap and detailed reviews on crypto exchanges and trading platforms.

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