If the phrases ‘wrapped Bitcoin’ or wrapped tokens’ have you intrigued, you’ve come to the right place. This article aims to shed light on what wrapped tokens are, their different types, how they work and what they mean to us as investors.
Let’s look at Bitcoin and Ethereum. These are two different blockchains that have protocols, functionalities, and algorithms that are unique to them. Now while these distinctions are responsible for the individual sovereignty and security of their respective blockchains, it also means that these blockchains cannot talk to each other. This inability further challenges the presence of an interoperable ecosystem where the exchange of information and data could be seamless.
This need for an elegant solution to permit communication between early blockchain networks led to the creation of wrapped tokens.
What is Wrapped Crypto Coins
Wrapped crypto tokens are cryptocurrencies pegged to the value of an original crypto asset or assets such as gold, real estate, stocks, and more.
A newly minted token is created by ‘wrapping’ the original asset into a digital vault. With the help of wrapped token, non-native assets can be used on any blockchain and build interoperability in the crypto space by building bridges between networks. They can stand in for anything, including fiat money, real estate, equity, commodities, arts and collectibles, and crypto assets. Wrapped tokens must be treated and handled by a custodian organisation that will wrap and unwrap the asset.
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wBTC, or wrapped Bitcoin was the first case of a wrapped token being used on the Ethereum blockchain via smart contracts. In addition to Bitcoin, wrapped tokens are other assets that are mainly compliant with Ethereum ERC-20 and Binance Smart Chain BEP-20. Additionally, in a curious twist of tale, ETH is not compliant with ERC-20 tokens even though they are issued on Ethereum as it was developed before them. As a result, akin to Bitcoin, Ethereum needs to be wrapped to be compliant with ERC-20 standards.
Types of Wrapped Coins
Despite major differences from the more seasoned wrapped coins, it is generally accepted that stablecoins were the first class of wrapped tokens. A stablecoin like USDT (Tether), for instance, is backed by roughly $1. However, Tether does not maintain an exact equal in actual dollars for each USDT it issues; instead, it holds a variety of assets, including cash and cash equivalents as well as investments and receivables from loans.
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Wrapped coins are of two types: cash-settled and redeemable. Tokens in the cash-settled category cannot be exchanged for the underlying asset. Redeemable tokens, on the other hand, let investors trade the wrapped token for the underlying asset. Wrapped tokens are hosted by other blockchains. The Monero or ZCash blockchains, for instance, host wrapped privacy coins.
How do Wrapped Tokens Work?
Merchants and exchanges such as Airswap, 0x, AAVE, or Maker can request a custodian to mint wrapped tokens on a blockchain such as Ethereum in the amount of the original tokens they send to the said custodian. Similarly, they can request a custodian to release tokens or assets from reserve when the wrapped token needs to be converted back to the original asset.
An argument can be made against the presence of a custodian organisation which involves trust in a decentralised trustless blockchain ecosystem. Since traders can’t independently issue and use wrapped tokens across blockchains, custodians become a necessary stakeholder. Although with evolving technology, we can look to more decentralised options in the near future.
Wrapped Bitcoin (WBTC)
With the aim of bringing the Bitcoin potential and liquidity to the Ethereum network along with the flexibility of an ERC-20 token, the first wBTC protocol was launched in 2019.
Bitcoin in its original form cannot be used for DeFi transactions. A wrapped BTC however, can replace the original asset and enable transactions with the DeFi ecosystem or any other decentralised app on the Ethereum network.
By simply connecting their wallet to a decentralised platform, a BTC holder can lend Bitcoin using smart contracts and receive a predetermined interest rate every year. Borrowers may also utilise their cryptocurrency as collateral, which automatically belongs to the lender in the event of default.
With improved functionalities and an increase in the possible use cases, all of this while maintaining its value to the original Bitcoin, wBTC becomes a significant addition to the crypto ecosystem.
How do Wrapped Bitcoin Tokens Work?
There are three stakeholders in the creation and management of wrapped Bitcoin tokens and its protocol:
- 17 member organisations from the DeFi space make up a DAO and hold a multi-signature contract to add or remove wBTC merchants and custodians.
- The merchants are administrators who trigger the minting process by sending a certain amount of BTC to the custodian and requesting the minting of the equivalent amount in wrapped tokens, according to the demands of their investors and traders.
- The custodians are vault-like entities that provide reliability and security to wBTC by ensuring that all wBTC are fully backed and verified. They mint BTC and send the equivalent amount of wBTC (one to one pegged to the value of BTC) back to the merchant.
- Simply put, merchants transfer BTC to the custodian address who then mint and send back an equal amount of wBTC. Inversely, when merchants want their assets back, the wBTC is burned, and the locked BTC is released back to the merchant. The minting and burning of a token is verifiable on the blockchain.
- The development of DeFi, now worth billions of dollars and used in loans, options, derivatives, and other financial applications, created the demand for such a token.
Is Wrapped BTC Safe?
A Bitcoin token that has been wrapped is secure from a technological standpoint. The security of the associated network will be held once it is transformed into an ERC-20 or BEP-20 token, which will most likely be in custody on secure platforms like Ethereum or Binance Smart Chain.
The necessity of having faith in the custodian who retains the underlying asset is one of the major drawbacks of wrapped BTC tokens. The owners of the wBTC would be left holding an useless asset if the custodian unlocked and released the real Bitcoin to someone else. Users must ensure that custodian organisations are at least backed up by guarantees and insurances in case something goes wrong.
Are Wrapped Coins a Good Investment?
In the cryptocurrency era, where decentralised finance will unquestionably play a key part, wrapped tokens are becoming more and more considered as a wise investment. The industry’s current capitalization can be inferred from the approximately $800 million worth of Bitcoin that was converted into wBTC in a little more than a year.
Wrapped tokens enable the movement of assets across various chains that would otherwise remain isolated, increasing liquidity and capital efficiency for both centralised and decentralised exchanges.
Summing up, wrapped tokens and wBTC are an evolutionary step towards a more decentralised yet connected ecosystem. In addition to increasing interoperability across networks, advantages such as quick transactions and lower fees along with fractional ownership offered by wrapped tokens is beneficial for slower blockchains such as Bitcoin and Ethereum.