In this blog, we shall discuss another interesting topic in the crypto space called wrapped tokens. We shall understand their need, working principles, advantages, disadvantages, and how they help in the smooth functioning of the DeFi gizmos.
What is a Wrapped Token?
Wrapped tokens are crypto-assets whose value is pegged to another original cryptocurrency. It is similar to stable coins except for the fact that, unlike stable coins whose value is pegged to fiat assets like currencies and gold, its value is pegged to another cryptocurrency.
The original token is ‘locked’ in a digital vault and a wrapped version of that token is simultaneously minted on the desired blockchain.
Why are Wrapped Tokens necessary?
Each blockchain has its unique principles and governing mechanisms. Apart from this, they also have their unique native tokens. With earlier blockchains like that of Bitcoin and Ethereum, interoperability was a huge issue. The inability to use specific tokens in an ecosystem different from its original one was considered a big obstacle in creating a world of decentralized finance.
The introduction of wrapped tokens has solved this problem and made interoperability among blockchains very easy.
How does a Wrapped Token work?
The process of ‘wrapping’ a token starts with depositing the token in a digital vault. To avoid the issues of double spending and to strengthen the security of the process, a custodian comes into play.
A custodian can be a smart contract, a DAO, a multi-currency wallet, or a merchant who verifies that the user has enough original tokens required to generate the wrapped tokens. Once verified, the custodian mints the wrapped tokens and sends them to the user.
The process of converting a wrapped token into its original form is called ‘unwrapping. The users looking to convert their wrapped tokens send the custodian a burning request. Once the custodian accepts this request, the wrapped tokens are burned and the original tokens are released from the vault.
Advantages of using Wrapped Tokens
As mentioned above, wrapped tokens solve the interoperability issue that prevailed among the early blockchains. They act as a bridge between various blockchains thus creating a larger ecosystem than the individual blockchains. With the use of wrapped tokens, users can now use their tokens more efficiently by switching between blockchains that meet their demands. This also allows users to enjoy the benefits of all the blockchains while avoiding the shortcomings of each blockchain to a certain extent.
Limitations of Wrapped Tokens
Since users can’t directly do cross-blockchain transactions and hence they require to trust the custodian to store, wrap and unwrap their tokens. Further developments in making the process more decentralized are required.
Also, the high gas fee in the early blockchains makes it uneconomic to frequently wrap and unwrap tokens.
Though there are some limitations of using wrapped crypto tokens, regular development in this field convinces us of a more decentralized future. Also, the limitations of such tokens are very less when compared to their advantages and in no way should they discourage anyone from enjoying the benefits of wrapped tokens.