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Bitcoin, the first blockchain network, was created to facilitate seamless, instant peer-to-peer payments. Twelve years on, the blockchain space has evolved with the creation of several other blockchains, each with its own underlying technology.

As is often the case with emerging technologies, some specific issues were overlooked during the development of these new fragmented blockchains.

Most blockchains created after Bitcoin were not designed to be interoperable with one another. Because provisions for cross-chain transactions were not made, basic activities such as transferring tokens between users and executing smart contracts could only be carried out within a single blockchain.

To conduct cross-chain transactions, users had to go through the lengthy process of converting their crypto into stablecoins, then transferring the stablecoins to the other blockchain before using the stablecoins to conduct the intended transaction on the other blockchain.

This user experience was essentially identical to that provided by traditional centralized financial institutions, as the main objective of fast, borderless payments had been severely undermined. Therefore, blockchain interoperability has become inevitable in order to accelerate cross-chain transactions and improve user experience.

In the context of blockchains, interoperability refers to a blockchain’s ability to freely exchange data with other blockchains. Interoperability would allow users to use other blockchains without having to jump through as many hoops in terms of token conversions, resulting in faster and more efficient transactions.

Blockchain interoperability is now more important than ever, especially given the massive adoption and popularity of DeFi. Several blockchain networks have DeFi applications built on them, but the true power of DeFi can not be unleashed until cross-compatibility between blockchains is enabled. Some novel interoperability solutions, such as cross-chain bridges and wrapped tokens, have been developed to address this issue.

Ethereum currently boasts the most extensive DeFi ecosystem. Anyone wishing to engage in DeFi activities on Ethereum must meet one essential requirement: they must have ETH or ERC-20 tokens.

Wrapped tokens, like stablecoins, act as a link between multiple on-chain systems by serving as tokenized representations of other assets. Currencies like Wrapped Bitcoin (WBTC), the most popular wrapped token, and renBTC help investors gain access to Ethereum’s vast DeFi ecosystem.

This article focuses solely on wrapped tokens, exploring how they enable blockchain interoperability and their impact on the DeFi and cryptocurrency markets.

What are Wrapped Tokens?

Wrapped tokens are digital assets that allow the value of native assets to be transferred from one blockchain to another.

Wrapped Bitcoin (WBTC) is one of the most popular wrapped tokens. Because the value of WBTC is linked to that of BTC at 1:1, 1 WBTC should be equivalent to 1 BTC. However, unlike Bitcoin (BTC), wBTC can be used and traded on the Ethereum and Tron blockchains because it is an ERC-20 or TRC-20 token.

Wrapped tokens are somewhat comparable to stablecoins like USDT, which is pegged to the value of the US dollar. 1 WBTC is equivalent to the price of 1 BTC, while 1 USDT is equivalent to the price of 1 dollar.

However, a wrapped token is not just a wrapped token because it is precisely linked to the price of another asset. Its value is supported and maintained by the technology that powers it.

The Significance of Blockchain Interoperability

Each blockchain has its own distinct protocol and database, making interconnection difficult. Wrapped tokens allow owners of tokens on one blockchain, such as Bitcoin, to benefit from opportunities on another blockchain, such as Ethereum, without purchasing Ethereum’s native tokens.

Wrapped tokens are classified as a “blockchain bridge” because they connect two blockchains. These bridges will become increasingly important as the digital asset ecosystem expands and more blockchains are added, enabling additional uses for wrapped tokens.

How Do Wrapped Tokens Work?

A wrapped token is a synthetic cryptocurrency token that can operate on a different blockchain while maintaining a 1:1 price correlation with its parent token.

To grasp this definition, you must first understand how blockchain works. The Bitcoin blockchain (which starts with a capital B) is a ledger that contains the balances of the bitcoin cryptocurrency (which begins with a small b). This ledger is maintained by a global network of independent computers.

These computers, known as nodes, also maintain accurate Bitcoin balances (known as addresses), generate new bitcoin at a predetermined rate (via a consensus method), and allow wallets to conduct bitcoin transactions.

The Bitcoin Protocol is software that runs on nodes and contains all of the rules for doing all of these things. The beauty of decentralization is that all of this takes place in the absence of any central authority.

Since those rules are publicly available, there are many examples of Bitcoin clones that use the same fundamental ideas but change certain aspects.

Bitcoin has served as a model for several new cryptocurrencies, each with its own set of rules, consensus mechanisms, and balance-tracking systems. These new currencies are referred to as “altcoins,” with Ethereum being the most popular.

Ethereum supports an ecosystem of interoperable digital platforms because it is Turing Complete and has a specialized language for creating smart contracts.

It also includes a set of standards designed to improve value transfer. These include ERC-721 for non-fungible tokens (NFTs) and ERC-20 for Ethereum-based tokens. These standards are beneficial because they allow any Ethereum wallet to support any ERC-20 token, thereby simplifying exchanges and transactions.

One of the reasons why the Ethereum ecosystem has expanded so quickly is that all of the components of this standard-based system are composable and can fit together like “Lego blocks”.

