Lesson 12 of 20
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12. What are wrapped tokens 

Wrapped tokens allow cryptocurrencies to be used on a different blockchain than the one on which they were originally built. They are backed 1:1 by the underlying asset and ideally solve the problem of blockchain interoperability. 

What are wrap tokens? 

They are digital assets that allow the value of native assets to be transferred from one blockchain, to another. For example – Bitcoin and Ethereum are two separate, distributed databases. The blockchains on which these two cryptocurrencies are based are unable to connect to each other. You cannot use Bitcoin directly on the  Ethereum blockchain, because only the Bitcoin blockchain “knows” that you own  BTC. And vice versa. In this case, we can use wrapped tokens, which will effectively solve our problem. We will move BTC onto the Ethereum blockchain and be able to use it across the cryptocurrency system. 

This type of token is often compared to stablecoins. The most popular wrap token is wrap Bitcoin (wBTC). wBTC is pegged to the price of Bitcoin at a 1:1 ratio; however,  it is available as an ERC-20 or TRC-20 token, so we can successfully use and trade it on the Ethereum and Tron blockchain. 

Operation of wrap-around tokens 

This type of token is created and destroyed in a process called “beating” and  “burning”. To create wBTC, the underlying asset, in this case, Bitcoin is sent to a  depositary and stored in a digital vault. Once the BTC is locked in there, a  corresponding amount of wBTC can be minted. Simply put, imagine that the underlying asset is wrapped by a smart contract and minted as a new asset for use on another blockchain. 

To take wBTC out of circulation, the reverse process is used. The wrapped token is burned, and an equal amount of BTC is released from the digital vault and allowed to circulate. So you see that all wrap tokens are backed by an equivalent amount of base currency. For every 100 wBTC that is minted, there is 100 BTC that secures the value of the wrapped token. 

Liability for wrapped tokens 

The constancy of token value is explained by a combination of two factors: 

∙ The presence of a custodian holding the exact amount corresponding to the  number of wrapped tokens put into circulation 

∙ A procedure for firing the packaged token to recover its initial stock at any time The custodian can come in several forms, including a smart contract, a wallet or a  DAO (Decentralized Autonomous Organization). 

Examples

1. wBTC – wrapped BTC so we can use it on the Ethereum blockchain.  Supported by the wBTC DAO. 

2. wETH – a wrapped ETH, an ERC-20 version of Ethereum, which can be used  as an asset in DeFi protocols. 

3. renDOGE – a wrapped Dogecoin that can be minted using RenBridge on the  RenVM protocol 

Advantages of wrap tokens 

They provide interoperability between blockchains, so we can easily transfer our assets and use features available on other blockchains. What are the benefits?  Faster transaction times, lower fees or even the ability to receive rewards in exchange for sharing your assets. 

At this point, it is also worth noting that as the number of wrap tokens increases, the number of blockchain bridges increases. That is, a solution that also enables the transfer of digital assets between blockchains. And as we know from our previous lessons, this comes with the risk of hacks and hacking attacks. 

Threats of wrap tokens 

Blockchain interoperability has its drawbacks. The main risk associated with wrapped tokens is based on the presence of a trusted third party. Indeed, to ensure the implementation of wrapped tokens, the trustee is required to store the exact equivalent in the native token. 

If 100 wBTC is made available to users on the Solana blockchain, then the custodian must store 100 BTC in its vault. 

The well-being of this process depends on the stability of the custodian so that it can live up to the trust that users place in it. Like any solution, bridges are not immune to the risk of hacking. This is exactly what happened in the case of the space-time tunnel. An attacker exploited a vulnerability in the issuance of contracts to empty their substance – and thus their value – into the ETH present on the Solana blockchain, as they seized their ETH equivalence in the bridge offered by the space-time tunnel. 

Summary 

You already know what wrap tokens are and how they work. In the crypto world, you will also find them under the name of wrapped tokens. They make trading digital assets possible on a much larger scale. They answer some problems for which answers have not yet been found. In particular, we could mention scalability and increased transaction costs due to network congestion. 

However, their use is not without risk and we can hope for a better decentralization of the mechanism in the future to reduce the risk of failure of the native token custodian.

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