Wrapped tokens have been introduced to overcome the limitations caused by a lack of reliable connection between blockchains. They allow for much-desired interoperability and seamless exchange of information, facilitating communication between previously incompatible blockchains.
Created through cross-chain bridges, wrapped tokens allow users to access specific products and services without trading crypto assets they might want to keep hold of. Therefore, wrapped tokens offer their holders new opportunities for trading, staking, and accessing other DeFi services.
Wrapped tokens are a type of cryptocurrency that represents the value of another cryptocurrency or token standard. They are similar to stablecoins, except that instead of being pegged to a fiat currency, they are pegged to a different cryptocurrency. For example, wBTC is a wrapped token that derives its value from Bitcoin but works on the Ethereum network. As a result, a wBTC holder can gain access to DeFi services provided by some Ethereum-based platforms without trading their Bitcoins away and losing possible profits in the future.
The advantage of wrapped tokens is that they can be used on different blockchain networks, giving users more flexibility. For instance, Bitcoin can be wrapped to work not only on Ethereum but also on any other chain (as long as there is a suitable cross-chain bridge). Moreover, wrapped tokens can be traded on exchanges like any other token, giving even more options to their holders.
You can learn more about wrapped tokens by reading this article on cross-chain bridges.
Let's break down the process of wrapping tokens by taking Bitcoin (BTC) as an example. Firstly, a user sends BTC to a custodian address on the Bitcoin blockchain (usually, a cross-chain bridge's smart contract). The custodian then locks BTC and generates the same amount of BTC in ERC-20 tokens, a token standard widely used for creating and issuing tokens on the Ethereum blockchain.
Once BTC is locked, the user can access wrapped tokens (wBTC) and use them for various Ethereum-based DeFi products or services, such as yield liquidity pools. Note that the market balance is maintained by ensuring that for every wBTC, the custodian holds an equivalent amount of BTC in reserve. Burn-and-mint bridges are an exception since they burn tokens before creating new wrapped ones.
If the user wants to receive their original assets, they can request them to be released from the bridge's reserves. The remaining amount of wBTC gets destroyed, and the user receives an equivalent amount of BTC in their wallet. However, keep in mind that this is only possible with some types of bridges. Therefore, it is crucial to read about a bridge you plan to use in advance to ensure its conditions are acceptable for you.
Although wrapped tokens have provided a convenient solution for connecting different blockchains and enabling users to interact with their crypto assets across various networks, they are not a flawless solution.
The primary issue with wrapped tokens is their vulnerability to cyber attacks. While blockchain technology has generally resolved security concerns through its distributed ledger and consensus mechanisms, the smart contracts used by cross-chain bridges for wrapping tokens do not currently possess the same level of robustness and protection. As a result, hackers may take advantage of these vulnerabilities to gain access to the crypto assets stored there.
If hackers succeed in stealing funds stored by bridges, the wrapped tokens become worthless, leaving users with nothing. They also can create numerous new wrapped tokens instead and sell them on the market, leading to price instability and significant losses for many crypto holders. Therefore, many experts strongly advise against keeping your assets wrapped for an extended period or wrapping the majority of your assets.
The second downside is frozen liquidity. During the wrapping process, original assets often get stuck in a smart contract that essentially pulls them out of circulation, preventing them from being used. Although popular crypto assets may not be affected, lesser-known tokens may experience insufficient liquidity and high volatility, which can be dangerous for new projects without significant community support.
The third problem, also related to liquidity, is fragmentation. There can be several wrapped versions of a coin or a token in circulation on different blockchains at the same time, leading to fragmented liquidity and negatively affecting the prices and usability of said assets.
The next downside is centralization. The creation and management of wrapped tokens still often require the presence of some custodians (usually a company or DAO) that facilitate the whole procedure and store user funds. It means that the process requires users to trust said custodians, which can be unacceptable for those users who value decentralization.
Lastly, the minting process of new wrapped tokens can be expensive due to high gas fees and possible price slippages. As a result, users can lose more than expected, which may make the process completely uneconomical.
Despite having some disadvantages, wrapped tokens continue to play a significant role in the DeFi space. As cross-chain technologies advance at a rapid pace, more decentralized solutions are being developed that could allow for trustless minting and redemption of wrapped tokens in the future.
Kinetex supports wrapped tokens, allowing users to swap them via the Kinetex dApp. By using the Kinetex Liquidity Aggregation mode, users can seamlessly exchange their wrapped tokens for any other coin or token. Since Kinetex aggregates liquidity from hundreds of protocols and supports over 5,000 tokens, it can offer users the smoothest swapping process and the most favorable rates, even for the rarest crypto assets.
The new version of the Kinetex dApp called Flash Trade, which the Kinetex team is developing right now, will enable users to move native liquidity directly. It will make the swapping process much faster and cheaper while eliminating all risks related to attacks on liquidity stored on DeFi platforms.