As DeFi progresses - so will the number of chains and this would lead to multiple ways of transferring value across protocols. Wrapped tokens are one such way of keeping the value intact while striding to achieve cross-chain composability.
What are Wrapped Tokens?
Wrapped tokens are created and destroyed by “minting” and “burning.” To mint, a wrapped token such as wBTC, the underlying asset, in this case, BTC, is sent to a custodian who stores the BTC in a digital vault. Once the underlying BTC has been locked away, an equivalent amount of wBTC can be minted.
This process can also be understood as “wrapping.” The underlying asset is “wrapped up” in a digital vault using a smart contract, and a newly wrapped asset is minted for use on another blockchain.
One of the best-known wrapped tokens is Wrapped Bitcoin (wBTC). wBTC is pegged 1:1 to the price of Bitcoin (BTC) so that one wBTC should always equal one BTC.
But unlike BTC, wBTC is available as ERC-20 or TRC-20 tokens, which means it can be used and traded on the Ethereum and Tron blockchains.
In a way, wrapped tokens are similar to stablecoins as one USDT is pegged to the price of $1, and one wBTC is pegged to the price of one BTC.
The wBTC token allows users to interact with a variety of Ethereum’s decentralised apps (dApps) and, in particular, Ethereum’s decentralised finance (DeFi) ecosystem.
A standard use for wBTC is as collateral, or a pledge for loan repayment, when taking out a cryptocurrency loan on DeFi platforms. Upon repayment of the crypto borrowed, the collateral, in the form of wBTC, is returned. If the collateral is liquidated, the wBTC is recouped by the platform.
Establishing Checks & Balances
Since Bitcoin and Ethereum are two separate protocols with little to no interoperability — the chains can’t natively talk to each other to increase trust and transparency. WBTC undergoes regular audits and publishes all on-chain transactions and verifications for the Bitcoin and Ethereum networks.
Celsius - a reward-earning and crypto lending platform - integrated Chainlink Proof of Reserve (PoR) to unlock cross-chain liquidity through wrapped tokens. This integration creates a hybrid CeDeFi application and marks one of the first instances of PoR being used in production to help audit and secure the on-chain minting, redeeming, and burning of wrapped cross-chain tokens.
Chainlink PoR enables the real-time auditing of Celsius’ wrapped tokens and checks the collateralisation of its Enzyme vault reserves to help trigger the minting, redeeming, and burning smart contract functions.
Obtaining Wrapped Bitcoin
Several tokenised representations of bitcoin exist. Wrapped Bitcoin (wBTC or wBTC), jointly created by Bitgo, Kyber, and Ren, was launched in 2019. To obtain wBTC, one must request the tokens from a merchant, such as Kyber, DeversiFi, or Airswap, who will then carry out Know-Your-Customer (KYC) and Anti-Money-Laundering (AML) checks to verify the identity.
The merchant then initiates a transaction with a custodian, who mints wBTC tokens and sends them to the merchant. Next, one swaps their bitcoin for wBTC with the merchant via a centralised exchange (CEX), decentralised exchange (DEX), or atomic swap. Only merchants can redeem wBTC for BTC.
It’s fairly simple for users to buy wBTC. Since wBTC is an ERC-20 token, it can be traded on decentralised exchanges (DEXs) such as Kyber or Uniswap. If one wants to swap BTC for wBTC, several platforms are available, including Atomic Wallet, Coinlist, and Poloniex.
What Wrapped Bitcoin Means For Other Protocols
Many of the most popular DeFi dapps on Ethereum require the use of collateral. Products such as MakerDAO and Compound require users to lock up crypto assets in order to borrow other crypto assets.
Because the overall value of Ethereum is significantly smaller than Bitcoin, this limits how much these protocols can grow. By bringing Bitcoin over, protocols boost liquidity and thus can create more collateral sources for their dapps.
Wrapped Bitcoin also allows Bitcoin holders to hold it as an asset while also using DeFi dapps like Compound to borrow or lend money.
Governing members of the wBTC DAO decide on major upgrades and changes to the protocol, as well as who can assume the roles of the merchants and custodians who manage the system.
Users who have BTC and want to convert it into wBTC must interact with merchants. Merchants initiate the process of minting or burning wBTC tokens by performing verification procedures to confirm users’ identities. Custodians hold the actual BTC being wrapped and do the actual minting and burning of tokens on the Ethereum blockchain. When wBTC is burned, BTC is returned to the user from the custodian. When a new wBTC is minted, BTC is taken from the user and stored by the custodian.
Even though ether (ETH) is the native currency of the Ethereum blockchain, it is not compatible with Ethereum’s ERC-20 tokens. Therefore, you cannot directly trade ETH for ERC-20 tokens without using a trusted third party, such as a centralised exchange.
To solve this problem, a collection of Ethereum projects led by 0x Labs created an ERC-20 compliant token called wrapped ether (wETH or WETH). To create wETH, you send ETH to a smart contract to lock it up. The smart contract then returns wETH tokens at a 1:1 ratio. You can send the wETH back to the smart contract to redeem your locked ETH. A variety of platforms facilitate this process, including Relay and Airswap
WrappedKitties, i.e., Wrapped CryptoKitties, solves the problem of liquidity around the market for a base value CryptoKitty so that one could trade ‘n’ number of kitties in one transaction by defining a token, WCK, for which they could 1:1 swap with a CryptoKitty. This, in turn, has become a valuable currency for the community, provides liquidity to the market and establishes a base floor value for all CryptoKitties.
Achieving interoperability between different blockchains is a challenge for the industry.
One problem is that as more blockchains are created, the number of bridges needed to ensure that assets on a blockchain can easily transfer to every other blockchain increases exponentially.
For the foreseeable future, at least, bridges and wrapped tokens are set to continue to be a central part of the solution for interoperability.