What is a wrapped token? Guide into wrapped crypto
Wrapped crypto was the next logical step in the quickly evolving world of decentralised finance (DeFi) and decentralised applications (DApps). Wrapped tokens enable cryptocurrencies such as bitcoin (BTC) to be used on non-native blockchains such as Ethereum without the need for constant exchange, vastly increasing the liquidity and user base of DeFi applications.
As DeFi becomes more widespread and increasingly critical for online commercial activities, token wrapping has become an essential aspect, allowing for holders of various tokens to interact.
So, what are wrapped tokens? Wrapped cryptocurrencies are remarkably similar to stablecoins in that their value is pegged to another asset. The key difference is that wrapped crypto tokens are pegged to the value of an existing cryptocurrency while stablecoins are typically pegged to a fiat currency such as the US dollar or a tangible asset like gold.
How do wrapped tokens work?
The process involved in minting wrapped crypto tokens and stablecoins is in many ways the same from a technical standpoint.
As we’ve explained, wrapped tokens are pegged to the value of another cryptocurrency and the value of the wrapped token will move with the value of the original crypto.
After ‘locking’ the original crypto assets in a secure digital vault through the issuance of a smart contract (which is typically a contract for a 1:1 exchange) the user is issued a corresponding ERC-20 token (a standard used for creating and issuing smart contracts on the Ethereum blockchain).
If the user wants to return to their original asset they simply trade their wrapped tokens back to the smart contract and exit with the corresponding value of the original crypto.
The first wrapped crypto was developed for ether, the native currency of Ethereum, which was created prior to the emergence of the ERC-20 standard. As ether was created before ERC-20 it was not compatible with other ERC-20 tokens. Due to this lack of interoperability, wrapped Ether (wETH) was created within the ERC-20 framework to allow users of ether to interact with other ERC-20 tokens.
The ERC-20 protocol is now the most widely used on the Ethereum network and coins issued within its framework possess all the required functionality to execute smart contracts and can also interact with all other tokens that follow the ERC-20 protocol.
Due to the huge number of potential applications for ERC-20 tokens, other non-native wrapped cryptos such as wrapped Bitcoin (wBTC) have been created.
The Ethereum network remains the largest destination for wrapped cryptocurrencies, although you can also wrap a long list of cryptos on the Binance Smart Chain through the issuance of BEP-20 tokens – a token standard of the Binance Smart Chain, whose architecture is similar to the Ethereum’s ERC-20 token.
Wrapped tokens explained
The best way to explain a wrapped token is through a real-life example. Bitcoin, the original and most widely held crypto, is still by far the largest, with a market capitalisation of more than $1.12trn as of 8 November 2021, according to CoinMarketCap.
While it is the original crypto, BTC was designed to function primarily as an alternative to fiat currency in that it is a store of value and can be exchanged for goods and services or transferred between parties.
However it lacks the functionality of other tokens such as those based on the Ethereum blockchain, which is where wrapping comes in.
In a similar way to wETH, wBTC is a token based on the Ethereum network and follows the most commonly used ERC-20 protocols. This means it can interact with any other token that also follows the ERC-20 protocol.
People who want to use functions on the Ethereum network such as placing insurance, executing smart contracts or extending liquidity place their BTC in a secure digital vault and are credited with the corresponding value in wBTC.
So wBTC provides interoperability with all other ERC-20 tokens without needing to exchange BTC itself for multiple tokens. While the list of wrapped cryptos is long, wBTC remains the largest, with a market cap of more than $15.4bn at the time of writing, according to CoinMarketCap.
Benefits of wrapped tokens
DeFi and corresponding dApps are continuously evolving to include potential new markets for users. As of the time of writing BTC is not compatible with the ERC-20 network other than through wrapped tokens.
To highlight some of the main benefits to wrapped crypto, we’ve taken wBTC as an example:
Liquidity. wBTC brings the huge market cap liquidity potential of BTC to the ERC-20 environment. The ability to wrap assets and use them on another chain enables a smooth connectivity between otherwise isolated liquidity.
Income generation. wBTC users can earn passive income through activities such as staking and yield farming that are not supported by the original BTC blockchain. Staking involves locking funds in a smart contract until the contract is executed in exchange for a share of the reward, while yield farming is essentially the issuance of short-term credit in exchange for interest.
DApps and interoperability. The BTC blockchain does not have the ability to run smart-contract protocols and must be exchanged for other tokens. Ethereum is compatible with most dApps. Interoperability, the ability to exchange value with other tokens, is possible with all other ERC-20 tokens when using wBTC.
Transaction speed. Bitcoin is slower than Ethereum. Normally, it processes 3-5 transactions per second, while Ethereum processes 10-15 transactions. Wrapped tokens allow users to benefit from the consistently faster transaction speeds without exchanging assets.
Limitations of wrapped tokens
The majority of wrapped tokens today require a custodian – a third-party holding an equivalent amount of the asset as the wrapped amount. It can be represented by a merchant, a Decentralised Autonomous Organisation (DAO) or a ‘multisig’ wallet (a crypto wallet shared by two or more users that requires several private keys to sign and send a transaction).
The process of creating a wBTC is known as minting. Minting is initiated by a merchant and performed by a custodian. In the case of wBTC, the custodian needs to hold one BTC for each wBTC minted – think of it as a wrapper or unwrapper.
However, there is a risk of centralisation, as wrapped tokens are dependent on the issuing platform. As wrapping can’t be performed automatically by a smart contract, it might increase the risk of manipulation and undermine the principle of decentralisation.
Back in May 2020, Vitalik Buterin, the creator of Ethereum, shared his concerns over the centralised nature of wrapped tokens on Twitter:
The minting process can also be costly, as it requires gas fees.
The future of wrapped tokens
As the world increasingly embraces DeFi applications, with a Total Value Locked (TLV) of $105.69bn as of 8 November 2021, the future of crypto in general is one of increasing acceptance by mainstream finance, with increased functionality and interoperability between currencies.
With the help of wrapping, traders can exchange non-native tokens through wrapped cryptos without paying high exchange fees. Users can benefit from the superior DeFi functionality of networks such as Ethereum while holding larger market-cap assets such as BTC. However, it might be a temporary solution.
Wrapped tokens are pegged to the value of the original asset and experience the same potential volatility as the underlying crypto asset. If you are looking to use crypto as a store of wealth with the potential to increase in value, traditional cryptocurrencies might be a better fit.
Before investing in any asset, always do your own research and remember that your decision should be based on your attitude to risk, your expertise in this market, the spread of your portfolio and how comfortable you feel about losing money. Never invest more than you can afford to lose and keep in mind that past performance is no guarantee of future returns.
If you are conducting frequent transactions and are interested in the potential of DeFi, wrapped crypto may serve as an alternative. Your individual requirements and risk preference should guide your decision-making.
The difference between stocks and CFDs
The main difference between CFD trading and stock trading is that you don’t own the underlying stock when you trade on an individual stock CFD.
With CFDs, you never actually buy or sell the underlying asset that you’ve chosen to trade. You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional stock trading you enter a contract to exchange the legal ownership of the individual shares for money, and you own this equity.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional stock trading, you buy the shares for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks.
CFDs attract overnight costs to hold the trades, (unless you use 1-1 leverage) which makes them more suited to short-term trading opportunities. Stocks are more normally bought and held for longer. You might also pay a stockbroker commission or fees when buying and selling stocks.