How do wrapped crypto tokens operate?

One of the most frustrating challenges people face in the crypto industry is the restriction they face in inter-blockchain transactions. Try as you might, sending a token from its native blockchain to another is virtually impossible. However, it can be done indirectly. You may wonder how, and the answer is Wrapped Crypto Tokens.

This article will fully explain wrapped tokens and how they help us to perform cross-chain transactions. What are some examples of wrapped crypto tokens, and how do they work? The inability to migrate crypto assets from the network is generic. We have all been there. We want to be able to host BTC on the Ethereum blockchain. Hold some Cardano on the Algorand network, etc.

While there has not been a direct way to do this just yet, there is a way to do this fairly seamlessly. That is the use of Wrapped tokens.

What are wrapped crypto tokens?
What are wrapped crypto tokens?

What are Wrapped crypto tokens?

Well, we cannot necessarily describe wrapped tokens as tools that can be used. They are more convenient for making it easy to trade cryptocurrencies on different blockchains. They are not real crypto, enabling you to use the cryptocurrencies on other blockchains. This is a better deal considering that normally you’d have to sell your crypto assets or convert them into a stable coin acceptable on the destination blockchain so that you can use it.

A Wrapped crypto token ties its value to a real cryptocurrency, just like stable coins are tied to the value of their corresponding fiat currency, e.g., USDT-pegged to the USD. The exception is Wrapped tokens do not derive value from the fiat USD. They are linked to the original coin they intend to use on a different blockchain. It acts as a stand-in cryptocurrency that is not loyal to any particular blockchain and, thus, can function on all of them.

When you use a wrapped token, you preserve the value of the original assets by storing them as reserves in a special digital vault. It is like how we use gold as a backup for certain fiat currencies. The difference is that this is temporary. So, for a while, you won’t be able to touch or use any of the original assets as long as the wrapped token is still in use.

However, this doesn’t mean the invested assets are lost. You can still unwrap the tokens. Although, you will need a special issue to be able to take the token out of the market and nullify it. When nullified, you recover the correct value of your original assets from the vault.

How do wrapped crypto tokens operate?

To trade a wrapped token, you must first create it. To create it, you need a secure third-party agent to act as custodian. The role of a custodian is to provide a form of escrow or a safe deposit for a certain amount of crypto asset to be used in the transaction.

What type of custodian do we need for transaction?

Your custodian must be one of the following.

  1. A wallet with multi-signatures (the signatures are required to access the contents of the wallet– it is extra security)
  2. A decentralized autonomous organization (otherwise known as a DAO)
  3. A DAO is an autonomous crowd-sourced investment organization acting like a venture capitalist firm that supplies funds to growing startups in exchange for a percentage stake in the assets.
  4. Smart contracts

A custodian receives the number of crypto assets you want to send to another crypto’s blockchain. So, if you want to send 1 BTC to an Ethereum-based platform, the custodian receives it and stores it. The definition of wrapping comes when the transferred BTC is stored in a digital vault. Subsequently, an equal amount of 1 wrapped BTC, or 1 wBTC, is minted on the Ethereum blockchain. Once the wBTC reaches the Ethereum blockchain, you can now use it for whatever transaction you need to do.

WBTC still holds the same value as the original BTC. As the value of the real BTC changes, so does the price of wBTC. This means if the value of the original BTC grows from $19,000 to $20,000, the wBTC will be valued at $20,000 per token. A smart contract algorithm tracks the market price and regulates it on the transaction.

If you want to exchange wBTC for BTC, you must unwrap it. To do this, you must first send a request to the custodian that will destroy the WBTC and unlock the BTC from where it is safely solved. The transaction is stored on the blockchain. Wrapping and unwrapping a token attracts a gas fee which may vary depending on the blockchain you are working with.

The Ethereum blockchain has characteristically high transaction fee deductions. The two main blockchains that apply Wrapped tokens are the Ethereum and Binance smart chain. These leading blockchains enable Blockchain bridges for interaction between two or more blockchains.

Check out our last article on Blockchain bridges to learn more about them. Wrapped Tokens can work with either the BSC or the Ethereum blockchain. You can use the wrapped tokens to replace non-native BSC or Ethereum assets. The wrapped tokens are created according to the standard of Ethereum, usually ERC-20. They are wrapped in wETH. For the BSC, the Binance bridge allows crypto like BTC, ETH, and USDT, among others, to be wrapped into BEP-20 network tokens. You can check out ethereum merge price prediction 

Examples of things you can do with the wrap tokens include buying and selling or yield farming. Yield farming is where you lend out your funds and earn a percentage from the transaction fees of other traders. On the Ethereum network, you need the regular ETH, which must first be converted into the ERC-20 standard ETH token. Your ETH must become wETH, a tokenized form of Ether.

What are the advantages of using wrapped crypto tokens?

The key advantage of wrapped tokens is the leverage it gives above that all blockchains use different standards and thus cannot communicate with one another. You can see these in the following ways:

  1. You can use the wrapped crypto tokens on a blockchain without having to generate them externally.
  2. Wrapped crypto tokens promotes network growth.
  3. It increases liquidity
  4. The use of wrapped crypto tokens increases capital efficiency
  5. It helps to put your unused assets to work
  6. Wrapped crypto tokens bridges the gap between different blockchains
  7. It allows more assets to be traded and exchanged in transactions
  8. It saves costs
  9. It increases the speed of transactions

What are the disadvantages of using wrapped crypto tokens?

As you have guessed, whatever has a good side must have a bad side, even if it is not so bad. Wrapped tokens are not without their own challenges. Use or wrapped tokens doesn’t exactly mean that you achieved a true block-to-block migration. This is because you still have to tokenize the original assets first. You must involve a third-party agent or custodian to help store your assets for them to work.

Your interaction with a third-party wallet or DAO will attract its own transaction fees, which are extra costs from the sending wallet. The transaction will fail if you do not have extra crypto assets to pay the GAS fee. Worst case scenario, you reduce the number of tokens you want to send to another chain, e.g., 1 BTC, to 0.998 BTC after removing transaction fees.

Wrapped tokens might not be a way to directly perform blockchain-to-blockchain transactions, but they are now the best alternatives. Are there other blockchains you would like to be able to perform cross-chain transactions with? Drop a comment down. Thanks for reading.

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