Wrapped tokens have made it possible to put digital assets like bitcoin (BTC) on Ethereum (ETH) so they can interact with decentralized finance (DeFi) applications. This has resulted in significant inflows of tokenized value on Ethereum, and other crypto networks, contributing to several wrapped coin use cases.
Read on to discover the five most prominent wrapped token use cases.
What are wrapped tokens?
Wrapped tokens are crypto tokens whose underlying value is pegged to another cryptoasset to enable cross-chain use cases.
A wrapped token is a version of an original cryptoasset, which operates on a host blockchain where it has been issued. The original crypto is tokenized by locking it in a digital vault, and the wrapped token is released on a different blockchain network.
For instance, wrapped bitcoin (WBTC) is pegged in the ratio of 1:1 to bitcoin but operates on the Ethereum network.
Wrapping tokens on Ethereum involves transforming an existing cryptoasset into an ERC-20 token. ERC-20 is the most widely recognized standard for token design and ensures that smart contract rules remain compatible with DeFi applications.
Digital tokens can also be wrapped to conform to the BEP-20 standard to be used on the Binance Smart Chain (BSC).
Wrapped tokens are designed to improve interoperability between blockchains by allowing native assets to work on different crypto networks. Wrapped tokens use a system that retains an equal amount of the crypto as the wrapped coins.
The wrapping process usually requires custodians to mint the tokens. Merchants send requests to the custodians to mint the wrapped version of crypto. The custodian acts as the wrapper of the asset by minting wrapped coins equal to what they retain in reserve. Conversely, the custodian destroys the wrapped tokens upon request of the merchant to release the original asset.
Now that we’ve introduced wrapped tokens and how they work, let’s take a look at the most prominent use cases of wrapped coins.
DeFi lending works by depositing a digital asset into a crypto lending pool to earn interest. Smart contracts manage the disbursement of funds and borrower collateral reduces default risks, enabling a thriving crypto lending market free from centralized intermediaries.
Wrapped tokens make it easier to borrow and lend with tokenized bitcoin (in the form of WBTC) since they can work in DeFi lending protocols like Aave (AAVE), MakerDAO (MKR), and Compound (COMP). Users can lend their WBTC and borrow USD coin (USDC), DAI, or other digital assets against it.
Moreover, traders can mint DAI on the MakerDAO protocol using WBTC as collateral and ultimately lend DAI at an interest.
Experienced crypto traders typically prefer to trade on margin. The basic idea behind margin trading is borrowing money to increase the potential profitability of a trade.
WBTC can be used by DeFi traders to trade on margin on decentralized derivatives exchanges.
Wrapped tokens like WBTC or renBTC increase liquidity by injecting liquidity into the Ethereum ecosystem from bitcoin holders. As a result, the entire decentralized trading ecosystem on the Ethereum network benefits from this wrapped token use case.
Moreover, wrapped token holders can earn yield for depositing their assets in decentralized liquidity pools.
Automated market maker (AMM) and numerous lending protocols enable wrapped token holders to earn yield farming rewards for depositing wrapped tokens in a liquidity pool. In addition to liquidity pool rewards, investors are also typically rewarded with the protocol’s tokens to boost earnings.
For instance, Compound allows you to earn interest on your WBTC by lending WBTC in a liquidity pool. You will earn the governance token COMP as a reward for providing liquidity.
Crypto loan collateralization
DeFi protocols that provide crypto lending usually require borrowers to provide collateral to secure their loans. In other words, a certain amount of crypto is held in reserve for some time until the loan is repaid.
Originally, the collateral was mostly provided in the form of ETH. However, relying solely on ETH as collateral exposed Ethereum users to a high risk of price volatility. Instead, wrapped tokens such as WBTC can be used as collateral. This lessens the risk to the overall stability of the Ethereum network.
Protocols such as Compound, MakerDAO, and AAVE, for example, allow you to use wrapped tokens such as WBTC as collateral.
Until cross-chain interoperability becomes standard, wrapped tokens will continue to grow and expand their existing use cases.
– What Are Wrapped Tokens?
– WBTC: Where Bitcoin Meets DeFi
– What’s Wrapped Bitcoin and What’s So Special About It?
– Thanks to DeFi, Ethereum Edges Out Bitcoin in Global Realized Crypto Gains
– ‘Crypto is Dead. Long live Crypto’: Veteran DeFi Developer Andre Cronje Urges More Regulation
– NFTfi Eyes Massive Growth for NFT Lending; CryptoPunks, BAYC & Art Blocks Most Common Collateral