In the world of cryptocurrency, innovation never stops. Compatibility between blockchains is becoming more important as the blockchain field expands. The key to a more user-friendly and linked crypto environment is cross-chain compatibility. Wrapped crypto assets, also known as wrapped tokens, have evolved as a solution to this problem, allowing digital assets to exist outside of their respective blockchains. It’s a game-changing approach that opens up a whole new realm of possibilities in the blockchain ecosystem. In this article, we’ll explain wrapped crypto in simple terms, looking at how it works, its benefits, and its importance in the world of decentralized finance(DeFi).

What Is Wrapped Crypto?

Wrapped crypto, commonly known as “wrapped tokens,” is a form of digital asset that reflects another cryptocurrency on a different network or blockchain. It acts as a bridge between multiple blockchain networks, with a primary focus on the Ethereum blockchain. They are formed by locking up the original asset on the original blockchain and issuing the equivalent amount of wrapped tokens on the destination network or blockchain.

For example, if you have Bitcoin (BTC) and wish to use it in a decentralized application (DApp) operating on the Ethereum network, you will be unable to do so. Wrapped Bitcoin, or WBTC, enables this. WBTC is an Ethereum blockchain token that represents Bitcoin. On the Ethereum network, it is basically a digital copy of your Bitcoin. WBTC has the same value as BTC, and it may be traded on the Ethereum network. WBTC is backed by actual Bitcoin that is held in reserve, making it a trustworthy representation of the original asset.

Let’s take a real life example to understand this concept more clearly. Suppose you are invited to a wedding function by your friend or any relative. Now, how will you dress up for the occasion? You would prefer to wear an outfit that is suitable for weddings, not any regular dress that you may wear for any other parties. Additionally, a dinner function would require a different outfit; a wedding dress would not be appropriate. It means there is a different outfit for each occasion, and you will dress or (wrap) yourself in something that is suitable for the occasion.

Similarly, to transact BTC on the Ethereum blockchain, we need to wrap it for the Ethereum blockchain, naming it Wrapped BTC.

How do Wrapped Crypto Tokens work?

Wrapped crypto tokens operate by building a bridge between different blockchains, allowing assets to move between them. This process is made possible by smart contracts. Wrapping a cryptocurrency can vary depending on the token and the blockchain on which it is to be wrapped. However, the general procedure is as follows:

1. The original cryptocurrency is deposited into a smart contract by the user.
2. The cryptocurrency is locked up by the smart contract.
3. On the other blockchain, the smart contract generates an equivalent number of wrapped tokens.
4. After that, the wrapped tokens are sent to the user’s wallet.

The user simply reverses the process to redeem the wrapped tokens. They return the wrapped tokens to the smart contract, which burns the tokens and releases the original cryptocurrency.  

When you send Bitcoin to be wrapped into WBTC, it is preserved in a smart contract. In exchange, you will receive the equivalent amount of WBTC tokens on the Ethereum network. As these tokens are fungible, each WBTC is the same as any other.

What are the components of wrapped tokens?

Wrapped tokens are commonly made up of the following components:

• Underlying asset: The cryptocurrency that the wrapped token represents is the underlying or original asset. For example, Bitcoin is the underlying asset for WBTC.

• Smart contract: The smart contract is the code that locks up the underlying asset and generates the wrapped tokens.

• Peg: The ratio at which the wrapped token is pegged to the underlying asset is known as the peg. WBTC, for example, is pegged to BTC at a 1:1 ratio.

• Custodian: The custodian is the entity assigned to holding the underlying asset in custody.

Popular wrapped tokens in DeFi

Some of the most common wrapped tokens in DeFi are:

• Wrapped Bitcoin (WBTC)
• Wrapped Ether (WETH)
• Wrapped Avalanche (AVAX)
• Wrapped Binance Coin (BNB)
• Wrapped Litecoin (WLTC)
• Wrapped Solana (SOL)

Pegged Tokens Vs. Wrapped Crypto Token

Pegged tokens are made by creating a new token that is pegged to the value of another crypto or fiat currency. The pegged token’s issuer is responsible for maintaining the peg by buying and selling the underlying asset as needed.

Examples of pegged cryptocurrencies include:

• Tether (USDT)
• US Dollar Coin (USDC)
• Binance USD (BUSD)

These cryptocurrencies are all pegged to the US dollar, which means they try to maintain a 1:1 exchange rate with USD. This is accomplished by a variety of techniques, such as holding USD reserves in a bank account or generating and burning tokens to adjust supply.

Wrapped tokens, on the other hand, are produced by securing the original asset in a smart contract and distributing an equivalent amount of tokens on a different blockchain. The smart contract maintains the peg by making sure the number of wrapped tokens in circulation is always equal to the amount of the locked-up original asset.

Benefits of Wrapped Crypto Tokens

1. Cross-chain compatibility: With wrapped tokens, you can use your assets across multiple blockchains. This enhances flexibility and access to various types of decentralized apps. This is helpful for users who want to get involved in DeFi activities across multiple blockchains or make use of their assets in decentralized apps (DApps) built on different blockchains.

2. Increased liquidity: The liquidity of assets on different blockchains can be increased with the help of wrapped tokens. This is because of the fact that wrapped tokens can be traded on exchanges that support both the underlying asset and the blockchain on which the wrapped token is created.

3. New investment opportunities: Users may be able to access new investing options with wrapped tokens. For example, users are able to invest in Bitcoin on the Ethereum blockchain, which was unavailable before wrapped tokens were developed.

4. Access to DeFi: DeFi (Decentralized Finance) has become extremely popular, especially on the Ethereum blockchain. Wrapped tokens allow users to participate in DeFi projects even if they hold assets on different blockchains.

5. Security and Transparency: Wrapping is usually backed by a transparent system of audits and reserve holdings, providing users with confidence in the token’s value.

How To Secure Wrapped Crypto Tokens

Crypto tokens that are wrapped are usually considered to be secure. However, there are a few steps users can take to protect their wrapped tokens, including:

• Use reliable wrapping services: It is essential to only use wrapping services from a trusted provider. By doing this, the chance of fraud or theft will be decreased.

• Secure wallet: Wrapped tokens should be stored in a secure wallet. They will be more protected from hackers and other malicious people.

• Risk awareness: You should be aware of the risks related to wrapped tokens. There is a risk, for example, that the peg between the wrapped token and the underlying asset may collapse.

Conclusion

In order to unlock the potential of cross-chain compatibility, wrapped crypto tokens are an effective tool. They provide a variety of advantages, such as increased liquidity, new investment opportunities, and the ability to use assets on different blockchains. Wrapped tokens are likely to become even more important to the cryptocurrency ecosystem as blockchain technology evolves. Therefore, keep updated on the developments in wrapped crypto if you’re interested in this fascinating field of crypto or just curious about it; it’s a field that continues to be expanding and evolving.