- Wrapped crypto tokens are sensible contracts representing locked collateral of the unique asset on a separate blockchain
- They supply liquidity to a rising DeFi ecosystem
Wrapped crypto tokens corresponding to wrapped bitcoin (wBTC) are sensible contracts representing locked collateral of the unique asset (i.e., BTC) on a separate blockchain. They’re used to supply liquidity to a rising DeFi ecosystem.
Consider wrapped bitcoin like an IOU briefcase. However as a substitute of paper representing a promise to pay your BTC again, inside is a stay feed to a vault containing each bitcoin and excellent wrapped bitcoin.
- DeFi wants cross-chain liquidity for world adoption.
- Wrapped tokens supply an answer.
- The mechanism of wrapping a crypto token requires 3 events: service provider, custodian and investor.
- Wrapped tokens carry inherent liquidity- and market-contagion dangers.
- The worth of wrapped tokens just isn’t essentially equal to that of their authentic counterparts.
Why wrapped tokens are necessary to DeFi
Wrapped tokens supply an answer to a vital downside in DeFi: cross-chain liquidity. Consider every blockchain and its native token as a silo. Demand for that particular token is contingent on the functions constructed on that community.
DeFi (decentralized finance) and its advanced credit score and lending ecosystem wants rapid settlement expertise that works throughout all blockchains. With out this expertise, blockchains can’t profit from your complete trade’s development.
Wrapped tokens break down these silos by providing native tokens utility outdoors their blockchain. This innovation unlocks a flood of capital effectivity that allows numerous funding devices throughout most chains.
How wrapped bitcoin works
All customers entry wBTC by way of third-party retailers corresponding to AAVE and Maker. When a person requests wBTC in change, the service provider takes their BTC and sends it to BitGo, a custodian managed by the wBTC DAO (a decentralized autonomous organization).
Within the earlier analogy, the vault containing each bitcoin and wrapped bitcoin represents the custodian. As soon as BitGo receives the bitcoin from the service provider, it then mints the equal in wBTC — an ERC-20 token on the Ethereum blockchain. This token is a great contract illustration, or IOU briefcase, of the unique bitcoin.
The custodian then sends the wBTC to the service provider, the place the person finalizes the transaction. Sometimes, there aren’t any service provider charges on this switch as a result of they solely cost charges for exchanging wBTC for BTC. The person shall be answerable for any fuel charges utilized in transferring wBTC on the Ethereum blockchain.
As a result of this change requires belief from a number of events, BitGo partnered with Chainlink to supply an automatic auditing system — just like the direct stay feed from the earlier analogy. This auditing system known as proof of reserve.
Different dApps (decentralized functions) within the Ethereum ecosystem use this protocol to watch BitGo’s stability sheet when accepting wBTC as collateral or change equivalency. If BitGo have been to mint extra wBTC than the BTC it holds in reserve, each software utilizing Chainlink’s protocol would cease receiving wBTC.
What’s the distinction between a pegged and wrapped token?
The worth of a pegged token or foreign money might be linked to that of one other asset — digital or bodily — utilizing a wide range of approaches. As a result of custodians hyperlink wrapped tokens to the worth of different crypto belongings, they fall underneath the pegged foreign money classification.
However they don’t classify stablecoins corresponding to USDT as a wrapped token as a result of it pegs its worth to the US greenback in off-chain money reserves. And in contrast to wrapped tokens, these reserves are usually not audited by way of an automatic protocol.
Is a wrapped token essentially the identical as the unique?
No: wBTC shouldn’t be thought-about a elementary equal to BTC. This widespread false impression is why many lose cash in liquidation disaster occasions. Within the analogy, the worth of the briefcase IOU depends upon three issues: the standard of the livesteam and the integrity of the vault and the briefcase holding it collectively.
Wrapped tokens, on this approach, require three layers of belief that the unique token doesn’t want. So, it could appear that the 2 have the equal worth for a time. However in bearish markets, the perceived worth of the wrapped tokens can drop quicker than that of the originals. That is how wrapped tokens can lose their peg although their stability remains to be 1:1.
The market-contagion threat of wrapped tokens
A crypto market contagion is a monetary disaster spreading from one protocol or crypto sector to a different. Contagion is extra doubtless when members distribute credit score dangers throughout establishments and markets.
So with wrapped crypto, elevated capital effectivity additionally comes with an elevated threat of contagion. For instance, if one protocol managing collateral vaults fails, each different software utilizing their wrapped token or ‘IOU briefcase’ is uncovered to a possible liquidity disaster. This sort of credit score contagion has occurred a number of instances all through the crypto cycles. They’ve been primarily related to the collateral requirement failures of pegged stablecoins corresponding to USDT and UST. Regardless of these earlier episodes, we now have but to see a failure of a wrapped token vault audited by a proof-of-reserve protocol.
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