Wrapped Coins: Everything to Know
By Beluga Research September 10, 2023
- Wrapped coins are crypto coins that are on one blockchain, such as Bitcoin, but are backed by a token on another blockchain, like Ethereum
- Wrapped coins create bridges between different platforms, which increases liquidity and promotes asset transfers
- Wrapped coins increase the utility of decentralized finance (DeFi) applications and facilitate cross-chain transactions
- Users of wrapped coins must trust the custodian responsible for minting and redeeming wrapped coins
Wrapped coins are crypto coins that are on one blockchain, such as Bitcoin, but are backed by a token on another blockchain, like Ethereum. The most popular wrapped coin is Wrapped Bitcoin (WBTC), which is tied to the value of Bitcoin.
WBTC is an ERC-20 token on the Ethereum blockchain. It is backed by an equivalent amount of Bitcoin. A user can spend or invest Wrapped Bitcoin in the Ethereum ecosystem and access decentralized applications (dapps) and smart contracts there.
A wrapped coin is created when a user puts a certain amount of a cryptocurrency aside to be held, by a decentralized autonomous organization (DAO), merchant, multisignature wallet or smart contract. The holder then mints the wrapped coin, which is backed by the deposited amount. The user can trade the wrapped coin on any blockchain networks that will support it. If the user wants to "cash in" the wrapped coin, they return it to the holder. The holder then releases the amount of the cryptocurrency that the user deposited.
A Brief History
The first wrapped coin was Wrapped Bitcoin. Wrapped coins were developed a bit later than initial coins because they are meant to address the lack of interoperability between blockchain networks. Initially, most cryptocurrencies operated on separate blockchains. This limited cross-chain functionality. Wrapped coins have made it more possible to link interactions on different blockchains.
Wrapped coins require a setting aside of the "backing" coin. The user who is acquiring a wrapped coin needs to trust the instrument or actor setting aside the "backed" coin. Innovations in security and transparency measures help users gain more confidence in the concept of wrapping.
Wrapped Coins: Everything to Know
- How Wrapped Coins Work. Wrapped coins function through tokenization. When a user wants to wrap a specific cryptocurrency, they send it to a custodian who holds the original cryptocurrency. In exchange, the custodian mints an equivalent amount of wrapped coins on the desired blockchain network. Users then use the wrapped coins within the designated blockchain ecosystem.
- Use Cases of Wrapped Coins. Wrapped coins have various purposes in the cryptocurrency ecosystem. They enable users to access DeFi applications like lending platforms, decentralized exchanges and yield farming protocols. These apps are built on specific blockchains like Ethereum. Wrapping cryptocurrencies makes it possible for users to build liquidity and engage in activities on these platforms.
Additionally, wrapped coins facilitate cross-chain transactions. Such transactions allow value transfers between different blockchain networks. There is no need for complex processes or intermediaries. This is why cross-chain transactions enhance liquidity.
- Trust and Security Considerations. Wrapped coins involve custody of the original cryptocurrency, so trust and security are crucial. Users must trust the custodian responsible for minting and redeeming the wrapped coins. Choosing reputable custodians with robust security measures is essential to minimize the risk of vulnerabilities or theft.
Transparency in the wrapping process is also important. Most wrapped coins offer mechanisms for users to verify the collateralization of the wrapped tokens. This ensures a one-to-one correspondence between the wrapped coins and the original cryptocurrency held by the custodian.
- Popular Wrapped Coins. Examples of wrapped coins include Wrapped Litecoin (WLTC), Wrapped Zcash (WZEC), Wrapped Filecoin (WFIL) and Wrapped Chainlink (WLINK). Each of these wrapped coins caters to users' needs within their respective blockchain ecosystems.
Increases the value of the original cryptocurrency. Backing a wrapped coin with a recognized cryptocurrency increases the value of the backing coin. The backed coin has provided new opportunities to develop a profit.
Promotion of interoperability. Wrapped coins make it more possible for users to interact with different platforms.
Enhances the reputation and credibility of custodians. Custodians such as DAOs and merchants which hold the backing coins have the opportunity to do a good job with the service. They can use their efforts to grow their goodwill and experience.
Facilitates interoperability between different blockchain networks. Wrapping a cryptocurrency allows a user to bring the coin into a different ecosystem. Then they can take advantage of the features and functionalities offered by the new blockchain. This opens up possibilities. Users can access decentralized applications (dapps), decentralized exchange (DEX) and other services that are unavailable on the original blockchain.
Increases cross-chain liquidity. A user can leverage the value and liquidity of one cryptocurrency, such as Bitcoin, within another ecosystem, such as Ethereum. Cross-chain compatibility expands the utility of cryptocurrencies. It promotes easy integration across various blockchain networks.
Allows users to employ a wider range of assets as collateral. DeFi protocols like lending platforms and decentralized exchanges usually require collateral in the form of specific cryptocurrencies. Not all cryptocurrencies are directly compatible with these protocols. Wrapped coins bridge this gap because they allow users to employ more assets as collateral. Wrapped coins increase the accessibility and liquidity of DeFi services.
Facilitate faster and more cost-effective transactions. Some blockchain networks, like Ethereum, have faced scalability issues. This results in high fees and slower confirmation times. Wrapping a cryptocurrency means a user can employ a different blockchain with faster transaction speeds and lower fees. Wrapping allows a user to overcome a blockchain's limitations and enjoy a more efficient transaction experience.
- Interoperability: Wrapped coins allow assets to be used across different blockchains. This enhances liquidity and integration between dapps and platforms.
- Increased Accessibility : By wrapping traditional assets or cryptocurrencies, wrapped coins make them more accessible within a specific blockchain ecosystem. This expands the user base and fosters adoption.
- Liquidity Provision: Wrapped tokens bridge liquidity pools across blockchains. They provide users with more trading opportunities and facilitate asset movement between DEX platforms.
- Security and Transparency: Wrapped coins leverage the security and transparency of the underlying blockchain. They record transactions on the blockchain for immutability and transparency. This increases trust and reduces risks.
- Programmability: Wrapped tokens inherit the programmability of the underlying blockchain. This allows developers to create innovative applications and use cases. For example, a user can automate processes like token transfers and DeFi protocols.
- Diversification: Wrapped coins represent different assets. They enable users to diversify their investment portfolios within the blockchain ecosystem. Users can therefore manage risk and gain exposure to various asset classes.
- Counterparty Risk: Users must trust the custodian or issuer of the wrapped asset. They introduce counterparty risk, or risk of the custodian making an error. This is because the custodian holds the underlying asset and mints the wrapped tokens.
- Centralization Concerns: The custodial nature of wrapped coins raises centralization concerns. The custodian controls the issuance and redemption. This goes against the concept of decentralization and introduces vulnerabilities.
- Regulatory Challenges: Wrapping traditional assets can pose regulatory challenges. These include compliance, Anti Money-Laundering (AML) measures and concerns about illicit activities. More regulation and stricter regulation could decrease user confidence in the value and liquidity of wrapped coins.
- Smart Contract Risks: Wrapped coins often rely on smart contracts, which are susceptible to coding vulnerabilities and exploits. Problems usually lead to financial losses that compromise the integrity of the wrapped assets.
- Limited Asset Support: The availability of wrapped coins depends on custodians' choices. This limits the range of assets available for wrapping. It restricts opportunities for diversification.
- Price Discrepancies: Price discrepancies can occur between wrapped coins and the underlying assets. Causes include liquidity, demand and wrapping efficiency. The concerns introduce opportunities for arbitrage and challenges for accurate price representation.