Cryptocurrencies are taking over financial markets across the world, even more so since the Covid pandemic of 2020. If you have thought to buy crypto in India, you might know this thing about cryptocurrencies: native crypto tokens from a specific blockchain can’t be used on other blockchain platforms. So before wrapped tokens, if you wanted to buy cryptocurrencies in India, you’d have had to buy different tokens for the blockchain platforms you wanted to be a part of. However, wrapped tokens quite efficiently solve that problem now.
And what are wrapped tokens, you wonder? In this post, we answer that question for you, and tell you about the workings of wrapped tokens. So if you’re looking to buy crypto in India, you’d better give this post a read!
What is a Wrapped Token?
Before wrapped tokens, you couldn’t use the token from one blockchain on another, as mentioned before. So you couldn’t use ETH for a bitcoin exchange on the Bitcoin platform, you couldn’t use BTC on the Binance Smart Chain, and so on and so forth. However, wrapped tokens solve that problem by acting as bridges between blockchain platforms.
You can think of a wrapped token as a tokenized representation of a cryptocurrency on a blockchain said crypto isn’t native to. Wrapped tokens are named thus because it’s like symbolically putting a crypto into a wrapper, a wrapper that is actually a digital vault that allows the minting of the wrapped token.
Wrapped tokens exist on the Ethereum blockchain, and they represent the same value as the actual value of the crypto they stand for. Ethereum’s wrapped tokens are based on the standard for the usual Ethereum tokens – the ERC-20 token standard. Wrapped tokens’ values can be pegged to the crypto they represent through smart contacts, or they can be backed by the crypto they represent at the ratio of 1:1, like stablecoins. Take WBTC, for example. WBTC, or Wrapped Bitcoin, represents Bitcoin on the Ethereum platform. An ERC-20 token, a WBTC holds the same value as an actual BTC. The protocol uses a smart contract algorithm to update WBTC’s price according to the real BTC’s price and maintain WBTC’s underlying fund and acquire the needed supply.
Wrapped Tokens vs. Smart Contracts:
Speaking of smart contracts, if you’re familiar with the world of crypto, you might realize that wrapped tokens sound a lot like stablecoins, both representing the values of another asset. The basic difference is this: while the price of a stablecoin can be tethered to a number of assets, including fiat currencies like the USD, other cryptocurrencies, and physical assets like precious metals, a wrapped token is only a symbol of a cryptocurrency on a non-native blockchain.
So, How Do Wrapped Tokens Work?
In a wrapped token’s working, there’s a number of organizational positions involved, as are algorithmic checks and balances. The mechanism behind the wrapped tokens ensures their trustless nature. dApps, or decentralized applications, are able to process wrapped token transactions quickly and effortlessly, for in this case they don’t have to be conducted across more than one blockchains.
As for the organizational positions, the working of wrapped tokens usually needs a custodian – an important position that holds an equivalent amount of the crypto tokens that the wrapped tokens represent, the same as the amount held up in the wrapped tokens. You can say the custodian is basically the wrapper and the unwrapper of the wrapped tokens. The position of a custodian can be held by anyone or anything – a merchant, a smart contract, a multisig wallet, or even a decentralized autonomous organization or a DAO. As for the governance of wrapped tokens, it’s usually handed in tandem by a number of custodians, who assume different roles and are handed the power to mint new wrapped tokens or burn existing ones as per necessity.
Again, let’s take WBTC for example, to demonstrate a wrapped token’s working. With WBTC, the custodian has in possession 1 BTC for every WBTC coin created. When a merchant needs a WBTC, they have to send a BTC to the custodian. Now the custodian generates a WBTC in exchange for that merchant.
On the flip side, if a WBTC needs to be burned and a merchant needs their BTC back, they would simply have to request the same of the custodian. The custodian would burn the WBTC accordingly and return the merchant’s BTC to them. Also, for Wrapped Bitcoin, the function of adding or removing custodians and merchants is done by a decentralized autonomous organization.
Why Are Wrapped Tokens Advantageous?
Wrapped tokens have many advantages, but here’s the primary ones rounded up:
- Wrapped tokens increase interoperability between blockchains and provide a simple way to conduct exchanges, like WBTC allows Bitcoin exchanges on the Ethereum chain.
- Since wrapped tokens can be used to put idle assets to use and also trade these new assets on a non-native blockchain, they create the scope for more liquidity and capital efficiency.
- Wrapped tokens can help traders avoid extra transaction fees on different blockchain platforms, thus they are also cost effective.