One method to understand blockchains is by viewing them as separate databases. As blockchains are independent, they can’t be in contact with each other. For example you cannot use a XYZ coin on a ABC blockchain as only the XYZ blockchain knows that you hold that token. Wrapped tokens were invented as a solution to this problem. With the help of wrapped tokens, you can move assets across blockchains and use them across the crypto
What are wrapped tokens?
Wrapped tokens are assets that permit the value of a particular asset from one blockchain to transfer to another blockchain. In a sense wrapped tokens are similar to stablecoins which follow the price of US Dollar. Identity of a wrapped token is not identified just by whether it is pegged 1:1 to the price of another token. It is the tech behind it and the manner in which its value is backed and maintained. In simple words, wrapped tokens are a way to use crypto on blockchains other than the one they were built on.
Functioning of Wrapped Tokens
Wrapped tokens are invented and demolished by a process named “minting” and “burning”. Burning or coin burning is a method of permanently removing crypto from circulation, thus reducing the total supply.
Let’s use an example to understand this process better.
Let’s take a coin, say WABC as our example, which is a tokenized version of ABC on XYZ (another blockchain). A merchant sends the ABC for the custodian to mint. The custodian then mints WABC on XYZ in accordance to the amount of ABC sent. When the WABC needs to be exchanged back to ABC, then the merchant puts a burn request to the custodian and the ABC is released from the reserves. The custodian here can be seen as a
wrapper and unwrapper.
Why wrapped tokens?
Although many blockchains have their own token standards, these can’t be utilized across multiple blockchains. Wrapped tokens enable a user to use non-native tokens on a particular blockchain. Additionally, wrapped tokens are instrumental in increasing the liquidity and capital efficiency for both centralized as well as decentralized exchanges. The potential to wrap idle assets and utilize them on another chain can create increased connection between theparticular otherwise isolated liquidity. Last but not the least, a great advantage is transaction times and fees. Sometimes a particular coin may possess great qualities but isn’t the fastest and can sometimes prove to be expensive to use. These kinds of problems may be avoided by using a wrapped version on a blockchain with a faster transaction speed and lower fees.