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What are Wrapped Tokens and How do they Work?

Introduction

One of the largest limitations of blockchain technology is the lack of interoperability between blockchains. Your interaction with the blockchain your tokens are on is limited to the applications available on that blockchain, Wrapped tokens unlock the potential of other blockchains. 

With the exponential growth of the DeFi sector, having this ability is huge!

What are Wrapped tokens?

Wrapped tokens represent the unwrapped, original version of that token but allow it to be used on a different blockchain. In this article, we will use “Davecoin (DAVE)”* as the example but there are many other types of wrapped tokens and more coming all of the time, especially as new DeFi products are launched.

As a blockchain grows, so does the number of people wanting to use it. If “Dave” has a stack of Davecoin (on the Davechain) but likes a DeFi project on the Cardano blockchain, without a wrapped version of his Bitcoin, he can’t use it.

*Davecoin, Davechain and Dave are all fictional and are used for illustration purposes only!

This is where wrapped tokens come in!

A wrapped token is pegged to the value of another token on a different blockchain, much in the same way that a stablecoin is pegged to the value of a fiat currency (e.g. USDC to the US Dollar).

If you consider a blockchain to be an ecosystem that works in with a particular set of parameters, like language for example. Only those tokens that are compatible will work in that ecosystem, all others just won’t work. 

In the same way, apps for an Android phone won’t work on an iPhone (and vice versa). There needs to be an iPhone version of the app for users to make use of it.

Wrapped tokens allow interoperability between blockchains, maybe in the future, we won’t need to wrap tokens but as it stands not, this is our only choice.

How do Wrapped Tokens Work?

Let’s return to Dave.

Dave has found a DeFi project on the Steve blockchain (also a fictional blockchain) that he wants to use. As we now know, the Dave and Steve blockchains are not compatible but Dave can wrap his Davecoins, this will allow him to use the value of his Davecoins on the Steve blockchain.

So how does it work?

Wrapped tokens require a custodian. The custodian can be a merchant, a multi-sig wallet, a DAO or a smart contract. The custodian holds the wrapped version of your token. 

Custodians are referred to as “Bridges”, in that they create a bridge between two blockchains.

In our example, the custodian holds the wrapped Davecoins (WDAVE) in a 1:1 ratio with DAVE (for each 1 WDAVE, the custodian must hold 1 DAVE token), this is known as the reserve and proof of this exists on the blockchain. WDAVE are a version of DAVE that are compatible with the Steve Blockchain.

That’s great, but how does Dave get his hands on WDAVE?

So, Dave sends his DAVE tokens to the custodian, the custodian then mints (creates) an equal amount of WDAVE on Stevechain.

Dave can now use his newly minted WDAVE to interact with the DeFi project he had his eyes on.

If Dave wants to “unwrap” his WDAVE (and have DAVE back on the Davechain), the custodian burns the WDAVE and releases the equivalent amount of DAVE.

Why do we Need Wrapped Tokens?

Wrapped tokens are needed for interoperability between blockchains.

What are the Benefits of Wrapped Tokens?

Interoperability

As we have already mentioned, the main benefit of wrapped tokens is interoperability between blockchains. As DeFi becomes more commonplace there is an ever-increasing number of dApps. In order for people to use dApps on other blockchains, they can use wrapped tokens to interact with them.

Increased Liquidity

Wrapped tokens can be used to increase liquidity on decentralised and centralised exchanges on other blockchains. For instance, wrapping idle tokens on one blockchain for use on another will allow greater liquidity. E.g. wrapped bitcoin (anetaBTC being used on Cardano).

Reduced Transaction Times and Fees

Some blockchains work faster and have lower fees than others, this is a very desirable quality. Wrapping tokens can unlock these benefits for token holders from slower or more costly blockchains.

It is well documented that fees on Ethereum can be very high and Bitcoin isn’t the fastest. Wrapping your ETH or BTC on Cardano allows you to keep the value of your tokens but benefit from the low fees and faster transaction times.

Are there any Limitations to Wrapped Tokens?

The main limitation of using wrapped tokens revolves around having to use a custodian (or bridge), the fees to wrap tokens and to some extent slippage.

Are Bridges Safe?

In order to work, bridges (custodians) are required to have a very large amount of crypto locked up in them, this makes them a very attractive target for thieves/hackers.

In fact, the majority of large crypto thefts have been made from these types of bridges (the Ronin and Wormhole bridges were attacked for $615million and $325million respectively).

This is scary but there are better, decentralised and trustless options coming out on other blockchains (including Cardano) that will directly address this huge security issue.

Final Thoughts.

Having the ability to use one token on another blockchain is a huge step forward and will allow a much more holistic use of your crypto. However, this does have its risks that you are now aware of.

As time goes on though, the technology will enable you to reduce the risk by using blockchains where the security is much tighter. Please, always do your own research into any project you are considering using.

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