Wrapped Token

Published on :

21 Aug, 2024

Blog Author :

N/A

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya

What Is A Wrapped Token?

A wrapped token is a digital representation of a specific cryptocurrency or asset functional on a different blockchain. It is "wrapped" or encapsulated with another blockchain's native token or asset, facilitating its use within a specific decentralized application. It enables cross-chain interoperability, allowing the smooth transfer of digital assets across different blockchain networks.

Wrapped Token

These tokens play a vital role in the growing blockchain and decentralized finance systems by enhancing versatility, promoting liquidity, and expanding the utility of digital assets across various blockchain networks. Moreover, they enable users to access more decentralized services and financial instruments.

Table of contents
  • A wrapped token represents a particular cryptocurrency or digital asset that operates on a different blockchain. They are "wrapped" or encapsulated with another blockchain's native token or asset.
  • The tokens can be seamlessly used within a specific decentralized application. It allows cross-chain interoperability and facilitates the transfer of digital assets across different blockchain networks.
  • The tokens are wrapped by locking the original tokens on its blockchain network and then minting an equivalent number of wrapped coins. 
  • This token enables assets from other blockchains to engage in the decentralized finance system. Furthermore, they are instrumental in enhancing decentralized lending, borrowing, and trading.

Wrapped Token Explained

A wrapped token is a unique mechanism for enabling the seamless transfer and utilization of digital assets across different blockchain networks. It is a digital representation of an existing asset or cryptocurrency. However, it exists on a separate blockchain from the one where the original asset is native. It is done through a process known as "wrapping."

The wrapping process involves crypto staking or locking up the original tokens on its blockchain network and then minting an equivalent number of wrapped coins. These coins serve as a bridge, allowing the value and functionality of the original asset to be transferred and utilized in any other blockchain where they are supported.

Wrapped tokens serve several crucial purposes within the blockchain ecosystem. Moreover, it enables cross-chain compatibility and increases liquidity by making assets available on multiple blockchains. Some tokens represent assets not native to the blockchain where they reside. This utility expansion allows assets from other blockchains to participate in the decentralized finance framework. Furthermore, it aids in opening up new potential for decentralized lending, borrowing, and trading.

How To Create?

The steps to create wrapped tokens are as follows:

  • The user must determine which blockchain network they want to create the tokens. The choice of network will influence the tools and standards they will use for creating the tokens.
  • Then, they must develop a smart contract. This contract should include functions for minting and burning the tokens. It must also include mechanisms for handling the underlying assets.
  • Users who want to wrap their assets must lock them on the native blockchain. This process often involves sending the original tokens to a specific address controlled by the smart contract. The smart contract should validate these incoming deposits and lock them up securely.
  • After the original tokens are locked and validated, the smart contract should mint an equivalent number of tokens and create wrapped tokens on the target blockchain. These newly minted tokens represent the locked assets. Users will use these tokens on the target blockchain.
  • Next, the users can initiate a burn transaction to redeem their tokens for the original assets. This involves sending the tokens back to the smart contract, which will then release the equivalent amount of the assets to the user's designated address.
  • Finally, the user must rigorously test the entire token system on a test net before deploying it on the main net to ensure that it functions as expected and securely handles the users' assets.

Examples

Let us understand wrapped tokens with the following examples:

Example #1

Suppose David owns a unique coin called "CryptoRX." He wants to use it in an online game that only accepts "RoyalCoins." So, he sends his CryptoRX to an application that turns it into "Wrapped CryptoRX." Then David could play the game with Wrapped CryptoRX, and the game treated it like RoyalCoins. However, after gaming, he changed his Wrapped CryptoRX back to regular CryptoRX. This is an example of a wrapped token.

Example #2

According to InvestorsObserver, on September 2, 2023, Wrapped Bitcoin witnessed an average long-term technical score of 54. This scoring method measures the price movements from recent months to a year. Moreover, it examines the token's resistance and support levels to identify whether it is a robust buy-and-hold investment option. Furthermore, this ranking measure is valuable for the buy-and-hold type of investors who aim to achieve firm and steady growth while allocating their assets. This is an example of a wrapped token.

