Understanding Wrapped Tokens
A wrapped token is a cryptocurrency whose value is pegged to an underlying asset. The term “wrapped” is used as the original asset is encapsulated or “wrapped” in a digital vault, enabling a new version of the token to be generated on a different blockchain.
The concept of a wrapped token can be likened to that of a stablecoin, which is a type of cryptocurrency that maintains its value from another asset. While stablecoins are typically pegged to a fiat currency, wrapped tokens are most commonly tied to a cryptocurrency existing natively on another blockchain.
You could think of a wrapped token as being similar to a stablecoin in that it derives its value from another asset. In the case of a stablecoin, this is usually fiat currency, while in the case of wrapped tokens, it is often an asset that exists natively on another blockchain.
The Purpose of Wrapped Tokens
Every blockchain possesses unique functionality and specific capabilities. However, due to their distinct architectures, they are unable to directly interact or “communicate” with one another. For example, the Ethereum and Bitcoin blockchains operate on entirely separate networks. Wrapped tokens enable a bridge between different blockchains, enhancing interoperability by allowing assets to move across chains.
Greater interoperability between blockchains is a much-anticipated advancement, promising to introduce numerous new use cases for blockchain technology. These include customizable web3 services such as interoperable smart contracts, increased decentralization, and improved cross-industry collaboration.
The Role of Custodians in Token Wrapping
To wrap a token and distribute it on another blockchain, a custodian often needs to act as an intermediary. The custodian holds an amount of the asset equivalent to the wrapped amount, ensuring the value of the wrapped token. This role can be played by various entities such as a merchant, a DAO, a multi-signature wallet, or even a smart contract. For instance, to mint Wrapped XRP (WXRP) on another blockchain, the custodian must hold 1 XRP for each 1 WXRP created.
The Token Wrapping Process
The token wrapping process typically works as follows: a trader sends Bitcoin to the custodian, who then mints an equivalent amount of Wrapped Bitcoin (WBTC) on Ethereum. If WBTC needs to be exchanged back to Bitcoin, the wrapped tokens on Ethereum are requested to be burnt or destroyed. Once this burn is confirmed, the original tokens on the Bitcoin blockchain are released from the reserves to the owner’s address. Wrapped XRP, for instance, can be bought on SushiSwap and staked in a liquidity pool.
The views and opinions expressed by the author, or any people mentioned in this article, are for informational purposes only, and they do not constitute financial, investment or other advice. Investing in or trading crypto-assets comes with a risk of financial loss.