Beginner's Guide: What is the difference between wrapped Bitcoin and Bitcoin?

Wrapped tokens and wrapped Bitcoin have emerged as significant DeFi innovations. Learn why in this in-depth examination of these cryptocurrencies.

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Wrapped Bitcoin or wrapped crypto tokens may be familiar to cryptocurrency enthusiasts. In this article, we will look at the different types of wrapped tokens in crypto, the purpose of wrapped tokens, and what they mean to you as a crypto trader and investor.

Blockchains such as Bitcoin and Ethereum have different protocols and functionalities, and they cannot communicate with one another due to fundamental differences in their algorithms. While this independence protects individual blockchains' sovereignty and security, it also calls into question the existence of an interoperable ecosystem in which data and information can be easily exchanged.

Wrapped crypto tokens, for example, have a valid application in decentralized finance (DeFi), where efficient, smooth, and fast movement of funds is critical.

Some more recent blockchains, such as Polkadot, were created to address the issue of interoperability. Wrapped tokens were created in order to find a solution and allow communication between early networks such as Bitcoin and Ethereum.

Wrapped crypto tokens

Wrapped crypto tokens are cryptocurrencies that are pegged to the value of another original cryptocurrency or asset, such as gold, stocks, shares, or real estate, and are used on DeFi platforms.

The original asset is 'wrapped' into a digital vault, and a new token is created for use on other platforms. Wrapped tokens enable non-native assets to be used on any blockchain, build bridges between networks, and implement cryptocurrency interoperability.

They can represent anything from art and collectibles to commodities, crypto assets, equity and stocks, and even fiat currencies and real estate. Because wrapped tokens are linked to another asset, they must be regarded and managed by a custodian entity that wraps and unwraps the asset. We'll look at why this is a limitation in the decentralized world of cryptocurrencies.

Wrapped The first wrapped Bitcoin tokens, denominated in wBTC, were used in the Ethereum blockchain via smart contracts, allowing investors to earn a fixed income. Aside from Bitcoin, the list of wrapped tokens also includes other assets that are primarily compliant with Ethereum ERC-20 and Binance Smart Chain BEP-20.

As strange as it may sound, despite the fact that ERC-20 tokens are issued on the Ethereum platform, ETH is not compliant with them because it was developed before them. As a result, Ether, like Bitcoin, must be wrapped in order to comply with other ERC-20 token standards. As a result, a tokenized version of Ether is created on the Ethereum platform.

Other blockchains, such as Cardano, Polkadot, and Solana, have begun to experiment with wrapped tokens in order to facilitate access to DeFi applications.

Among the more recent projects is the bLuna, a wrapped Luna token that can be freely traded or used as collateral on other protocols on the Terra network, which is both a price-stable and growth-driven platform.

Types of wrapped tokens

Despite significant differences with the more established wrapped coins, it is widely acknowledged that stablecoins were the first type of wrapped tokens. A stablecoin, such as USDT (Tether), is backed by approximately one dollar. Tether, on the other hand, does not hold the exact amount of physical USD for each USDT held, and its reserves include a variety of assets, including cash, cash equivalents, investments, loan receivables, and so on.

Wrapped tokens are classified into two types: cash-settled and redeemable. Tokens with a cash settlement cannot be redeemed for the underlying asset. Redeemable tokens, on the other hand, allow investors to exchange the wrapped token for the underlying asset. Wrapped tokens can also be found on other blockchains. Wrapped privacy coins, for example, are hosted on the blockchains of Monero and ZCash.

How do wrapped tokens work?

The custodian mints on a given platform, such as Ethereum, the amount of the original token sent at the request of merchants such as Airswap, CoinList, 0x, AAVE, or Maker.

When the wrapped token needs to be converted back into the original asset or a coin like Bitcoin, the user will request the custodian to release the token from the reserves in a similar manner. In other words, for every wBTC that exists, there is a Bitcoin that a custodian holds.

The process of creating and managing wrapped tokens represents a limitation in crypto as the requirement of a custodian to trust for holding the funds defeats the purpose of an open and decentralized blockchain ecosystem.

Because traders cannot use wrapped tokens for cross-chain transactions independently, a custodian is still required. However, technology is rapidly evolving, and we may soon have some decentralized options.

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Wrapped Bitcoin

The first wrapped Bitcoin (wBTC) protocol, which debuted in January 2019, was designed to bring Bitcoin potential and liquidity to the Ethereum network while also providing the flexibility of an ERC-20 token.

