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Nov 24, 2020

16 min

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16 min

What Are Wrapped Tokens

wrapped tokens cover

A wrapped token is an asset hosted on the Ethereum blockchain whose price is identical to another underlying asset even if it’s not on the same blockchain or not in a blockchain at all. The wrapped token is either backed directly with the underlying asset or through the use of smart contracts. Wrapped tokens adhere to a centralized system; however, they do not depend on a single institution but prefer different entities to perform diversified roles.

Wrapped tokens are a form of stablecoins since assets back them; however, they provide a way for various institutions in the crypto space to overcome the issues faced by the current implementation of stablecoins, especially the challenge of centralization.

Wrapped tokens are paving the way for a new generation of stablecoins that can utilize Ethereum in a more trustful way geared towards achieving reduced transaction fees, global liquidity, as well as smart contract programmability. The massive adoption of the ERC20 is mainly responsible for the massive emergence of the wrapped tokens.


How do Wrapped Tokens Work?

ERC20 is the preferred blockchain technology for DeFi or Decentralized Finance. If you are looking to use DeFi applications using your Bitcoin, you need a bridge to connect Bitcoin and Ethereum; this is where wrapped tokens come in to offer the much-needed liquidity to DeFi protocols.

DApps can process wrapped token transactions much faster compared to the speed of using different blockchains. The users can be confident in their transactions because of the wrapped tokens’ trustless nature preserved by the framework backing each token of the underlying assets.

Governance of the wrapped tokens is carried out by assigning different institutions vital roles; these institutions include the custodian, the user, and the merchant, whose different functions. 


The Custodian

The custodian is the institution that holds the asset as well as the keys to mint tokens. BitGo is the custodian for the wrapped Bitcoin (WBTC) 


The Merchant

The merchant is the institution where the wrapped tokens are minted to and burnt from. The distribution of the wrapped tokens is also a vital role for the merchants. Each merchant holds the key to initiate new wrapped tokens and the burning of wrapped tokens. The merchant in WBTC is the Kyber network and the Republic protocol.


The User

The users are the holders of the wrapped tokens. The wrapped tokens can be used like any other ERC20 token in the Ethereum blockchain; the user can transact with the token or transfer them to another token.

For example, when you wrap ETH, you will be trading it against a smart contract for an equal token of WETH; if you need your plain ETH back, you unwrap the WETH by selling it back for plain ETH. The two tokens are always exchanged at a ratio of 1:1.


Wrapped Token Distribution

Custodians exchange wrapped tokens assets with merchants through minting and burning transactions. These transactions are publicly available through the block explorer. Minting is creating new wrapped tokens; minting is done by the custodian but must be initiated by the merchant. Burning, on the other hand, is the process of reducing the supply of wrapped tokens. Only merchants can burn tokens; by burning wrapped tokens, the amount is deducted from the merchants’ balance, and thus the token supply is reduced.

After the initial exchange, the merchants aim to maintain a cushion of wrapped tokens exchanged with the users. Minting and burning wrapped tokens is time consuming; this cushion helps reduce the time it takes for users to get wrapped tokens.


Wrapped Framework Trust Model

Custodians in the wrapped token space take up the role of the trusted intermediaries to some extent. Assets could be stolen or might fail to honor the one on one backing; the wrapped framework works to minimize this trust issue through the following ways:

  • Quarterly audits are audits conducted by a third party to verify that the minted wrapped tokens have an equal amount of assets stored among the custodians.
  • Minting of tokens involves both the merchant and the custodians- custodians cannot mint tokens independently; the process requires the merchant’s initiation, ensuring that the supply is kept in check.
  • The credibility of all institutions involved in the framework is at stake; therefore, every institution involved is careful about its actions.
  • A set of merchant institutions insulates the user from interaction with the custodian-an individual merchant does not need to be trusted, but all merchants need to be trusted.


Types of Wrapped Tokens

Wrapped tokens are mostly supported by other blockchains but are also recognized as stablecoins pegged to the dollar. The first wrapped tokens were fiat-backed stablecoins, often supported by the Ethereum platform since it is the most significant DeFi ecosystem. Stablecoins such as TrueUSD, USDC, and USDT are pegged to the US dollar. Other fiat currencies that back stablecoins include the Yen, Euro, and Yuan.

The digital assets are backed accordingly through the reserves, and the coins are fed in depending on online crypto exchanges and more prominent institutional investors. The market players are interested in quickly exchanging their money to crypto and manage their assets within a particular platform; this makes it easy to deposit fiat currency into dApps and blockchain wallets. This helps protect traders from crypto asset volatility.

Zcash is a crypto that can be transacted entirely anonymously. Zcash has created a wrapped token that will offer the anonymity benefits of Zcash to the dApp users. The wrapped token has built a two-way bridge that will benefit both Zcash users and Ethereum users.

After the Zcash wrapped token, other cryptos are also launching their versions of wrapped tokens. There now is wrapped Bitcoin as well as wrapped Ether tokens.


Wrapped Bitcoin (WBTC)

Wrapped Bitcoin is a relatively recent innovation that brings Bitcoin to the Ethereum blockchain. WBTC is an ERC20 token on Ethereum backed by Bitcoin in the ratio 1:1. Wrapped Bitcoin allows its users to explore other blockchains without selling their Bitcoin to buy another crypto. When you wrap Bitcoin, the cryptocurrency is held in reserve by BitGo Trust. WBTC DAO oversees the whole WBTC project, i.e., wrapped Bitcoin Decentralized Autonomous Organization.

