DeFi is a rapidly growing and evolving niche that is changing many industries and our perception of finance in general. When considering the constant growth of DeFi solutions, we need to pay specific attention to the study of the role of wrapped tokens since they provide cryptocurrency users with a number of benefits. So, let’s find out the importance of token wrapping in DeFi and some actual advantages average crypto enthusiasts need to consider for further growth.
Before we explore the role of token wrapping in the sector of Decentralized Finance, it’s necessary to provide a basic definition of this concept and reveal some of its key features. So, warped tokens are tokens representing the value of other digital assets. For instance, when comparing wrapped and native Ether, you realize that WETH is pegged to the value of the native coin. Users can unwrap their WETH holdings whenever they want applying special bridge services, which are widely regarded as efficient solutions to eliminate the issue of cross-chain compatibility.
This idea slightly resembles the concept of stablecoins, which are also digital assets pegged to the value of other underlying assets. The only difference is that stablecoins’ values are derived from fiat currencies, while wrapped tokens are pegged to other cryptocurrencies running on different blockchains. This means that warped Ether, for instance, doesn’t represent the Ethereum network but runs as an ERC-20 token.
Incompatibility is one of the most common issues in the world of decentralized finance. This means that coins launched on one blockchain cannot be used on another. This creates a limitation on the use of cryptocurrencies and makes a negative impact on the overall flexibility and adaptability of digital assets. Token wrapping is one of the ways to eliminate this issue because wrapping a token means creating a new digital asset on another blockchain but that digital asset will remain pegged to the native one.
Every blockchain network and its corresponding native token form an independent ecosystem, where the value of the token is determined by the applications running on that particular network. To fully capitalize on the expansion of the DeFi sector, it is crucial to have technology that operates seamlessly across multiple blockchains.
Wrapped tokens play a vital role in achieving this interoperability by extending the functionality of native tokens beyond their original blockchain. This breakthrough enhances capital efficiency and opens up diverse investment possibilities across various blockchain ecosystems. By facilitating the seamless transfer of assets between different chains, wrapped tokens bridge the gap and foster a connected and fluid landscape of blockchain networks. This innovation propels the growth of decentralized finance by facilitating greater liquidity, accessibility, and interconnectedness in the digital asset space.
Despite the huge importance of this technology for the further growth of the DeFi sector and its big prospects, it’s necessary to realize that it still has some limitations to deal with. Here they come:
- Huge dependence on the native token: This issue is also common for stablecoins, as we all know numerous stories with stablecoins that failed because of the issues with their fiat currency reserves. The same can happen to wrapped tokens: any challenge in the original protocol leads to further complications in applications where the wrapped version of the asset is used.
- Bridging fees: To bridge tokens to other blockchains, for example, from Ethereum to Polygon, users need to pay high gas fees.
- Potential insolvency: Token wrapping is now the function of third parties, which aren’t as reliable and well-established as teams behind original projects. This means that their potential insolvency can force the value of the wrapped token extremely down leading to all its users losing their holdings.
- The disparity in value between wrapped tokens and their underlying assets: For example, if a wrapped token is designed to represent one Bitcoin, its actual value may not be equivalent to that of one Bitcoin. This variation can occur due to market fluctuations and the fees involved in creating and maintaining the wrapped token. Consequently, the value of the wrapped token may deviate slightly from the value of the underlying Bitcoin, despite their intended parity.
This discrepancy highlights the importance of understanding and evaluating the mechanisms that govern the pricing and redemption of wrapped tokens. Users should be aware of the potential risks associated with the inherent value disparities and carefully consider the implications before engaging in transactions involving wrapped tokens. Proper due diligence and awareness of market conditions are essential to mitigate any potential adverse effects on the value and usability of wrapped tokens.
So, what we have in the end: while having the potential to solve the incompatibility issue, wrapped tokens still carry risks for users due to their extreme dependence on both original protocols and third parties that manage them. That’s why, when you decide to deal with wrapped tokens, make sure you are aware of all the potential pitfalls that might encounter you in this way.