Wrapped coins allow interoperability between different ledgers. Before DeFi, BTC users didn’t need to migrate coins from the Bitcoin network to the Ethereum network. But once the DeFi sector arrived with innovative features for (decentralized applications) the demand for emerging currencies in the Ethereum network skyrocketed.
This meant that BTC whales didn’t have a chance to interact with a red hot market that offered some of the biggest features of today’s DeFi sector, like on-chain governance systems, atomic swaps, flash loans, yield farming, etc. The only way to do so was to sell their coins and then buy Ether, but this didn’t make sense as a massive sell-off would plunge BTC’s price.
The lack of interoperability between different blockchains has been a frustrating problem for many in the crypto community. This is how wrapping tokens became a solution for users who wanted to issue tokens on another network.
Understanding Blockchain Standards
Every token has its own standard based on the network it was issued. For example, we have ERC-20 tokens — the standard for cryptocurrencies issued on the Ethereum network. or BEP-20 for tokens launched on the Binance Smart Chain — Binance’s decentralized exchange.
The problem is that users can’t swap coins with different standards on different platforms. Wrapping coins allows us to modify our token to comply with a specific standard and send it to the Ethereum network.
How Wrapped Tokens Work
Wrapped Bitcoin (WBTC) is the best example we can use here. Wrapping Bitcoin gives you an ERC-20 version of them that is 1:1 pegged to the original value of BTC and is compatible with the ERC-20 standard. Now you can effectively use your BTC in the Ethereum blockchain.
Wrapped tokens require a custodian, an entity that will hold an equivalent amount of the WBTC circulating. To wrap your BTC, you send them to a custodian to mint them on Ethereum and then send it back to you in the form of WBTC. You can also send your WBTC to the custodian and receive the equivalent of BTC in return. Doing so requires you to put in a burn request to the custodian, a process in which you permanently remove the coins from circulation and reduce the total supply.
Wrapping and unwrapping tokens cost gas, which depends on the blockchain. Ethereum is by far the most expensive platform for gas fees as its network has experienced a tremendous amount of activity in the last couple of months. Network congestion increases gas fees, and the current network capacity of Ethereum is not able to meet the current demand.
However, there are other blockchains with significantly lower gas fees and higher throughput, like Binance Smart Chain (BSC).
Types of Wrapped Tokens
There are two types of wrapped tokens: redeemable — tokens backed by assets held by custodians, and cash-settled —tokens that cannot be redeemed for the underlying asset.
Redeemable tokens can be redeemed for something, like a good or service that can be provided to you by the custodian.
Cash-settled tokens are collateralized in digital dollars, which in the case of Binance, it will be BUSD.
Some people might think that USDT (Tether) is a wrapped cryptocurrency — this is not true. While USDT is pegged to the US Dollar, its underlying value is backed by several cash equivalents, commodities, and other assets.
What are the Benefits and Limitations of a Wrapped Crypto?
Wrapped tokens allow interoperability between multiple blockchains. Currently, there’s no way users can send an ERC-20 token to the Bitcoin network as interoperability is not yet possible. A side effect of wrapping cryptocurrencies is that they add liquidity for crypto companies, like decentralized exchanges.
What Platforms Can I Use to Wrap Bitcoin?
Several projects allow us to wrap Bitcoin, like WBTC, Huobi BTC (HBTC), and renBTC. These have been, so far, the most popular platforms for wrapping Bitcoin.