Other stablecoins struggle with transparency issues; to overcome this issue, the amount of WBTC in circulation has been made public. Since the wrapped Bitcoin launch, DeFi protocols such as Kyber Network, Compound Dharma, and MakerDao allow borrowers to use WBTC as collateral. Using a smart contract, the crypto loan is then paid out using DAI stablecoin. WBTC can be unwrapped and wrapped in wallets such as those in CoinList.


Wrapped Ether (WETH)

Wrapped Ether is the ERC20 compatible version of Ether. Ether backs the WETH in the ratio of 1:1 created by sending Ether to a smart contract so that the Ether is placed on hold. If need be, the same WETH can be sent back to the smart contract to be unwrapped, i.e., to be redeemed back to the original Ether at the same ratio of 1:1. 

Ether is the native currency in the Ethereum blockchain created before the ERC20 protocol. It then means that Ether is not compatible with other ERC20 tokens. It cannot be exchanged directly with other ERC20 tokens without the need for a third party or additional technical implementation. Therefore, to avoid these complexities of implementing two interfaces for both tokens involved, it is easier to wrap the Ether and make it compatible with the ERC20 token.

Wrapping Ether allows seamless user transactions with ERC20 tokens, eliminating the risk of unexpected errors during the transaction. Ethereum based dApps require their users to convert their Ether into WETH because of the additional functionality provided by the WETH, such as direct and decentralized peer to peer transactions between the WETH and the ERC20 tokens. 


Wrapped Zcash

Zcash is a decentralized peer-to-peer cryptocurrency created as a fork of Bitcoin with a hard limit of 21 million coins. Despite forking from Bitcoin, Zcash has a few differences from the world’s largest cryptocurrency. Unlike Bitcoin, which is all about transparency, Zcash offers complete privacy and anonymity to its users. Zcash allows the user to choose between the private shielded transaction or the typical transparent kind of transaction. If both users opt for a private transaction, their identities and transaction details would be confidential.

Wrapped Zcash provides a way for Zcash to be used for the financial applications built on the Ethereum blockchain. Wrapped Zcash builds a bridge between the Ethereum and Zcash ecosystems; this benefits both Ethereum and Zcash users. The Ethereum users get the privacy benefits provided by Zcash, providing new ways for DeFi applications limiting the publication of identifying information and still pass the auditory and compliance standards.


Design Models of Wrapped Tokens

Wrapped tokens’ designs are broadly classified into two: algorithmic and centralized models.


Algorithmic Model

In this model, the wrapped tokens’ demand and supply are controlled by a set of Ethereum smart contracts. The smart contracts help keep the token price in line with the value of the fiat currency. An example of an algorithmic stablecoin includes the DAI token from the MakerDAO, whose value is tied to the USD.


The Centralized Model

In this design model, all assets are stored with a custodian organization responsible for regularly publishing proof of reserves. Tokens with the centralized design model include TrueUSD and Tether. 


Use Cases of Wrapped Tokens

Wrapped tokens have a wide application in the crypto space; here are some ways wrapped tokens can be applied.

  • Fiat backed stablecoins provide a safer way for investors to invest in cryptocurrency without the worry of price fluctuation. The tokenization of assets enables policies to be enforced on-chain, making the rules more transparent and not being manipulated as enforcement does not rely on a single party.
  • Increase the transaction speed- Ethereum’s blocks are created in approximately 15 seconds, which is faster than the transaction of any other assets, including Bitcoin, gold, 
  • Improved transparency- All the transaction details, number of tokens, number of token holders, and the rules of transfer can all be viewed on the public block explorer.
  • Boost usability- Many institutions and products have adopted the ERC20 standard. The users have various dApps, exchanges, and wallets they can use when handling their tokenized assets.
  • Improved security- Tokenization enables users to control the assets’ private keys fully; the users can also move the keys from the exchanges to a secure custodian if they so wish.

The wrapped framework enables any cryptocurrency to be represented on the Ethereum blockchain, therefore allowing the different cryptocurrencies to harness the capabilities of Ethereum.


Where to Buy Wrapped Tokens

Different wrapped tokens have different official merchants from whom you can buy the wrapped token. If you are looking to buy WBTC, you can do so by purchasing WBTC on any supported exchange, such as the Kyber network and Uniswap. You can buy your wrapped ETH in most of the exchanges; however, most cryptocurrency exchanges will require that you have ETH or Bitcoin to trade with.

However, at Coinbase, you don’t need to have Bitcoin or Ether for you to get the wrapped tokens. You can use your credit card or bank account to buy the cryptocurrency at Coinbase. Once you have Ether, you can quickly wrap it to get WETH, and when you have your Bitcoin, you can quickly obtain your WBTC.


Conclusion

Wrapped token design developers can extend an existing cryptocurrency capability by tapping into the other platforms’ advantages. The crypto industry involves a series of systems operating alongside each other using the same technology but walled separately. Blockchain interoperable can share information across different blockchain networks without restrictions; wrapped tokens have provided this, seeing that Bitcoin can now use the Ethereum blockchain via wrapped BTC.

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