A “wrapped token” is a method of pegging the value of a native cryptocurrency with a non-native cryptocurrency. Wrapped tokens are generated by transforming the original cryptocurrency token into an ERC-20 (an asset class based on the Ethereum blockchain) token. All the token implementation on theEthereum blockchain needs to be carried out in the form of ERC-20 smart contracts. The primary difference between ERC-20 tokens, Bitcoins andLitecoins is that these tokens are issued on the Ethereum blockchain rather than their own nativeblockchain. The concept of wrapped tokens is remarkably similar to Stablecoins wherein the value of the cryptocurrency is pegged with the value of fiat currency.
Process
‘Wrapping’ requires a custodian, which can be a smart contract, merchant or even a decentralized autonomous organization. The custodian needs to hold an equivalent amount of asset as the wrapped amount. For example, the custodian needs to hold 2 Bitcoins to mint 2 wrapped bitcoin tokens.
The user sends out a request to the custodian to mint cryptocurrency in a wrapped form. The custodian takes the original cryptocurrency from the user and mints it in the form wrapped token equivalent to the value provided by the user. The process of minting is carried out by blockchain-based AI robots.
The wrapped tokencan be brought to its original form through a burn request. The user has toinitiate a burn request to the custodian andrelease the wrapped tokens in the Ethereum blockchain back to their original status.
Advantages
One of the biggest challengescryptocurrencies have been facing is volatility and lack of deep liquidity in the market. This is due to lack of trust, reliability, transparency among the users. Ethereum blockchain is the largest decentralized financial ecosystem with robust transparency and security measures which offers a boost to idle assets having isolated liquidity with this ability to be wrapped and used in a different blockchain with better connections resulting in increased liquidity power.
Wrapped tokens can be used on any Ethereum based smart contract which can be used in various decentralized blockchain-based applications. They bring in reliability and trust in the decentralized financial system.
It offers a transparent option, in every single transaction.The number of crypto converted to wrapped tokens can also be checked through Ethereum blockchain viewer and explorer.
They drastically reduce the number of intermediaries with quick update circulation in the market.Being generated on the Ethereum blockchain, the need for post transaction confirmation and affirmations is eradicated. They have reduced the costs and the pace of cryptocurrency transactions with lesser fee and quicker processes.
Disadvantages
The chances of manipulations and mismanagement of tokens could be high as they depend on the platform which generates them. As these tokens are sensitive to centralization, the risk of market manipulation or abuse of power by the institution generating them remains high.
“I am worried about the trust models of some of these tokens. It would be sad if there ends up being 5 billion dollars of BTC on Ethereum and the keys are held by a single institution” – Vitalik Buterin, Inventor of Ethereum
These conversions cannot always be done through automated smart contracts on the Ethereum blockchain and are often reliant on a central program that completes the conversion. Therefore, making it open for manual manipulation and abuse of power.
Types of assets that can be wrapped
- Crypto Assets
- Equity and stocks
- Commodities
- Debt instruments
- Government securities
- Art and collectables
- Intellectual Property Licenses
Wrapped token: Use cases
The process of asset of tokenization helps enhancing the transactions speed and transparency and increase liquidity in the market.
ERC-20 has enforced its own blockchain policies providing a set of rules and regulations to increase transparency and security measures. These regulations are not dependent on any particular party making it immune to data manipulation and abuse.
Various non-performing cryptocurrencies can now be pegged with non-native cryptocurrency tokens which will increase reliability and liquidity.
In terms of concept, wrapped tokens are excellent and provide traders and users an opportunity to invest in non-compatible crypto assets much more profitably through various decentralized applications. It helps in the additional injection of capital and volumes in the market with self-enforced regulations and rules on the Ethereum blockchain.
Though, on the ground level, there are significant limitations to wrapped tokens as the current mechanism of wrapping assets by a single institution could lead to various centralization issues. Market manipulation and abuse of power being primary.
Stricter regulations with implementation of advanced solutions could protect the decentralized financial ecosystem.
The monthly CryptoBlock is only for information purposes. Nothing contained herein is, purports to be, or is intended as legal advice and you should seek legal advice before you act on any information or view expressed herein.
Endeavoured to accurately reflect the subject matter of this alert, without any representation or warranty, express or implied, in any manner whatsoever in connection with the contents of this. This isn’t an attempt to solicit business in any manner.
Sources – Investopedia and PayBito