Benefits

Some benefits of wrapped tokens are as follows:

  • The tokens enable cross-chain interoperability, allowing assets from one blockchain to be used on another. This promotes a more connected and versatile blockchain ecosystem, where assets can move seamlessly between networks.
  • These tokens increase liquidity by representing assets from other blockchains on a particular network. As a result, users can trade and access a more extensive range of assets on decentralized exchanges and lending platforms, boosting overall market efficiency.
  • Users can participate in specific blockchain ecosystems and their associated decentralized applications and services by wrapping their assets. This allows users to explore different blockchain networks and their unique offerings without switching between wallets or chains.
  • These tokens often serve as collateral in DeFi lending and borrowing protocols. Users can use wrapped assets to borrow stablecoins or other tokens, providing liquidity without selling their underlying assets.
  • The tokens enable users to diversify their holdings across different blockchain networks. This diversification can help mitigate risk in case of network-specific issues or vulnerabilities.
  • Some blockchains offer lower transaction costs or faster confirmation times than others. Moreover, users can leverage these tokens to take advantage of these characteristics when interacting with specific networks or applications.

Limitations

The wrapped token limitations are:

  • Many token systems rely on oracles and price feeds to maintain the peg between the tokens and their underlying assets. These oracles can be manipulated or compromised, leading to inaccurate pricing and issues with the peg.
  • While the tokens aim to improve interoperability, not all blockchain networks support the same standards or have the infrastructure to interact with these tokens seamlessly. This can limit the effectiveness of the tokens across different chains.
  • There is currently no universal standard for these tokens, leading to fragmentation in the DeFi ecosystem. Additionally, different projects may implement their own wrapping solutions that could confuse users and developers.
  • Wrapping tokens is primarily used for digital assets like cryptocurrencies. Representing real-world assets as these tokens may face legal and regulatory challenges. Furthermore, it may limit the scope of asset types that can be wrapped.
  • Some token systems rely on centralized governance models, where a small group of entities make decisions about the management and operations of the token. This centralization can lead to conflict of interest and reduced transparency.

Wrapped Token vs Pegged Token vs Stablecoin

The differences are as follows:

Wrapped Token

  • This digital asset represents another cryptocurrency or asset from a different blockchain.
  • It is created by locking up the original asset on its native blockchain and minting an equivalent number of tokens on a different blockchain.
  • It aims to enable cross-chain functionality and expand the use of assets across various blockchain networks.
  • These tokens maintain a 1:1 peg with their underlying assets. Thus, they ensure that one token is always equivalent to one unit of the original asset.

Pegged Token

  • These are cryptocurrencies designed to maintain a stable value by pegging their price to a specific reserve or asset, like a fiat currency or a commodity.
  • Its purpose is to provide stability in a volatile cryptocurrency market.
  • Centralized pegged tokens are typically issued and managed by a central authority that holds reserves matching the token's value.
  • Decentralized pegged tokens aim to achieve stability through algorithmic mechanisms, collateralization, or governance.

Stablecoin

  • These are a broader category of cryptocurrencies that aim to maintain a stable value, and they can be either collateralized or algorithmic.
  • To support their value, collateralized stablecoins are backed by reserve assets, often held in custody. However, algorithmic stablecoins rely on smart contract algorithms to adjust the token supply in response to market conditions.
  • Stablecoins serve as a reliable medium of exchange and store of value within the cryptocurrency ecosystem.
  • Moreover, it facilitates transactions, provides stability in volatile markets, and enables users to access the benefits of blockchain technology without exposure to extreme price fluctuations.

Frequently Asked Questions (FAQs)

1. Are wrapped tokens securities?

Considering these tokens as securities depends on various factors, including their specific characteristics and how they are structured and marketed. Moreover, if a token represents ownership in an underlying asset, provides dividends, or promises profits, it may be treated as a security under securities regulations in some jurisdictions. However, many tokens are designed to function as utility tokens or digital representations of assets and do not involve investment contracts.

2. What are the risks of wrapped tokens?

These tokens come with several risks, which are as follows:
- Intermediaries in the token systems may pose centralization and counterparty risks, as users must trust them to manage the underlying assets.
- Smart contract vulnerabilities can lead to hacking or exploitation. Thus, user funds may be compromised.
- Regulatory compliance is a concern, primarily if the tokens represent real-life assets.
- Network congestion and complexity may cause operational challenges.

3. Are wrapped tokens taxable?

This token's tax treatment differs according to jurisdiction. Additionally, it depends on its specific use and regulatory classification. Furthermore, token acquisition, trading, and use in many countries may lead to tax events, like capital gains or income tax liabilities. Tax authorities often consider factors like the purpose of the tokens, frequency of transactions, and whether they represent investments or utility to determine if they are taxable.

This article has been a guide to what is a Wrapped Token. We explain how to create it, examples, limitations, benefits, & comparison with pegged token & stablecoin. You may also find some useful articles here -