Don’t ask me where I got this image but its creepy AF. Keep it in mind as we delve into the topic of: Wrapped tokens, such as Wrapped Bitcoin (wBTC).
Wrapped tokens are a type of cryptocurrency that represents a tokenized version of another cryptocurrency on a different blockchain. Essentially, they allow a cryptocurrency to be used on a blockchain it wasn’t originally designed for. This enables the integration of different blockchain ecosystems and increases liquidity across different platforms.
Key Concepts of Wrapped Tokens:
Interoperability: Wrapped tokens enable assets from one blockchain to be used in another blockchain’s ecosystem, facilitating cross-chain interactions. For my visual peeps imagine different blockchains as isolated islands. Wrapped tokens act like bridges, allowing crypto assets to travel and interact seamlessly between these islands.
Liquidity: By wrapping assets, they can be made available on other blockchains, enhancing their liquidity and usability in decentralized finance (DeFi) applications. Again since I am a visual learner: think of illiquid assets like diamonds locked in a vault. Wrapping them creates a tradable token representation, similar to selling shares of a company that owns the diamond. Wrapped assets can be traded on exchanges that support the target blockchain, expanding their reach. DeFi platforms leverage wrapped tokens to enable borrowing and lending of various crypto assets, increasing their utility.
Pegged Value: Wrapped tokens maintain a 1:1 value ratio with their underlying assets. For instance, 1 wBTC is always meant to be equal in value to 1 BTC. The 1:1 peg between a wrapped token and its underlying asset ensures trust and stability. It's like a gold-backed currency, where each unit is guaranteed a specific amount of gold. This peg is often maintained through smart contracts, which are self-executing code on the blockchain that automates the process of locking and unlocking the underlying asset when minting and redeeming wrapped tokens.
How Wrapped Tokens Work
Minting: When a user wants to convert their BTC into wBTC, the BTC is sent to a custodian. The custodian then mints an equivalent amount of wBTC and sends it to the user’s wallet on the Ethereum network.
Redeeming: To convert wBTC back to BTC, the process is reversed. The wBTC is sent to the custodian, who then unlocks the original BTC and transfers it back to the user’s Bitcoin wallet.
Example: Wrapped Bitcoin (wBTC)
Blockchain Compatibility: wBTC brings Bitcoin’s liquidity to the Ethereum ecosystem, allowing BTC holders to interact with DeFi applications on Ethereum.
Use Cases: With wBTC, users can lend, borrow, or trade Bitcoin in Ethereum-based DeFi applications, participate in smart contracts, and contribute to liquidity pools.
Optional Metaphor section if you wish to go more in depth
Imagine a user wanting to bring their car (BTC) onto a racetrack (Ethereum network). Minting is like converting the car into a special racing vehicle (wBTC) compatible with the racetrack.
Here's a breakdown:
User deposits BTC: The user sends their BTC to a trusted custodian, similar to leaving their car at a secure parking lot.
Custodian verifies and locks BTC: The custodian verifies the ownership and amount of BTC, then securely locks it in a digital vault.
Smart contract mints wBTC: A pre-programmed smart contract (think of it as the racetrack's entry system) mints an equivalent amount of wBTC, representing the user's "racing car."
wBTC sent to user's wallet: The newly minted wBTC is sent to the user's wallet on the target blockchain, allowing them to participate in the racetrack's activities (DeFi applications on the Ethereum network).
Redeeming: Exiting the New Blockchain and Reclaiming the Asset:
When the user wants to leave the racetrack and take back their car, redeeming comes into play. It's like converting the racing vehicle back to its original form.
Here's the process:
User sends wBTC: The user sends their wBTC back to the custodian.
Smart contract verifies and burns wBTC: The smart contract verifies the ownership and amount of wBTC, then "burns" (cancels) the wBTC tokens, effectively removing them from circulation.
Custodian unlocks and sends BTC: The custodian unlocks the corresponding amount of BTC from the vault and sends it back to the user's original Bitcoin wallet.
User regains original asset: The user regains their original BTC, ready to be used outside the target blockchain.
Benefits:
Enhanced Functionality: Wrapped tokens like wBTC allow users to leverage the advantages of both the Bitcoin and Ethereum blockchains, such as participating in Ethereum’s smart contracts using Bitcoin.
DeFi Participation: They enable assets that were previously isolated to a single blockchain to participate in the broader DeFi ecosystem, opening up new opportunities for yield farming, lending, and borrowing.
Remember that island example well now think of a use case like transferring gaming tokens across platforms: Move in-game assets from one game's blockchain to another, potentially enabling wider usage and value.
Considerations:
Custody: The process involves trust in custodians who hold the original assets. This central point of potential failure contrasts with the decentralized ethos of cryptocurrency.
Smart Contract Risks: Wrapped tokens rely on smart contracts, which can have vulnerabilities or bugs that might put the wrapped assets at risk.
Wrapped tokens like wBTC are a crucial innovation in the blockchain space, bridging gaps between different cryptocurrencies and enabling a more interconnected and liquid digital asset ecosystem.