Wrapped tokens are a type of cryptocurrency that represent another cryptocurrency on a different blockchain network. They were created to solve one of the key challenges in the cryptocurrency space: the lack of interoperability between different blockchains. 

By wrapping a token, you essentially create a bridge that allows one cryptocurrency to be used within the ecosystem of another blockchain.

Here’s a more detailed look into what wrapped tokens are, why they exist, and how they are used.

Wrapped Tokens – The Technicals

Wrapped tokens are digital assets pegged to the value of another asset and issued on a different blockchain. 

The most common example is Wrapped Bitcoin (WBTC), which is an ERC-20 token representing Bitcoin on the Ethereum blockchain. 

The value of 1 WBTC is pegged to the value of 1 BTC, allowing Bitcoin holders to interact with decentralised applications (DApps) on Ethereum.

Why Do They Exist?

1. Interoperability

Different blockchains operate independently and cannot natively communicate with each other. Wrapped tokens bridge this gap by allowing assets from one chain to be used on another. This interoperability is crucial for enhancing liquidity and enabling cross-chain transactions.

2. Increased Functionality

Many blockchains offer unique functionalities and DApps that are not available on others. For instance, Ethereum has a vast ecosystem of DApps that Bitcoin does not. Wrapped tokens allow holders of a cryptocurrency like Bitcoin to access these DApps without having to sell their BTC for ETH.

3. Liquidity

By wrapping tokens and transferring them to platforms with more active trading environments or different financial instruments, users can potentially tap into larger pools of liquidity. This can help reduce slippage in trading and provide more stability to the asset’s price.

How Are They Used?

1. DeFi Participation

One of the primary uses of wrapped tokens is to participate in the decentralised finance (DeFi) ecosystem. This includes lending, borrowing, yield farming, and liquidity mining. For example, a Bitcoin holder can wrap their BTC into WBTC and then use that WBTC as collateral in DeFi platforms to earn interest or borrow other assets.

2. Cross-Chain Transactions

Wrapped tokens facilitate the transfer of value across different blockchain ecosystems. This enables traders and investors to easily move assets between chains to take advantage of opportunities or utilise specific blockchain functionalities.

3. Tokenisation of Assets

Beyond cryptocurrencies, the concept of wrapping can be applied to other types of assets, such as fiat currencies, commodities, or even real estate. This tokenisation process brings real-world assets onto blockchain platforms, increasing their accessibility and liquidity.

Mechanism of Wrapping

The process of wrapping typically involves a trusted custodian or a decentralised protocol. For example, in the case of WBTC, users send their BTC to a custodian who then mints WBTC tokens on Ethereum in a 1:1 ratio to the BTC deposited. The wrapped tokens can be unwrapped at any time to redeem the original asset, ensuring the peg is maintained.

Types of Custodians

1. Centralised Institutions

These are often well-known and regulated financial entities or companies that specialise in digital asset custody. They hold the original assets (e.g., Bitcoin in the case of WBTC) and issue the wrapped versions on the target blockchain (e.g., WBTC on Ethereum). These institutions must be trusted by users, as they have control over the assets being wrapped.

2. Decentralised Protocols

Some wrapped tokens are managed through smart contracts and decentralised protocols rather than a single centralised entity. These protocols can automate the process of wrapping and unwrapping tokens, with mechanisms in place to ensure that the value of the wrapped tokens is always backed 1:1 by the original assets. Decentralised custodians might use a variety of mechanisms such as over-collateralisation or DAO-managed reserves to secure the assets.

Functions of Custodians

– Asset Storage: Custodians securely store the original assets. In the case of cryptocurrencies, this usually means holding the private keys to wallets containing the original tokens.

– Token Issuance and Redemption: Custodians issue the wrapped tokens when original assets are deposited and burn the wrapped tokens to release the original assets when they are redeemed.

– Compliance and Security: Especially in the case of centralised custodians, they ensure compliance with regulatory requirements, implement security measures to protect the assets, and sometimes provide insurance to cover potential losses.

Example: Wrapped Bitcoin (WBTC)

For WBTC, the custodians are a group of recognised institutions within the cryptocurrency community. They collaborate under a consortium that sets rules for the minting, burning, and overall management of WBTC. 

Users who want to wrap their Bitcoin into WBTC must interact with these custodians or through merchants affiliated with the custodians. 

The process involves verifying the amount of BTC deposited and then minting an equivalent amount of WBTC. The BTC is held in reserve by the custodian, ensuring that every WBTC in circulation is backed by an actual Bitcoin.

Trust and Security Concerns

The trustworthiness of the custodian is a crucial aspect for users when it comes to wrapped tokens, especially in the case of centralised entities. 

Users must have confidence that the custodian can securely manage the original assets and will act honestly in the minting and burning processes. 

This trust is bolstered through transparency measures, such as regular audits and the publication of proof of reserves, showing that the custodian indeed holds the necessary amount of the original asset to back the wrapped tokens in circulation.

In conclusion, wrapped tokens play a pivotal role in enhancing the interoperability and functionality of the blockchain ecosystem. 

They enable a more connected and efficient decentralised landscape by allowing assets to flow freely between different blockchains, thereby opening up a world of possibilities for users and developers alike.