What Are Wrapped Tokens and How Do They Work?
Most blockchains, like Bitcoin and Ethereum, operate in isolation and cannot naturally communicate with each other. This limits the utility of their native assets, keeping valuable liquidity locked within separate ecosystems.
Wrapped tokens act as a bridge between these separate networks. They enable cryptocurrencies on their native blockchains to be moved to another chain, which provides additional functionality to the underlying assets and unlocks new opportunities.
This article will introduce you to wrapped tokens, explaining what they are, how they work, their practical uses, and the risks you should be aware of.
Let's dive in!
What Are Wrapped Tokens?
A wrapped token is a tokenised version of another cryptocurrency that is pegged 1:1 to the value of the asset it represents. Think of it like a casino chip or a coat check ticket; it is a placeholder that can be redeemed at any time for the original, underlying asset. The main purpose of wrapped tokens is to enable interoperability, allowing a cryptocurrency from one blockchain to be used on another.
The core example is BTC. The Bitcoin network is highly secure, but it lacks the complex smart contract capabilities of a network like Ethereum. This means native BTC cannot be used in Ethereum's vast decentralised finance ecosystem. By wrapping Bitcoin, Wrapped Bitcoin (wBTC) is created—an ERC-20 token that is fully compatible with Ethereum's dApps, allowing Bitcoin's immense value and liquidity to flow into DeFi.
Other key examples include:
Wrapped Ether (wETH): This is a unique case. Native ETH was created before the ERC-20 token standard became universal on its own network. As a result, ETH itself is not compliant with many DeFi protocols that are built to handle ERC-20 tokens. Therefore, ETH must be wrapped into wETH to interact seamlessly with these applications.
Wrapped Staked ETH (wstETH): This is a wrapped version of Lido's stETH token. Staking rewards cause the balance of stETH to change daily, a process known as rebasing. However, some DeFi protocols require tokens to have a constant balance. wstETH solves this by wrapping stETH into a non-rebasable token whose value still accrues staking rewards.
How Are Tokens Wrapped for Use on Another Blockchain?
The process of creating a wrapped token typically involves three parties: a user who wants to wrap their asset, a custodian who holds the original asset in reserve, and a merchant or decentralised bridge protocol that manages the minting and burning. The custodian's role is crucial, as they must securely lock away the original asset to back the wrapped version.
Here is a step-by-step breakdown of how wrapping and unwrapping work:
A user sends their native cryptocurrency (for example, 1 BTC) to a merchant or directly to a custodian's smart contract.
The custodian securely locks the 1 BTC in a reserve. To ensure transparency and build trust, this is often verifiable on-chain through a "Proof of Reserve" mechanism.
The custodian then instructs a smart contract to mint an equivalent amount of the wrapped token (in this case, 1 wBTC) on the target blockchain, such as Ethereum.
The newly minted 1 wBTC is sent to the user's wallet address on the Ethereum network. The user is now free to use it in any DeFi application that supports ERC-20 tokens.
When the user wants their original Bitcoin back, the process is reversed. The user sends the 1 wBTC back to the custodian, who then burns the wBTC. Once the wrapped token is destroyed, the custodian releases the original 1 BTC from the reserve back to the user.
This constant mint-and-burn mechanism is what ensures the 1:1 peg between the wrapped token and the original asset is always maintained.
Practical Use Cases
Wrapped tokens play an integral role in the crypto ecosystem, enabling a wide range of powerful applications that were previously impossible.
Access to DeFi: Wrapped tokens allow non-native assets, like Bitcoin, to be used as collateral in lending protocols, for trading on decentralised exchanges, and for earning returns in yield farming on other blockchains.
Enhanced Liquidity: By bringing assets from major blockchains like Bitcoin into the DeFi ecosystem, wrapped tokens significantly increase the overall liquidity available, leading to more efficient markets and better pricing for traders.
Cross-Chain Trading and Interoperability: They act as bridges, enabling the seamless transfer of value and data between otherwise isolated blockchain networks.
Faster and Cheaper Transactions: Users can wrap an asset and transact with it on a faster, more cost-effective blockchain (e.g., a high-throughput Layer 2 network) to avoid the high fees or slow speeds of the native chain.
What Are the Risks of Wrapped Tokens?
While wrapped tokens are incredibly useful, they introduce new layers of risk that users must understand before interacting with them.
Many wrapped tokens, including wBTC, rely on a centralised custodian to hold the underlying assets. This introduces a single point of failure. If the custodian is hacked, mismanages funds, or faces regulatory action that freezes the assets, the wrapped tokens could lose their backing and become worthless.
Moreover, the entire wrapping, unwrapping, and bridge infrastructure is powered by smart contracts. Any bug or vulnerability in the code could be exploited by attackers, leading to a potential loss of funds. This has been demonstrated in several high-profile bridge hacks that resulted in hundreds of millions of dollars in losses.
Also, the 1:1 peg between a wrapped token and its underlying asset is reliant on the integrity of the reserves and the minting/burning mechanism. In scenarios of extreme market stress or a loss of trust in the custodian, the wrapped token could lose its peg and trade at a significant discount to the original asset.
How to Use Wrapped Tokens Securely
While risks exist, they can be managed by following a few key security best practices.
Stick to well-established and audited wrapped tokens like wBTC and use trusted, battle-tested bridge protocols.
Whenever possible, check if the provider offers a transparent Proof of Reserve dashboard where you can independently verify that the assets are fully backed.
Be aware of whether the wrapped token relies on a centralised custodian or a decentralised smart contract system and understand the specific risks of that model.
Protect your own wallet with strong passwords and never share your seed phrase, as this is the ultimate safeguard for all your assets, including any wrapped tokens you hold.
Get Started on VALR
Wrapped tokens are essential tools that bridge different blockchains, unlocking greater liquidity and utility for digital assets across the crypto market. While they come with risks related to custody and smart contracts, using them securely allows investors to access a much broader range of opportunities in the DeFi sector.
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Risk Disclosure
Trading or investing in crypto assets is risky and may result in the loss of capital as the value may fluctuate. VALR (Pty) Ltd is a licensed financial services provider (FSP #53308).
Disclaimer: Views expressed in this article are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.