Bitcoin Wrapped Token vs. Ethereum Wrapped Token

When examining how the Ethereum and Bitcoin blockchains operate, it is important to consider the possibility of their interconnection (i.e., interoperability). Wrapped tokens are one way to bridge these blockchains.

Tokens from other blockchains that have been wrapped for use on Ethereum adhere to the ERC-20 token standard. However, because Ethereum launched before the ERC-20 standard, many dApp users were forced to switch between Ethereum (ETH) and ERC-20 tokens.

The Ethereum network then required a wrapped ETH coin to be created and burned. Wrapped ETH (WETH) is an ETH variant that adheres to the ERC-20 standard. WETH is a tokenized version of Ether based on Ethereum that can be used for more than just transaction fees (also known as gas fees).

The Bitcoin blockchain operates uniquely. Because Bitcoin (BTC) is incompatible with the Ethereum blockchain, wrapped Bitcoin (wBTC) replaces it on the Ethereum network. Customers can use WBTC to spend Bitcoin on the Ethereum blockchain via a decentralized exchange or dApps in the DeFi ecosystem.

Benefits of Wrapped Tokens

Interoperability

This is the primary advantage of wrapped tokens in the crypto market. Wrapped tokens allow people to use Bitcoin on the Ethereum blockchain through wrapping, unlike in the early days of blockchain technology. Wrapped tokens make it easy for anyone to take advantage of basic interoperability when making or managing dApps.

Increased liquidity

Wrapped tokens make an asset much more liquid because they are easy to trade and use on non-native networks, whether centralized (as fiat currencies) or decentralized (as cryptocurrencies).

Increased transaction speed

Wrapped tokens have a significant advantage in terms of transaction speed. For example, sending BTC over the Bitcoin blockchain takes longer than sending WBTC over the Ethereum network.

Reduced transaction costs

In some cases, transaction fees for wrapped tokens may be lower than those for transactions involving the original assets.

Some protocols launched on the Ethereum blockchain, for example, based their wrapped tokens on the BNB chain to significantly reduce gas fees.

Limitations of Wrapped Tokens

Dependence on a custodian

A custodian is required to make the minting (wrapping) and burning (unwrapping) of wrapped tokens possible. A breach or mistake by the custodian will directly impact the minting or burning process.

Centralization

The adoption of decentralized systems is a key selling point for cryptocurrencies. Because custodians create and destroy wrapped tokens, they must usually be centralized or rely on an escrow contract.

Wrapping charges

Manufacturing and packaging of wrapped tokens incur costs. The gas costs associated with these procedures may outweigh the benefits provided by wrapped tokens.

Are Wrapped Tokens a Wise Financial Investment?

Wrapped tokens are increasingly being considered a wise investment in the cryptocurrency market, where DeFi already plays a key role. Approximately $800 million worth of Bitcoin was converted into WBTC in just over a year. This reflects the industry’s current value as well as its enormous growth potential.

According to Arcane Research, 189,000 BTC are currently locked on the Ethereum blockchain. Wrapped Bitcoin tokens are now estimated to account for a record 1% of the 18.73 million Bitcoins currently in circulation and being used in DeFi.

Wrapped tokens make it possible for assets to move between chains that would otherwise be incompatible. This makes both centralized and decentralized exchanges more liquid and efficient with their capital.

Another benefit is that wrapped tokens are especially helpful for slow blockchains like Bitcoin or Ethereum since they enable faster transaction times and cheaper gas fees.

Finally, wrapped tokens, unlike other assets, offer fractionalized ownership, allowing owners to acquire and hold a small portion of the asset.

Future of Wrapped Tokens

Relevant industry stakeholders are making concerted efforts to get different blockchains to work together. However, the inevitable problem is that, as more blockchains are created, the number of bridges required to ensure that assets on one blockchain can easily be transferred to every other blockchain would increase proportionately.

Several solutions are being developed to make connecting assets across blockchains easier and more efficient.

A “bridge hub” (a core bridge to which all other blockchain bridges lead) is one such solution developed to facilitate blockchain interoperability. Due to their numerous benefits, wrapped tokens are expected to remain an integral component of blockchain interoperability solutions.

In Conclusion

Before DeFi, it was relatively easy for investors to trade tokens on the market, so there was no need to bridge the Bitcoin-Ethereum divide.
This drastically changed with the introduction of DeFi, as Bitcoin maximalists and whales were left without a way to utilize flash loans, decentralized applications (dApps), yield farming techniques, and governance tokens without selling their BTC and buying ETH.
However, buying ETH for DeFi activities soon proved counterproductive, as selling BTC to make profits in a riskier environment defeated the purpose. This is because a drop in the price of Bitcoin almost certainly implies a decrease in the price of altcoins due to the impact of BTC dominance.
The development of blockchain interoperability solutions, such as wrapped tokens, has emerged as a viable option. Wrapped Bitcoins make up almost 13% of DeFi’s total market value, indicating the success of this new asset class.

Disclaimer: This article is intended solely for informational purposes and should not be considered trading or investment advice. Nothing herein should be construed as financial, legal, or tax advice. Trading or investing in cryptocurrencies carries a considerable risk of financial loss. Always conduct due diligence.

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