What Are Wrapped Tokens?
Wrapped tokens are tokenized versions of cryptocurrencies that exist on one blockchain but are represented and used on another. For example, Wrapped Bitcoin (WBTC) is an ERC-20 token on the Ethereum blockchain that represents Bitcoin (BTC).
The main goal of wrapping is to bring the value of a non-native asset (like BTC) to another blockchain (like Ethereum), allowing users to access new functionalities such as smart contracts, DeFi (Decentralized Finance), and faster transaction processing.
Why Wrapped Tokens Are Needed
- Interoperability
Blockchains like Bitcoin and Ethereum operate independently. Bitcoin doesn’t support smart contracts or DApps. Ethereum does. Wrapped tokens bridge the gap by allowing Bitcoin holders to use their BTC on Ethereum-based DeFi platforms. - Liquidity Expansion
Wrapping tokens increases liquidity on platforms that don’t natively support the original asset. For instance, ETH-based platforms can use WBTC to tap into Bitcoin’s vast liquidity. - Efficiency
Wrapped tokens can be faster and cheaper to transfer on more efficient blockchains. Bitcoin transactions may take longer and cost more than transferring ERC-20 tokens.
How Wrapped Tokens Work – Step-by-Step
Let’s take WBTC (Wrapped Bitcoin) as our example and explore how it’s created and used.
Step 1: Initiating a Wrap
Suppose Alice wants to convert her BTC to WBTC to use it on a DeFi app like Uniswap or Aave.
- Alice contacts a merchant (e.g., Kyber Network or Ren).
- She deposits BTC to the merchant’s Bitcoin wallet address.
- The merchant verifies the transaction on the Bitcoin blockchain.
Step 2: Custodian Issues WBTC
- After verifying Alice’s BTC deposit, the merchant sends a minting request to a custodian (e.g., BitGo).
- The custodian holds the actual BTC and mints an equivalent amount of WBTC on the Ethereum blockchain.
- If Alice sends 1 BTC, the custodian mints 1 WBTC and sends it to Alice’s Ethereum wallet.
This process is known as minting.
Step 3: Using WBTC
Now that Alice has 1 WBTC in her Ethereum wallet, she can:
- Trade WBTC on Ethereum-based exchanges like Uniswap or Sushiswap.
- Lend or stake WBTC on DeFi platforms for interest.
- Use WBTC as collateral for loans on platforms like Compound or MakerDAO.
Since WBTC is an ERC-20 token, it behaves just like any other Ethereum-based token.
Step 4: Redeeming WBTC
Later, Alice decides to convert her WBTC back into BTC.
- She initiates a burn request through the merchant.
- The merchant sends a burn instruction to the custodian.
- The custodian destroys (burns) Alice’s 1 WBTC on Ethereum.
- The custodian releases 1 BTC from its Bitcoin reserve and sends it to Alice’s Bitcoin address.
This process ensures the 1:1 backing of WBTC to BTC is always maintained.
Who Are the Key Players?
- User – The individual who wants to wrap or unwrap tokens.
- Merchant – Facilitates the wrapping/unwrapping process and communicates with the custodian.
- Custodian – Holds the actual asset (e.g., BTC) and issues or burns the wrapped version (e.g., WBTC).
- Governance DAO – The WBTC DAO includes various DeFi platforms and community members who govern the protocol.
Smart Contract Role
Wrapped tokens rely on smart contracts to manage the minting, transferring, and burning process transparently. These contracts:
- Maintain the supply of wrapped tokens.
- Record all wrapping/unwrapping events.
- Ensure that users can verify the one-to-one backing.
Ethereum’s transparency allows anyone to audit the WBTC smart contract and verify the BTC reserve using public blockchain data.
Benefits of Wrapped Tokens
- Access to DeFi
BTC holders can use their assets in DeFi without selling them. - Interoperability
Tokens can move freely across chains using bridges. - Increased Liquidity
Helps DeFi apps by providing liquidity in assets that were previously unavailable. - Programmability
Wrapped tokens like WBTC can interact with smart contracts, enabling automated financial services. - Speed and Cost
Transfers can be faster and cheaper on Ethereum or Layer 2 networks.
Risks and Limitations
- Centralization Risk
Custodians like BitGo control the actual BTC. If compromised or mismanaged, users could lose their funds. - Smart Contract Risk
Bugs in the smart contract could be exploited, leading to losses. - Trust Assumption
Users must trust that the custodian holds the actual BTC and won’t default. - Regulatory Concerns
As wrapped tokens involve custodians, they may be subject to regulatory compliance and audits.
Real-World Use Cases
- Yield Farming
BTC holders wrap their coins as WBTC to stake or lend in DeFi platforms and earn interest. - Collateralization
WBTC is used as collateral to mint stablecoins or take out loans. - Cross-Chain Swaps
Wrapped tokens allow users to trade assets across chains seamlessly using DEXs and bridges. - Liquidity Pools
WBTC is commonly paired with ETH or USDC in pools on Uniswap or Curve, allowing users to earn fees.
Examples of Wrapped Tokens
- WBTC (Wrapped Bitcoin) – BTC on Ethereum.
- renBTC – Another wrapped version of BTC using a different decentralized custodian (RenVM).
- wETH (Wrapped ETH) – A wrapped form of ETH that conforms to the ERC-20 standard.
- WBGL, WBNB, WADA – Wrapped versions of other coins like BNB and ADA on different chains.
Each wrapped token follows a similar principle: a real asset is locked, and an equivalent token is issued on another blockchain.
Wrapped Tokens vs. Bridges
While both serve cross-chain needs, they’re different:
- Wrapped Tokens rely on custodians and are issued as representations.
- Bridges move assets across chains through liquidity pools or synthetic assets without always needing a 1:1 peg.
Bridges may involve more complex mechanisms like burning and minting on both sides, or locking on one chain and releasing on another.
Future of Wrapped Tokens
As cross-chain technology improves, the need for wrapped tokens may decrease in favor of native multi-chain support. However, until seamless interoperability becomes the norm, wrapped tokens will continue to play a crucial role in DeFi and blockchain ecosystems.
New approaches like cross-chain liquidity networks, zero-knowledge proofs, and non-custodial bridges may redefine how assets move across chains, reducing reliance on centralized custodians.