A wrapped token is an ERC-20 token with a value identical to another asset that it represents, either through a smart contract or by being backed one-to-one with the underlying asset. It is an asset hosted on the Ethereum blockchain with a price that is the same as another underlying asset, even if it’s not on the same blockchain or on a blockchain at all.
A wrapped token is a multi-institutional asset tokenization framework that adheres to the centralized approach. However, instead of relying entirely on a single institution, it relies on a consortium of institutions performing different roles in the network.
Wrapped tokens provide a methodology through which multiple institutions in the cryptocurrency space can cooperate to get past common issues faced by current stablecoin implementations.
Paving way for a new generation of stablecoins that can harness Ethereum in a much more trust-free manner towards enabling global liquidity, reduced transaction fees, increased fractional ownership, and smart contract programmability.
The translation between Token and Wrapped Token is often reversible, as users can transform between the two versions at any time. The wrapping process usually involves users locking their Tokens in a smart contract, which then mints an equivalent amount of Wrapped Tokens for the user. Users can trade their Wrapped Tokens to the smart contract to receive their original Tokens back.
WBTC (Wrapped Bitcoin), the first stablecoin based on the wrapped tokens framework, is an ERC20 token on Ethereum backed 1:1 by Bitcoin, allowing dApps native access to Bitcoin. No additional utility token is required to use WBTC and no extra transfer fees other than the gas consumed as blockchain fees. WBTC uses a simple federated governance model and strives to promote usability.
Asset-backed tokens (stablecoins) are digital tokens that are usually backed by traditional assets (such as gold, fiat), reflect the price of the underlying asset backing them.
These tokens can be broadly classified into two design models:
- Algorithmic: Demand and supply of tokens are controlled by a set of Ethereum smart contracts such that to keep the token’s price in line with that of a fiat currency. MakerDAO’s DAI token is an example of an algorithmic stable-coin tied to the USD.
- Centralized: Assets are stored with a custodian organization that regularly publishes proof of reserves. Such tokens include Tether and TrueUSD.
How do Wrapped Tokens work?
Wrapped tokens are each backed by an equal amount of the underlying asset or currency as well as a variety of organizational roles, and algorithmic checks and balances.
DApps can process wrapped token transactions much faster because they are not done across multiple blockchains. Users can transact confidently because wrapped tokens’ trustless nature is preserved by a framework that backs each one-to-one with the underlying assets.
The complex model is enough to provide DApp users native access to other cryptocurrencies without burdening both blockchains in the processing of any DApp transaction. One minimal gas fee on Ethereum is all it takes.
Governance over wrapped tokens is typically done by assigning necessary roles to organizations, predominantly custodians who hold underlying assets and mint (or burn) new wrapped tokens as necessary. Merchants provide a medium to wrapped token buyers, while users own the tokens.
When you “wrap” ETH, you are trading it against a smart contract for an equal token called WETH. If you want to get plain ETH back you “unwrap” WETH by trading it back for plain ETH. ETH and WETH are always exchanged at a 1:1 ratio. The Ether collateral is securely locked within the smart contract until it’s traded for WETH at some point in the future.
Kinds of Wrapped Tokens
As Ethereum is the biggest DeFi ecosystem, wrapped tokens are often those hosted on other blockchains but are also stablecoins that are pegged to the dollar.
Many of the first wrapped assets were fiat-backed stablecoins, such as tokens with prices pegged to the dollar — Tether, Coinbase’s USDC, or TrueUSD. There are also euro, yen, yuan, and countless other fiat stablecoins that are mostly based on the Ethereum blockchain.
These are backed through the reserves, with coins fed in according to the demand of online crypto exchanges and larger institutional investors who want to quickly exchange fiat money into crypto and manage their money within a given platform.
This makes it as easy to deposit dollars into DeFi applications and blockchain wallets as it does to have a reliable counter currency providing traders relief from crypto asset volatility.
Key Roles of Wrapped Tokens
- Custodian: The institution that holds the asset and also holds the keys to mint tokens.
- Merchant: The institution to which wrapped tokens are minted to and burnt from. Merchants play a key role in the distribution of the wrapped token.
