What are Wrapped Tokens? How do Wrapped Coins Work & their Importance

Wrapped tokens are digital assets that represent the value of another crypto, typically at a 1:1 ratio. Continue reading this article to find out how wrapped tokens work, their benefits, limitations and much more!

5 MAY 2023, 3 min read

While innovations and breakthroughs have become the norm in the crypto world, wrapped tokens have soared onto the scene as a game-changing solution for bridging the divide between various blockchains.

Picture this: a world where digital assets can effortlessly and securely move between networks, unlocking previously unattainable opportunities and connecting communities like never before. This article will explore the concept of wrapped tokens, how they work, their benefits and limitations, and their significance in the crypto ecosystem.

What are Wrapped Tokens?

Imagine a universal gift card you could use at any store, not just your favorite one. Wrapped tokens operate similarly within the crypto realm. They are digital assets representing the value of another crypto, typically pegged at a 1:1 ratio.

Their primary goal is to facilitate seamless interaction between various blockchain networks, empowering users to trade or utilize tokens from one network to another easily. In a nutshell, wrapped tokens function much like stablecoins, preserving their value in line with the original tokens worthwhile enabling cross-chain transactions and interactions.

How do Wrapped Tokens Work?

Creating wrapped tokens is like exchanging your gift voucher for another voucher of equal value, usable at a different store. This process involves a custodian or a smart contract that locks up the underlying asset, like Bitcoin or Ethereum and issues an equivalent number of wrapped tokens on the target blockchain.

These wrapped tokens can then be traded or used on the target blockchain network for various purposes, such as decentralized finance (DeFi) applications.

For example, Wrapped Bitcoin (WBTC) is a popular wrapped token representing Bitcoin on the Ethereum blockchain. Bitcoin holders can participate in Ethereum's DeFi ecosystem without converting their BTC into ETH.

Benefits of Using Wrapped Coins

Wrapped coins bring several advantages to the crypto ecosystem:

a. Interoperability: Wrapped tokens enable seamless interaction between different blockchain networks, allowing users to trade and use tokens from one network on another without the hassle of converting them on a centralized exchange.

b. Enhanced liquidity: By bridging the gap between various blockchains, wrapped coins contribute to increased liquidity in decentralized exchanges (DEXs) and DeFi platforms, leading to more efficient markets and better price discovery.

c. Access to DeFi opportunities: Wrapped tokens unlock new financial opportunities for holders of cryptos that may not be natively supported on a particular blockchain. For example, WBTC allows Bitcoin holders to participate in Ethereum's DeFi ecosystem and access various lending, borrowing, and yield farming opportunities.

d. Simplified asset management: Wrapped tokens can help users manage their crypto assets more efficiently by allowing them to hold, trade, and interact with multiple tokens on a single platform.

e. Improved privacy: Some wrapped tokens, like RenBTC, use decentralized and permissionless protocols that enhance privacy by not requiring users to reveal their identity or undergo a Know Your Customer (KYC) process.

Limitations of Using Wrapped Coins

Despite their benefits, wrapped tokens do come with a few drawbacks:

a. Centralization risks: In some cases, wrapped tokens rely on centralized custodians to hold the underlying assets, creating a single point of failure and potential security risks. However, decentralized protocols like Ren mitigate this risk by not relying on a single custodian.

b. Limited availability: Not every crypto is available as a wrapped coin, which could restrict users' choices and potential opportunities.

c. Additional fees: Converting assets to wrapped tokens may involve fees from intermediaries, custodians, or smart contracts, which can increase transaction costs. Users should compare different wrapped token solutions and their associated fees before deciding.

d. Complexity: The concept of wrapped coins and their underlying technology might be challenging for beginners to understand, which could create a barrier to entry for some users. However, as the crypto space matures, user-friendly tools and educational resources are becoming more accessible, making it easier for newcomers to grasp these concepts.

Bottomline

Wrapped coins revolutionize how cryptos and blockchain networks interact, creating a more interconnected and seamless ecosystem. They offer numerous benefits, including enhanced liquidity, access to DeFi opportunities, simplified asset management, and improved privacy. However, users should also know wrapped tokens' limitations and potential risks, such as centralization risks, limited availability, additional fees, and complexity.