While the original BTC could not be used for decentralized finance (DeFi) transactions, a wrapped Bitcoin could replace the original asset and transact within the DeFi ecosystem or any other decentralized application within the Ethereum network.

A Bitcoin that has been wrapped is a significant addition to the cryptocurrency world. While the wBTC has the same value as the original Bitcoin, the functional aspect has increased significantly, increasing the possibility of using Bitcoin for other use cases such as DeFi.

Simply put, a Bitcoin holder can lend Bitcoin using smart contracts by connecting their wallet to a decentralized platform and earning a fixed interest rate per year. Simultaneously, borrowers use their cryptocurrency as collateral, which is automatically transferred to the lender if they default.

Using this type of financing, investor lenders can still earn some returns even during bear markets when the asset's value falls.

How do wrapped Bitcoin tokens work?

The wBTC protocol was created and is managed primarily by three actors:

The DAO (Decentralized Autonomous Organization) is made up of 17 DeFi space members who will hold a multi-sig (multi-signature) contract to add or remove wBTC merchants and custodians.

The merchants are administrators who initiate the minting process by sending a certain amount of BTC to the custodian and requesting the minting of the equivalent amount in wrapped tokens based on the demands of investors and traders.

Custodians act as vaults for wBTC, providing reliability and security while also ensuring that all wBTC is fully backed and verified through on-chain proof of reserves. They mint BTC and return to the merchant the equivalent amount of wBTC (one to one pegged to the value of BTC).

In essence, the merchant sends real Bitcoin to a Bitcoin blockchain custodian address, where it is locked. The custodian address mints the equivalent amount in wBTC on Ethereum once it receives the real BTC.

When the wBTC must be converted back into real BTC, the ERC-20 BTC token is burned (destroyed), and the locked BTC on Bitcoin is released. The blockchain tracks and verifies the minting and burning of tokens.

The demand for such a token arose as DeFi grew in popularity, with billions of dollars now being invested in lending, options, derivatives, and other types of financial applications. The demand for using BTC as an underlying asset in DeFi was so great that it had to be converted into an ERC-20 compatible token in order to participate in the ecosystem, which is primarily built on Ethereum.

The complete order book of wBTC trading can be viewed here. wanBTC, renBTC, sBTC, WBTC, and tBTC are all examples of ERC20-based BTC tokens minted on Ethereum, depending on the protocol or organization behind them.

Is wrapped BTC safe?

A wrapped Bitcoin token is safe from a technical standpoint. It will most likely be held in safe platforms like Ethereum or Binance Smart Chain, and once converted into an ERC-20 or BEP-20 token, it will secure the related network.

One of the major flaws of wrapped BTC tokens is the requirement to trust the custodian who holds the underlying asset. If the custodian unlocks and releases the real Bitcoin to another party, token holders of the ERC-20 compatible wrapped BTC will be left with a worthless asset.

The level of security provided is determined by how Bitcoin is held. A centralized custodial bridge that holds Bitcoin is an organization that, for example, promises to mint ERC-20 tokens on Ethereum. The centralized entity must be trusted to keep the BTC and not flee with it. Users must ensure that these organizations are at the very least backed by guarantees and insurance in the event that something goes wrong.

In the decentralized world of crypto, a decentralized smart-contract-managed bridge would be the best option. There is no need to rely on a third party; instead, rely on the code of immutable time-stamped smart contracts.

Wrapped BTC bridges (cross-chain connections) have long been a source of contention in the DeFi community, with custodians insisting on their security.

Are wrapped tokens a good investment?

Wrapped tokens are becoming more popular as a good investment in the cryptocurrency world, where decentralized finance will undoubtedly play an important role. In just over a year, approximately $800 million in Bitcoin was converted into wBTC, giving an idea of the industry's current capitalization.

Arcane Research estimates that the amount of Bitcoin locked on the Ethereum blockchain in 2021 will be 189,000 BTC. It is estimated that wrapped Bitcoin tokens now account for a record 1% of Bitcoin's circulating supply of 18.73 million.

Wrapped tokens improve liquidity and capital efficiency for both centralized and decentralized exchanges by allowing assets to be moved across multiple chains that would otherwise be isolated.

Another advantage is that wrapped tokens offer faster transaction times and lower fees, which are especially beneficial for slow blockchains like Bitcoin or Ethereum.

Wrapped tokens, unlike other assets, provide fractionalized ownership, allowing owners to purchase and hold a small portion of the asset.

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