One of the biggest challenges facing the blockchain and crypto space is the lack of interoperability of different blockchains and their respective assets.
That means you cannot directly transfer a cryptocurrency based on chain X to chain Y and use it there. Blockchains, by design, cannot enable such cross-chain digital asset support.
With decentralized finance (DeFi) predominantly on Ethereum, but coins and tokens existing across multiple other blockchains, supporting assets cross-chain has become crucial for cryptocurrencies and DeFi.
This is where wrapped crypto tokens come into the picture.
Defining Wrapped Crypto
Wrapped crypto or wrapped tokens are digital assets that; represent the exact value of an original cryptocurrency from a different blockchain or follow a different token standard to the chain its on. WBTC and WETH are good examples of the former and latter respectively.
Wrapping original tokens to mint new tokens compliant with another blockchain allows users to use assets from one chain on another chain entirely.
For instance, Bitcoin (BTC) by design can originally only function inside the Bitcoin ecosystem. But what if you want to use the world’s largest cryptocurrency on the world’s largest dApp blockchain Ethereum?
In short, you can go to the Wrapped Bitcoin Network and deposit your BTC from your Bitcoin wallet and receive WBTC — an ERC-20 token — in your Ethereum wallet.
The WBTC you receive will be a wrapped token that represents the original value of the BTC that you deposited. This will let you use the wrapped token across any Ethereum-based decentralized application that supports WBTC transactions.
As mentioned, “wrapping” is a just figurative term used to describe the minting or creation of a new token that derives its value from an underlying digital asset.
To understand this better, let’s take a look at how wrapped tokens actually work.
How Does A Wrapped Crypto Work?
So far, you know that a wrapped token is an equivalent representation of a cryptocurrency based on a different blockchain. Or, in some cases, it is a representation of an asset based on the same chain, but having a different token standard.
But how do we exactly “wrap” these tokens?
Let’s go back to the wrapped Bitcoin (WBTC) example.
There are three types of entities involved in the wrapping of BTC to create an equivalent amount of WBTC on Ethereum:
1. Merchants: Entities that lock their BTC to mint new WBTC on Ethereum or, conversely, burn WBTC to free up the locked BTC.
2. Custodians: Organizations responsible for securing the BTC reserves on the Bitcoin network.
3: Wrapped Tokens DAO: A set of organizations that constitute a decentralized autonomous organization (DAO) and collectively decide what custodians and merchants to add or remove to WBTC Network. The organizations in the DAO use a multi-sig wallet to make these decisions.
Now that you understand the three key players in WBTC, let’s look at a simple step-by-step process of token wrapping:
Step 1: A merchant sends 10 Bitcoin (BTC) to the custodian.
Step 2: The custodian adds it to a reserve (a crypto wallet) whose proof is published on-chain.
Step 3: An equal amount of ERC-20 compatible WBTC is minted on Ethereum.
Merchants can follow a similar process to request to burn WBTC on the Ethereum blockchain and free an equal number of BTC on the Bitcoin network.
While WBTC relies on a DAO model to ensure security and decentralization, wrapped tokens are issued either by centralized entities or smart contracts.
However, most DeFi proponents advise against using a wrapped token managed by a centralized entity. This is because a central entity may, at any point, defraud its users by tampering with the asset reserves. These reserves determine a wrapped token’s value. Thus, in situations like these, a wrapped token can lose significant value in a short time.
Apart from WBTC, there are several other wrapped tokens such as WETH, WMATIC, renBTC, WFTM. Across the DeFi space, there are multiple wrapper platforms issuing such tokens.
Now that we’ve understood how wrapped tokens work, let’s check out what benefits they offer.
Advantages of Wrapped Crypto Tokens
There are 197 countries in the world using around 180 different currencies. These countries have a combined total of thousands of banks.
Imagine a world where you were not able to send money from one bank to the other. Further still, imagine you visited a country that didn’t allow you to exchange your currency for its own.
That would make for a terrible financial ecosystem, where people would fail to experience anything beyond the limits of their own country or bank.
Currently, the same would be the case with users of different blockchains if not for wrapped tokens.
At the time of writing, BTC makes up over 40% of the crypto market’s value. Following BTC is ETH, making up almost 20% of the market capitalization.
Thanks to WBTC and other wrapped representatives of BTC, Bitcoin users no more need to stay cut off from Ethereum, which boasts the largest DeFi ecosystem. They can simply go to a decentralized exchange and purchase WBTC. That way, the user gets the same exposure to BTC, but on Ethereum.
But it’s not just about Bitcoin and Ethereum. In fact, there are a wide variety of wrapped tokens for transferring value between popular chains, such as Polygon, Solana and Avalanche.
With the help of wrapped tokens, users don’t need to transfer their assets on one chain to a centralized exchange, convert it to another asset, and send it to another compatible chain. Instead, they can get their hands on a wrapped token representing their original asset.
