Key Takeaways
Wrapped tokens are digital tokens that represent other assets, typically those that belong to another blockchain.
They are designed to keep a 1:1 value match with the original asset held in reserve.
Wrapped tokens allow assets from one blockchain to be effectively used on another chain, which helps improve interoperability and increase the flow of assets.
Wrapped tokens can also open up new opportunities for users to explore decentralized finance (DeFi) services across different blockchain networks.
Introduction
Ever found it frustrating that you can’t use BTC on Ethereum, or ETH on the BNB Chain? Coins that exist on a given blockchain can’t be simply transferred to another network. Wrapped tokens are a way to circumvent this limitation, allowing you to effectively use non-native assets on different blockchains.
What Is a Wrapped Token?
A wrapped token is a tokenized version of another cryptocurrency. It’s pegged to the value of the asset it represents and typically can be redeemed for it (unwrapped) at any point. It usually represents an asset that doesn’t natively live on the blockchain that it’s issued on.
For example, Wrapped Bitcoin (WBTC) is a token on Ethereum that represents Bitcoin and maintains a 1:1 peg with the BTC held in reserve. This enables Bitcoin’s value to be used on Ethereum (or other chains).
It’s worth noting that you don’t have to worry about the wrapping and unwrapping process; you can trade wrapped tokens like other cryptocurrencies on crypto exchanges, such as Binance’s WBTC/BTC spot market.
How Do Wrapped Tokens Work?
Let’s take Wrapped Bitcoin (WBTC) on Ethereum as an example. WBTC is an ERC-20 token designed to hold a one-to-one peg to the value of Bitcoin, allowing you to effectively use BTC on the Ethereum network.
Wrapped tokens typically require a custodian, i.e., an entity that holds an equivalent amount of the asset as the wrapped amount. This custodian can be a merchant, a multisig wallet, a decentralized autonomous organization (DAO), or a smart contract. In WBTC’s case, the custodian needs to hold 1 BTC for each 1 WBTC that is created (minted). Proof of this reserve exists on-chain.
But how does the wrapping process work? A merchant sends BTC for the custodian to mint. The custodian then mints WBTC on Ethereum according to the amount of BTC sent. When the WBTC needs to be exchanged back to BTC, the merchant makes a burn request to the custodian, and the BTC is released from the reserves. You can think of the custodian as the wrapper and unwrapper. Typically, the addition and removal of custodians and merchants is managed by a DAO.
Which Blockchains Support Wrapped Tokens?
All major blockchains support different versions of wrapped tokens. Initially, Ethereum was the most common place for wrapped tokens (using the ERC-20 standard), but the technology has expanded to other blockchains like BNB Chain, Solana, Avalanche, and more.
WETH (Wrapped Ether) is a unique example on Ethereum: since ETH is not an ERC-20 token, WETH wraps ETH to comply with the ERC-20 standard, enabling seamless interaction with ERC-20-based applications.
Benefits of Wrapped Tokens
Wrapped tokens can offer multiple benefits, such as:
Boosted liquidity: Assets from different blockchains can be used on various platforms, making capital more efficient.
Better interoperability: They connect different blockchain networks, allowing cross-chain operations and integration.
Wider DeFi participation: Users can lend, borrow, farm yields, stake, and vote on platforms beyond their tokens’ original blockchain.
Lower costs and quicker transactions: Wrapped tokens may sometimes offer cheaper and faster transactions than the original chain.
Challenges and Risks
There are some risks and limits to keep in mind:
Trust in custodians: Many wrapped tokens depend on trusted parties that hold the original assets, which can pose risks and create points of central control.
Smart contract risks: The codes managing wrapping and unwrapping could have vulnerabilities.
Complexity: Using wrapped tokens can require some technical knowledge of different blockchains.
Regulation: Rules governing wrapped tokens vary globally and are still developing.
Fees and slippage: High transaction fees and possible price slippage during swaps may reduce some benefits.
Common Use Cases for Wrapped Tokens
Common use cases for wrapped tokens include:
Cross-chain trading and transfers: You can swap assets or transfer value across different blockchain networks.
Liquidity provision: Liquidity providers can deposit wrapped assets into pools on different blockchains.
DeFi collateral: You can use wrapped tokens as collateral for loans or yield farming on non-native blockchains.
NFT interoperability: NFTs can also be wrapped and used across multiple platforms.
Closing Thoughts
Wrapped tokens help increase liquidity and DeFi accessibility across different blockchain networks. They open up a world where capital is more efficient, and applications can easily share liquidity with each other. Still, it’s important to consider the risks before using wrapped tokens.
Further Reading
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