Glossary
What is a Wrapped Token? Definition and Use Cases
What is a Wrapped Token?
Wrapped tokens are digital assets enveloped in another using another contract or custodian. They are created to extend functionality or enable the use of an asset on a blockchain that is not natively supported.
Bitcoin and USD are examples of assets wrapped to be used on smart contract platforms like Ethereum and Neo. The original asset is locked in a smart contract or with a custodian, and a corresponding token is minted. The wrapped token can be converted back to the original asset by destroying the wrapped version and releasing the original from the smart contract or custodian.
Another example is BNeo and LNeo, wrapped versions of the NEO token. They add new features to the native, indivisible NEO token.
Using wrapped tokens often includes delegating custody of the original asset to a custodian, which can introduce counterparty risk. The custodian can be a centralized entity or a decentralized smart contract.
Wrapped Token — Key Concepts
- Tokenization: Creating a representation of the value of an underlying asset, enabling its use on a blockchain where the asset is not natively supported.
- Extended Functionality: Wrapped tokens can add new features or capabilities to the original asset, such as interacting with smart contracts.
- Unwrapping: The process of converting a wrapped token back to the original asset by destroying the wrapped version and releasing the original from the smart contract or custodian.
- Custodial Risk: Delegating custody of the original asset to a custodian introduces counterparty risk, as the custodian can be a single point of failure.
- Decentralized Custodians: Smart contracts can act as decentralized custodians, improving security and transparency by automating the minting and burning of wrapped tokens.
- Interoperability: Wrapped tokens enable cross-chain interoperability, allowing assets to move between blockchains.
- Minimum and Maximum Supply: Wrapped tokens are minted and burned to ensure the supply matches the underlying asset, maintaining a 1:1 ratio.
- Automatic Wrapping: Some platforms automatically wrap assets when deposited, enabling users to interact with smart contracts without manual wrapping and unwrapping.
Cross-Chain Wrapped Tokens
Cross-chain wrapped tokens are created to make assets from one blockchain available on another. These tokens are pegged to the value of the original asset and can be used on a different blockchain. They are minted when the original asset is locked in a smart contract or with a custodian and burned when the original asset is released.
Cross-chain wrapped tokens enable users to access assets from different blockchains, expanding the utility and interoperability of digital assets. They can be used for various purposes, such as decentralized finance (DeFi) applications, provision, and asset transfers between blockchains.
Maintaining a 1:1 peg between the wrapped token and the original asset is necessary to ensure that users can redeem the token for the underlying asset at any time.
Wrapping and Unwrapping Process
Wrapping an asset involves locking the original asset in a smart contract or with a custodian and minting a corresponding wrapped token on the target blockchain. The original asset is held in reserve to back the wrapped token, ensuring it can be redeemed for the underlying asset at any time.
Unwrapping a wrapped token involves burning the token and releasing the original asset from the custodian or smart contract.
Custodian Risk
Wrapped tokens represent a claim on the underlying asset, which is held by a custodian. The centralized or decentralized custodian is responsible for maintaining the reserves backing the wrapped tokens and ensuring that users can redeem them for the original asset.
Custodial risk arises when the custodian fails to maintain the reserves or becomes insolvent, preventing users from redeeming their wrapped tokens for the underlying asset. Frauds or vulnerabilities can lead to the loss of user funds.
Proofs of Reserve
Some custodians provide proof of the reserve, demonstrating that the reserves backing the tokens match the total supply of tokens issued. Users can verify the reserves and ensure that the custodian is solvent and trustworthy.
Decentralized Custodians
Decentralized custodians, such as smart contracts, can reduce custodial risk by automating the minting and burning of wrapped tokens and ensuring that the reserves are transparently managed on-chain.
However, smart contracts are not immune to bugs or exploits, and users should carefully evaluate the security and reliability of the platform before using it. Audits, community reviews, and open-source code can help assess the trustworthiness of decentralized custodians.
Cross-Chain Interoperability
Migrating assets to different blockchains can be facilitated by wrapped tokens. Users can lock their tokens on one blockchain and redeem them in another. This process ensures that the reserves backing the wrapped tokens are maintained.
Bringing assets from different blockchains together through cross-chain wrapped tokens enables decentralized applications to access a broader range of assets and liquidity. If a token is in high demand on one blockchain, trading it on another can be profitable due to price discrepancies.
Arbitrage Price Balancing
Since it’s possible to unwrap a wrapped token for the original asset, the price of the wrapped token should closely track the underlying asset’s price. If the cost of the wrapped token deviates significantly from the original asset, arbitrage opportunities arise, allowing traders to profit by buying the cheaper asset and redeeming it for the more expensive one. This process is called arbitrage and helps maintain the price balance between the wrapped token and the original asset.
The price of an asset on different blockchains can vary due to differences in liquidity, demand, and trading volume. If the fees to transfer the asset between blockchains are lower than the price difference, traders can exploit arbitrage opportunities to balance the prices and make a profit.
The profit potential from arbitrage incentivizes traders to monitor the prices of wrapped tokens and their underlying assets. The profit margin from arbitrage decreases as more traders exploit the price difference, leading to a convergence of prices between the wrapped token and the original asset.
