In the world of cryptocurrencies, a wrapped token is a digital representation of a cryptocurrency or asset that is made compatible or convertible when ‘wrapped’ so that it can be used on other blockchains. This version of the cryptocurrency is on a different blockchain than the one it was originally on. It is backed by reserves and is pegged 1:1 to the real asset.
Blockchains are like separate digital networks or ledgers. You could think of them as different countries, each with its own rules and money. A wrapped token then works like a digital gift card. The gift card isn’t actual cash, but it represents cash. So now, you can use that cash in places where cash itself isn’t accepted.
Bitcoin (BTC) and other cryptocurrencies are built on their own blockchain, which for BTC is the Bitcoin network. This means it can’t directly interact with other blockchains like Ethereum. A wrapped token addresses this issue by creating a bridge between the two blockchains. It locks up the original asset on its home blockchain and gives out a token that is the same on the target blockchain.
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To make this even easier, think of it like having dollars (BTC) and wanting to buy something in a store that only takes euros (Ethereum tokens). You can go ahead and exchange your dollars for a “wrapped dollar” voucher that’s treated like euros in that store. Better still, you can always redeem the voucher back for your original dollars.
How did wrapped tokens come to be?
The idea of cryptocurrencies started with Bitcoin in 2009, then came Ethereum in 2015, which introduced smart contracts that enable decentralized applications (dApps). It brought in lending platforms, decentralized exchanges (DEXs), and games that used various DeFi Protocols. With this, the Ethereum ecosystem exploded as people could now earn interest, borrow, or trade without banks. But Bitcoin holders were left out because BTC couldn’t run on Ethereum.
This interoperability problem led to the creation of wrapped tokens between 2018 and 2019. The idea was to bring Bitcoin’s massive liquidity into Ethereum’s DeFi world. Wrapped Bitcoin (WBTC) was one of the first popular ones. It was made by a group of companies, including BitGo, Kyber Network, and Ren. Since then, wrapped tokens have become common and are seen across blockchains, like Solana, Binance Smart Chain, Polygon, among others. It solves the basic ask of blockchains being able to talk to each other by acting as an interoperability tool.
When Can You Use a Wrapped Token?
You use wrapped tokens when you want to move value or functionality between blockchains without selling the asset you already have. It lets you use DeFi features. For instance, if you own Bitcoin and want to lend it on an Ethereum-based platform like Aave or Compound to make money, you can’t just send it. You will have to convert it to a WBTC and only then will you be able to earn.
Wrapped tokens allow you to trade on different exchanges. This is particularly true for DEXs such as Uniswap on Ethereum, which exclusively accept ERC-20 tokens. Wrapping tokens from other chains allows for seamless trading. These tokens can also be used in liquidity pools on platforms like PancakeSwap (on BSC). This give people access to assets from various chains and can provide liquidity and earn fees while doing so. Sometimes, users wrap tokens to move to faster, and trade on cheaper chains, like wrapping ETH into Wrapped ETH (WETH) on Polygon for lower gas fees.
How Does it Work?
The wrapping process involves three steps:
1. Locking up the original asset: by sending it to a decentralized protocol or, in some cases, a centralized agency like BitGo, which is the custodian for WBTC. Once this is done, the original asset is locked up and can’t be moved while the wrapped tokens exist.
2. Wrapping the asset: a copy of it is created on the chosen blockchain.
3. Getting the token back: When a user wants their original asset back, the wrapped token is destroyed, and they get the original asset back.
It is easy to use wrapped tokens thanks to wallets like MetaMask or Trust Wallet. All you have to do is to approve the transactions once you are connected. There are fees (gas), and it could take anywhere from minutes to hours, depending on how busy the network is.
There are also two main types of wrapping. One is custodial, which means that a trusted third party, like BitGo for WBTC, keeps the original assets safe. This is centralized, but it is safe because there are regular audits conducted. The second one is not custodial: Wormhole is an example of a decentralized bridge that uses smart contracts to wrap tokens up. The money isn’t controlled by one person, and hence this lowers risks.
The Merits and Demerits of Wrapped Tokens
Wrapped tokens offer several advantages that make them more user-friendly. They bring idle assets into high-yield environments. Wrapped tokens have helped DeFi TVL (Total Value Locked) grow to hundreds of billions. They let you make hybrid apps, like using BTC as collateral for loans based on ETH. You can hold your main asset (like BTC) and earn on another chain without having to sell it. This kind of plan is called risk diversification.
Wrapped tokens also make crypto easier to use for beginners because they let them use advanced features without having to know a lot about technology. But they have their own problems, just like any other technology. If the custodian gets hacked or goes out of business, your locked assets could be lost. Remember the 2014 Mt. Gox hack? Similar risks apply.
Even decentralized bridges can have points of failure. For instance, the Ronin Bridge hack in 2022 took $625 million worth of wrapped assets. Exploits can happen when there are bugs in code. Audits are helpful, but they don’t work all the time. Another disadvantage is that gas fees add up, and for beginners, understanding bridges can be hard, which could lead to mistakes like sending money to the wrong addresses.
Real-World Examples of Wrapped Tokens
Let’s look at some practical examples of wrapped tokens.
- Wrapped Bitcoin (WBTC): This is among the most used. A Bitcoin holder wraps 1 BTC into WBTC on Ethereum. They can now lend it on Aave to get 2–5% APY or trade it for NFTs on OpenSea. As of 2023, WBTC’s m-cap has risen to over $10 billion, which shows how popular it is.
- Wrapped ETH (WETH): Ethereum’s native ETH isn’t ERC-20 compliant, so WETH wraps it for use in dApps. Example: To provide liquidity on Uniswap, you wrap ETH into WETH, pair it with another token, and earn trading fees.
- Wrapped Solana Tokens on Ethereum: Using the Wormhole bridge allows you to wrap SOL into wSOL on Ethereum. A gamer might do this so they can use SOL in an Ethereum-based metaverse without having to sell it.
- Cross-Chain Stablecoins: Wrapped USDT (Tether) that can be found on more than one chain today. There are several examples of how users wrap USDT from Tron to Ethereum to get better returns.
Wrapped tokens act like a passport for your crypto assets, allowing them to travel and thrive across borders. They’re crucial, as they facilitate a connected blockchain world. While merits like liquidity and innovation are hard to miss, challenges like security risks are a clear sign that reminds us to proceed with caution. In simple words, wrapped tokens democratize finance, turning isolated assets into global players.
