• Wrapped crypto tokens are good contracts representing locked collateral of the unique asset on a separate blockchain
  • They supply liquidity to a rising DeFi ecosystem

Wrapped crypto tokens resembling wrapped bitcoin (wBTC) are good contracts representing locked collateral of the unique asset (i.e., BTC) on a separate blockchain. They’re used to offer liquidity to a rising DeFi ecosystem. 

Consider wrapped bitcoin like an IOU briefcase. However as a substitute of paper representing a promise to pay your BTC again, inside is a dwell feed to a vault containing each bitcoin and excellent wrapped bitcoin. 

Fast details

  • DeFi wants cross-chain liquidity for international adoption.
  • Wrapped tokens provide an answer. 
  • The mechanism of wrapping a crypto token requires 3 events: service provider, custodian and investor.
  • Wrapped tokens carry inherent liquidity- and market-contagion dangers. 
  • The worth of wrapped tokens shouldn’t be essentially equal to that of their unique counterparts.

Why wrapped tokens are necessary to DeFi

Wrapped tokens provide an answer to a crucial downside in DeFi: cross-chain liquidity. Consider every blockchain and its native token as a silo. Demand for that particular token is contingent on the purposes constructed on that community.

DeFi (decentralized finance) and its complicated credit score and lending ecosystem wants speedy settlement expertise that works throughout all blockchains. With out this expertise, blockchains can’t profit from all the business’s progress. 

Wrapped tokens break down these silos by providing native tokens utility exterior their blockchain. This innovation unlocks a flood of capital effectivity that permits various funding devices throughout most chains. 

How wrapped bitcoin works

All customers entry wBTC by way of third-party retailers resembling AAVE and Maker. When a consumer requests wBTC in change, the service provider takes their BTC and sends it to BitGo, a custodian managed by the wBTC DAO (a decentralized autonomous group). 

Within the earlier analogy, the vault containing each bitcoin and wrapped bitcoin represents the custodian. As soon as BitGo receives the bitcoin from the service provider, it then mints the equal in wBTC — an ERC-20 token on the Ethereum blockchain. This token is a brilliant contract illustration, or IOU briefcase, of the unique bitcoin. 

The custodian then sends the wBTC to the service provider, the place the consumer finalizes the transaction. Sometimes, there aren’t any service provider charges on this switch as a result of they solely cost charges for exchanging wBTC for BTC. The consumer will likely be chargeable for any fuel charges utilized in transferring wBTC on the Ethereum blockchain. 

As a result of this change requires belief from a number of events, BitGo partnered with Chainlink to offer an automatic auditing system — much like the direct dwell feed from the earlier analogy. This auditing system is named proof of reserve.

Different dApps (decentralized purposes) within the Ethereum ecosystem use this protocol to observe BitGo’s steadiness sheet when accepting wBTC as collateral or change equivalency. If BitGo had been to mint extra wBTC than the BTC it holds in reserve, each software utilizing Chainlink’s protocol would cease receiving wBTC.

What’s the distinction between a pegged and wrapped token?

The worth of a pegged token or forex could be linked to that of one other asset — digital or bodily — utilizing quite a lot of approaches. As a result of custodians hyperlink wrapped tokens to the worth of different crypto property, they fall beneath the pegged forex classification.  

However they don’t classify stablecoins resembling USDT as a wrapped token as a result of it pegs its worth to the US greenback in off-chain money reserves. And in contrast to wrapped tokens, these reserves should not audited by way of an automatic protocol. 

Is a wrapped token basically the identical as the unique?

No: wBTC shouldn’t be thought of a elementary equal to BTC. This widespread false impression is why many lose cash in liquidation disaster occasions. Within the analogy, the worth of the briefcase IOU is determined by three issues: the standard of the livesteam and the integrity of the vault and the briefcase holding it collectively. 

Wrapped tokens, on this method, require three layers of belief that the unique token doesn’t want. So, it might appear that the 2 have the equal worth for a time. However in bearish markets, the perceived worth of the wrapped tokens can drop quicker than that of the originals. That is how wrapped tokens can lose their peg although their steadiness continues to be 1:1.

The market-contagion threat of wrapped tokens 

A crypto market contagion is a monetary disaster spreading from one protocol or crypto sector to a different. Contagion is extra seemingly when contributors distribute credit score dangers throughout establishments and markets. 

So with wrapped crypto, elevated capital effectivity additionally comes with an elevated threat of contagion. For instance, if one protocol managing collateral vaults fails, each different software utilizing their wrapped token or ‘IOU briefcase’ is uncovered to a possible liquidity disaster. Any such credit score contagion has occurred a number of instances all through the crypto cycles. They’ve been primarily related to the collateral requirement failures of pegged stablecoins resembling USDT and UST. Regardless of these earlier episodes, we’ve got but to see a failure of a wrapped token vault audited by a proof-of-reserve protocol.

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  • Blockworks

    Editor, Evergreen Content material

    John is the Editor of Evergreen Content material at Blockworks. He manages the manufacturing of explainers, guides and all instructional content material for something crypto associated. Earlier than Blockworks, he was the producer and founding father of an explainer studio known as Finest Defined.

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