- User: The holders of the wrapped token. Users can use wrapped tokens to transfer and transact like any other ERC20 token in the Ethereum ecosystem.
- WBTC DAO member: Contract changes and addition/removal of custodians and merchants are controlled by a multi-signature contract. Institutions are the holders of the keys to the multi-sig contract as part of the WBTC DAO.
Uses-Cases for Wrapped Tokens
- Asset Tokenization
The act of tokenizing assets can:
Increase speed of transactions: Ethereum blocks are created every 15 seconds and it is possible to have a fair deal of confidence in the irrevocability of a transaction in less than 5 minutes. This speed is faster than transacting natively compared to many other assets including Bitcoin, gold, and fiat currencies
Improve transparency: The total number of tokens, token creation transactions, token removal transactions, number of token holders, and rules for transfers can be seen on a public block explorer by anyone.
Boost usability: The ERC20 standard has been adopted by a large number of institutions and products. This provides users with a variety of exchanges, wallets, and Dapps to use while handling their tokenized assets. They also have the ability to transfer tokens quickly, 24/7.
Enhance security: Tokenization enables users to have full control of the private keys of the asset. Users who do not want to hold keys can reduce counterparty risk by moving it from exchanges to a security-focused custodian.
2. Fiat backed stablecoins that offer a safer way for traders to keep their money in a cryptocurrency without having to worry about price fluctuations.
3. The wrapped framework makes it easy to represent any cryptocurrency, such as Bitcoin on Ethereum blockchain, thereby harnessing all Ethereum capabilities.
4. Tokenization provides a mechanism to enforce policies on-chain. On-chain policy enforcement makes rules more transparent and doesn’t rely on one single party to enforce them, hence immune to manipulation.
5. The majority of ERC20 trading in centralized exchanges is done with BTC and not ETH, while most decentralized exchanges offer only ETH/Token and not BTC/Token trading pairs. Wrapped tokens can help bridge this gap and provide the much-needed liquidity on decentralized exchanges.
Wrapping ERC20 Tokens
Let’s look at some examples of extending existing ERC20 tokens:
- Horizon Games’ ERC20 Meta Wrapper: Horizon Games’ ERC20 Meta Wrapper adds meta-transaction methods to any token compliant with the ERC-20 standard. When you deposit ERC-20 tokens (e.g. DAI) in the wrapper contract, it will give you back metaTokens (e.g. MetaDAI) with a 1:1 ratio. These metaToken have native meta-transaction functionalities, which allow you to transfer tokens without doing an on-chain transaction yourself, but by simply signing a message and broadcasting this message to “executors”. You can also “approve” addresses to transfer tokens on your behalf with a signed message instead of calling the ERC-20 to approve() function. Normally, transferring ERC20 tokens cost gas paid in Ether. With metaTokens, users can pay directly in any ERC20 token they wish. Hence, at a high level, users could transfer DAI by paying the transaction fee in DAI as well, never needing to possess ETH.
- Compound cTokens: Compound is an open-source protocol for algorithmic, efficient Money Markets on the Ethereum blockchain. It lets users supply assets to the protocol and earn interest. Every asset supported by the Compound protocol is integrated through a cToken smart contract, which is an ERC20 compliant token holding representation of balances supplied to the protocol. This Wrapped Token is the primary way of interacting with the Compound Protocol. Each ERC20 token available on Compound has a corresponding CErc20 token. For example, BAT has a corresponding cBAT and ZRX has a corresponding cZRX. Each cToken contract creates its own money market. When a user mints, redeems, borrows, repays a borrow, liquidates a borrow, or transfers cTokens, she will do so using the cToken contract.
- Bonding Curves: Bonding Curves utilizes a similar ‘wrapping’ technique to mint and burn continuous tokens. It uses a curve to mint different amounts based on the curve-bonded token’s supply.
The Wrapped Tokens pattern can be applied to add custom functionality to an existing ERC20 token.
Thus, with the Wrapped Tokens design pattern, developers can extend the capability of an existing crypto asset and make it interoperable with other decentralized applications.