As part of the security measures taken by blockchains, non-native tokens are not inherently compatible with them, which makes interoperability a challenge. Wrapped tokens were created to resolve this issue by allowing communication between different networks.
They are digital assets representing another cryptocurrency or an asset on a non-native blockchain, like art and collectibles, shares, real estate, or gold. They are backed in value to their native cryptocurrency and can be converted back into the original token, when necessary.
Wrapped tokens: features
Since wrapped tokens are pegged to the value of another digital asset, it gives way to cross-chain interoperability and improves liquidity. This lets users stake their tokens and trade across various blockchains to earn rewards, rendering the market more effective.
Unlike original tokens, wrapped tokens rely on a centralized custodian. The custodians manage the wrapping and unwrapping of these tokens on demand. When a new coin is minted to transact on different platforms, the original token is wrapped and stored in a digital vault, which will be released from the reserve when the user requests the token on the second network to be burned. But are they risk-free?
Risks associated with wrapped tokens
While offering a solution to the lack of adaptability of traditional tokens, wrapped tokens pose certain security threats and risks that a user needs to be aware of before starting trading in them. Let’s see what exactly are those and see if the tokens are worth investing in.
1. Counterparty risks
The transaction of wrapped tokens involves different parties including the issuer, custodian, or the digital vault manager. Their responsibilities include writing the code, selecting the tokens, holding, rapping, and unwrapping them, and finally, converting the token in favor of the user.
So, if one of them fails to complete their tasks properly, this puts the users at risk, and they might lose all of their money in an instant.
2. Technical risks
Cross-chain interoperability greatly affects the security and privacy of blockchains. It creates a larger attack surface for potential threats, causing vulnerabilities in one of the networks to affect the rest.
Also, the smart contracts involved in cross-chain interoperability pose potential threats to security since they are vulnerable to bugs, network congestion, hacks, and so on. These issues could not only affect the network of blockchains but also the tokens they trade-in.
3. Centralization risk
Wrapping tokens takes away the decentralization feature of the cryptocurrency space. Unlike the original tokens that can be mined and issued by anybody, and are completely decentralized in their exchange, wrapped coins are often issued by a single, central authority.
If a user wants to wrap their tokens, they need to send them to a centralized exchange, where they will hold the original tokens for as long as the user requires, and send back an equal amount of wrapped tokens in exchange. This could lead to risks due to control and manipulation over conversion, and expose the tokens to a single point of failure.
4. Regulatory risk
Cryptocurrencies are normally not supported by governments or encouraged by central banks since they pose potential threats with their volatility and anonymity. Although mostly centralized, wrapped tokens that allow cross-chain transactions may pose the same threats or worse and make the government create laws restricting their possession and exchange.
New regulatory measures or actions regarding the issuance, adoption, trading, and redemption of wrapped tokens that could be established in the future might lead to legal ambiguity and affect the popularity, use, and value of the tokens.
As we have seen, wrapped tokens carry a few risks, but offer services that make up for the shortcomings of original tokens. Cross-chain interoperability benefits traders by providing them access to different networks with a single token, without having to purchase their native currencies.
Even though not fully decentralized, they are interchangeable and offer lesser transaction time and lower fees, making them a better option in slow networks like Bitcoin.
Whether the benefits trump the risks or is the other way around is a matter that needs a lot more research, and you need to educate yourself about every aspect of the tokens before investing in them.
