You most likely have heard of wrapped Bitcoin. What exactly is wrapped Bitcoin?
The concept of wrapping cryptocurrencies is an important one to understand, especially with the rise of decentralized finance applications (popularly known as DeFi).
Just to remind you, a DeFi is an application built on a blockchain whose purpose is to provide a financial service that would otherwise only be available from a centralized financial entity like a bank, insurance, or a brokerage firm.
The initial application of blockchain was payment. But the financial institutions that the technology seeks to compete with do more than just payments. They take deposits, give credit, provide insurance services, and support other transactions such as stock trading.
In fact, payments are not the primary product of banks.
DeFi is an application that is offering these additional services on the blockchain in a peer-to-peer arrangement.
The smart contract executes the processes in a DeFi.
Now, what is a wrapped token, and what does the concept have to do with DeFi?
A wrapped token is a token created to represent another in a smart contract. The need to create a wrapped token arises when the original token does not exist on the platform on which the smart contract is formulated.
For example, the Ethereum blockchain was developed to primarily host, power, and execute smart contracts. While smart contracts can be implemented on the Bitcoin blockchain, the process is a little more complicated.
For that reason, almost all active decentralized Finance applications (or DeFi), have been built on the Ethereum blockchain.
It turns out that some of these DeFi applications, in particular, decentralized exchanges (or DEX), need to support the trading of Bitcoin, which is an asset outside of Ethereum. For example, many investors would love to trade Bitcoin on the Uniswap exchange.
To facilitate transactions that involve Bitcoin, DeFi applications like Uniswap have a solution in wrapping assets that are not domiciled on the Ethereum blockchain.
That means, for example, creating a token on the Ethereum blockchain that represents Bitcoin.
For each wrapped Bitcoin, an equivalent amount of real bitcoins is locked in a special wallet.
The wrapping process is implemented by a protocol that talks to the Bitcoin blockchain, the Ethereum blockchain, and the DeFi itself.
We now have wrapped Bitcoin, wrapped Ethereum, and others. Over time we might see this concept become a critical component of the blockchain ecosystem, especially as we embraced interoperability.