As mighty as it is, the Bitcoin (BTC) blockchain has been criticized for its shortcomings with regard to interoperability. The need for interoperability across blockchain networks has become more pertinent, especially with the emergence of decentralized finance (DeFi). Essentially, cryptocurrency enthusiasts are actively seeking various means of deploying crypto assets across DeFi protocols without incurring restrictions.
One apt solution that has surfaced to address the challenge of composability is the wrapped asset. These assets enable users to send and utilize cryptocurrencies on blockchains to which they are not native. For example, BTC can be deployed on the Ethereum blockchain even though both blockchains do not share an atom of compatibility under normal circumstances. Apart from BTC, some other blockchains are not in any way interoperable with the Ethereum network but given the advent of wrapped assets, this has become a possibility.
What is A Wrapped Asset or Digital Currency?
A wrapped asset is a crypto token that is pegged to the value of another cryptocurrency. It is called a wrapped asset because the it is put in a smart contract or stored by a custody provider that allows it to be tokenized or wrapped and then utilized on another blockchain, despite the limitations surrounding composability. A wrapped asset’s value corresponds to that of the asset it represents and can be redeemed for the original asset at any time.
Wrapped assets could be thought of as stablecoins which often derive their value from fiat currencies, particularly the US dollar. A case in point is Tether (USDT), which is pegged to the fiat dollar on a one-to-one ratio. However, in the real sense, Tether (USDT) cannot be considered a wrapped asset because the equivalent amount of fiat dollar for each circulating USDT is not held in the reserve. Rather, the reserve comprises cash, assets including receivables from loans. In the context of wrapped assets, USDC could be regarded as the wrapped version of the fiat dollar (USD).
How Wrapped Assets Work
The most commonly held wrapped asset or digital currency—Wrapped Bitcoin (wBTC)—was created by MakerDAO who are also the creators of the stablecoin DAI. wBTC is a tokenized version of Bitcoin on the Ethereum blockchain; in other words, wBTC is an ERC-20 token that is pegged to the value of Bitcoin and permits the use of Bitcoin on Ethereum, despite the two being antithetical to each other. The Ethereum blockchain is tolerant to other tokens because it is Turing-complete and supports smart contracts that are compatible with decentralized applications or DApps. On the other hand, the BTC blockchain lacks Turing-completeness, which is responsible for its inability to enable smart contracts for decentralized finance.
Custodial Tokenization of Bitcoin
Wrapped tokens are often in the possession of a custodian who holds the exact amount of an asset that a user is willing to convert into a wrapped token. The custodian does not necessarily have to be human—it could instead be a smart contract, a multisignature (multisig) wallet or even a decentralized autonomous organization, which was briefly known as a DAO. In addition, the custodian holds one BTC for every one wBTC that has been tokenized.
Wrapped Bitcoin is minted when a user sends Bitcoin to the custodian to be tokenized. In turn, the custodian mints wBTC on Ethereum based on the amount of BTC he received. Subsequently, the wBTC can be utilized across Ethereum-based DeFi protocols without any hassle. When the merchant has completed the activity for which he minted wBTC, he can unwrap the token by initiating a burn request to the custodian, and the deposited Bitcoin is then released to the merchant's wallet. Here, the custodian plays two roles: first as a wrapper and then as an unwrapper.
Non-Custodial Tokenization of Bitcoin
While custodial tokenization may be the best way to tokenize Bitcoin, it often requires the trust of the merchant. The other means by which Bitcoin can be tokenized for use on Ethereum involve an automated framework or smart contracts, which are also known as non-custodial techniques[DP8] . In this case, no trusted entity is needed. Instead, both the minting and burning processes are executed on-chain and in a trustless and permissionless manner. The original token, which also serves as the collateral, is locked on-chain until the tokenized version has been destroyed.
Both types of approaches have their advantages and disadvantages. While the custodial means provides more security but falls short in relation to trust, its non-custodial counterpart fulfills trust requirements as it adopts an automated process, yet it increases security risks due to bugs and other errors that may arise on the user's part. An apt example of a Bitcoin that is minted via smart contracts is renBTC, which is tokenized through the Ren Virtual Machine (RVM). Other examples of tokenized Bitcoins include sBTC, iBTC, imBTC, and HBTC, which are owned by the crypto exchange, Huobi.
Wrapped Assets on Ethereum
A cryptocurrency wrapped on Ethereum is usually made to comply with the ERC-20 standard, which consists of a set of rules that regulate token creation on the Ethereum blockchain. Interestingly, Ether, the native token of the Ethereum network, has a wrapped version known as Wrapped Ether (WETH). While WETH are built according to the ERC-20 standard, Ether is not. This is because Ether was developed before ERC-20 became a part of the cryptocurrency landscape. As such, many DApps require users to swap Ether for WETH or any other ERC-20 compliant cryptocurrency before they can interact with their platforms.
Wrapped Assets on Algorand
Algorand blockchain is one of the leading technologies that is contributing to the expansion of DeFi by supporting blockchain composability with a highly scalable, secure and cost-efficient network. The green and carbon-negative blockchain give an edge to wrapped assets because it uses a pure proof-of-stake consensus model (PPoS). This way, interoperability across blockchains is facilitated without the consumption of much energy. At the core of the Algorand ecosystem is ALGO, the blockchain's native token, which promotes involvement among members of the community and supports research and development. ALGO also has a wrapped version known as wALGO or Wrapped Algorand, which is a fully collateralized synthetic representation of the token.
wALGO can be deployed on Ethereum (ERC-20) and on Algorand (ASA) itself. Each wALGO is backed by the native token (ALGO) on a one-to-one ratio. The wrapped ALGO can be used for a number of purposes, such as minting and receiving rewards by staking on StakerDAO—a platform for governing financial assets in a decentralized, secure, and compliant fashion. Other utilities include swapping and withdrawal where they are exchanged for ALGO and the vault on StakerDAO burns the wALGO while unlocking the equivalent amount in ALGO.
The cross chain bridge Algomint has also significantly contributed to the popularity of wrapped assets on Algorand with their protocol allowing users to wrap BTC and ETH to mint goBTC and goETH. These assets are back by their namesake on a one-to-one ratio while giving them the inherent utility of the Algorand blockchain. The platform are also looking to add several other assets including stablecoins in the coming months which server to increase accessibility and activity for DeFi on Algorand.
Merits of Wrapped Assets
While many blockchains have their own token creation standards, they lack multi-chain functionality. In light of this, wrapped assets support the use of non-native tokens on a unique blockchain; for example, BTC can deployed on Ethereum to produce wBTC. In addition, wrapped assets promote liquidity and capital efficiency for cryptocurrency exchanges. The possibility of wrapping an asset for use in another blockchain helps to bridge otherwise isolated liquidity. Moreover, there is a great advantage in terms of transaction speed and fees. For instance, when deployed on Algorand as a wrapped asset, Bitcoin’s ability to settle transactions within 10 minutes can also be coupled with the other currency’s carbon-negative and low-cost execution.
Disadvantages of Wrapped Assets
Minting wrapped Bitcoin on Ethereum can be costly, especially during periods of network congestion. Slippage can also occur during the minting process, thereby reducing the amount of wBTC in comparison to the amount of BTC deposited as collateral. Ethereum has failed to address the problem of high gas costs on its network, which is one of the bottlenecks that is slowing down the adoption of decentralized finance.
Wrapped assets remain one of the best solutions to the problem of composability in the related ecosystem as they create more bridges between the various blockchains. These assets unlock the opportunities in DeFi, meaning that capital is becoming more efficient and decentralized applications can leverage a vast liquidity pool.