What Are Wrapped Cryptocurrencies?
by Justin Caccappolo
Although decentralization is an integral characteristic of the majority of digital assets, certain tokens can lean away from decentralization to further expand the infrastructure of the digital asset industry. Stablecoins, such as Tether (“USDT”) or USD Coin (“USDC”), are centralized tokens that have allowed for users to exchange their crypto holdings for a U.S. dollar pegged token without having to fully exit the crypto markets. These tokens also allow for markets to be quoted against USDT or USDC, which added further liquidity and revamped the crypto markets to break away from trading pairs being solely quoted against Bitcoin. Wrapped assets are another type of digital assets that can be considered centralized and have an infrastructure on the Ethereum blockchain and other layer 1 protocols.
Often regarded in decentralized finance (“DeFi”), wrapped assets have expanded the limits of multiple decentralized applications throughout the Ethereum blockchain. Wrapped assets or tokens are 1:1 pegged representations of other crypto assets often in the form of ERC-20 tokens – therefore usable on the Ethereum blockchain. Some may wonder why you would need to wrap an asset. For example, Ethereum was created before the ERC-20 token standard. Therefore, in order to interact with other ERC-20 tokens or decentralized applications you will need to convert your Ethereum or alternate cryptocurrency to an ERC-20 token. Ethereum is not the only token you can wrap. Other wrapped assets include wrapped BTC, wrapped MATIC, and more. Allowing assets to become wrapped on the Ethereum network improves liquidity and usability as users can deposit and trade BTC on other blockchains and with decentralized applications. This increase in interoperability increases capital efficiency and cross chain flow of assets, which benefits DeFi on Ethereum, Solana, Avalanche, and other layer 1 protocols.
The Function & The Opportunity
In order for wrapped assets to be created, custodians and merchants are required to play individual roles in creating and removing wrapped assets from the market. Instead of relying on a single institution like USDT or USDC, wrapped assets need multiple entities to perform different functions to ensure usability. In summary, wrapped assets are created through custodians minting the wrapped asset on the specific network after being initiated by any merchant. Merchants must provide collateral equal to the minted amount and can only redeem their collateral once they send back the wrapped asset to be burned and removed from the total supply. This interaction is reputable as quarterly audits are conducted by third parties to verify that all wrapped tokens minted have an equal amount of collateral under management by custodians which is transparent on the public blockchain. Additionally, custodians cannot mint wrapped assets without the initiation from a merchant, further securing the total supply of wrapped assets between these two parties. Protocols such as Ren have also developed decentralized alternatives to wrapped assets by locking the original collateral provided by a user in a smart contract vault, sending that user renBTC, and only allowing users to redeem their original collateral once the renBTC has been burned. Overall, wrapped assets provide a method for multiple entities to cooperate and provide solutions to global liquidity, reduced transaction fees, increased fractional ownership, and enhanced smart contract programmability.
The opinions expressed in the CrossTower Classroom are those of the author(s) and not necessarily that of CrossTower. We appreciate diverse perspectives of our employees and we thank them for having a voice.
CrossTower Inc. provides this content for general information purposes, to better inform you on your digital asset investment journey. We do not provide investment recommendations or provide tax advice. Please consult your investment professional or tax advisor if you require assistance in these areas.
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