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What Are Wrapped Tokens?

By placing cryptocurrency in a special kind of digital vault, one can create what is called a wrapped token. The value of which depends on the stored Bitcoin, but the wrapped asset runs on a separate blockchain.

For example, consider Wrapped Bitcoin (CRYPTO: WBTC) and Bitcoin BEP-2 (CRYPTO: BTCB). One can swap WBTC or BTCB for Bitcoin (CRYPTO: BTC) directly on most wallets. And both are Bitcoins, but they don't operate on the Bitcoin blockchain. Instead, they transact on the Ethereum (ERC-20) and Binance (BEP-2) chains. Binance is the largest cryptocurrency exchange in the world by trading volume.

Readers might be wondering: What's the point of going through all this? Well, creating a wrapped token enables users to use their Bitcoin in self-executing, programmable agreements -- aka, smart contracts -- and earn fixed income.

Bitcoin on a blockchain circuit board.

Image source: Getty Images.

Bitcoin, but a bit better

The technology behind Bitcoin is becoming rapidly obsolete. One can only use regular Bitcoin to send money to one another, so its utility is limited and the network is relatively slow and inefficient. In fact, the Bitcoin blockchain can only process four transactions per second with an average confirmation time of 10 minutes. That all changed with the invention of WBTC and BTCB.

Take WBTC. Someone who has money in these tokens can lend it out through smart contracts on decentralized finance platforms like Aave. It allows users to connect their wallets and deposit cryptos or take out loans.

The lenders receive up to 4% per year at a fixed interest rate. Meanwhile, borrowers pledge their crypto as collateral, which automatically goes to the lender if they default. Correspondingly, Bitcoin holders who need cash but who don't want to sell their coins can pledge their WBTC and take out a loan in the form of stablecoins pegged to the U.S. dollar or other fiat money.

The interest rate on these loans typically varies between 3% to 9% per year, which is generally a better deal than swiping one's credit cards and paying 20% compounded interest per annum. In addition, payment terms are much more flexible than personal loans issued by banks, which typically stretch over a period of a few years to maximize interest profit.

Investors can also deposit their WBTC into liquidity pools to facilitate crypto trading. For example, imagine that on a certain day, a big crypto market participant decides to unload $10 million worth of an obscure altcoin. However, there are not enough buyers. Peer-to-peer liquidity providers (LPs) can come in to purchase those altcoins at below-market prices and then flip them at above-market rates. LPs typically earn a 0.3% commission for each trade they pro-rata facilitate with their coins. So in the above example, the WBTC investor would receive $3,000 for that trade if he deposited $1 million worth of WBTC and facilitated an equivalent volume of altcoin purchase. Rewards are deposited automatically as long as the tokens are used to provide liquidity on the platform.

A big step forward

The ability to earn fixed income from one's Bitcoin holdings is definitely novel. Plus, wrapped token holders will continue to benefit from any Bitcoin price gains, as both WBTC and BTCB are directly pegged to it. Also note that one can reinvest the interest back into the financial services, leading to compounded gains. Even if one isn't a big fan of the two decentralized finance services mentioned above, there are also tools like WBTC savings accounts, which offer higher interest rates than those of the major banks.

In sum, wrapped tokens are yet another innovation in the burgeoning cryptocurrency space. Bitcoin holders should definitely consider swapping their BTC for WBTC or BTCB, and take the opportunity to earn some extra cash on the side.

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Zhiyuan Sun owns shares of Bitcoin. The Motley Fool owns shares of and recommends Bitcoin. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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