What is Wrapped Crypto?
Imagine you have euros in your wallet but need to spend dollars at a store. You'd need to exchange your currency first, right? Wrapped crypto works in a similar way, but for blockchain assets.
Wrapped cryptocurrency is a tokenised version of another crypto asset that lives on a different blockchain. Think of it as your original crypto asset wearing an outer layer that lets it work on another blockchain network. For example, Bitcoin can't naturally function on the Ethereum network because they're separate systems with different rules.
But by "wrapping" Bitcoin, you get a token that represents Bitcoin's value while being compatible with Ethereum's ecosystem.
This seemingly simple innovation has become a cornerstone of decentralised finance (DeFi), allowing assets to move between otherwise isolated blockchain ecosystems and unlocking billions of dollars in cross-chain liquidity.
How wrapped crypto works
The wrapping process involves three key elements: custodians, merchants, and smart contracts.
Here's how it typically works:
- Deposit: You send your original cryptocurrency (like Bitcoin) to a custodian—an entity or smart contract that holds your assets safely.
- Minting: Once the custodian confirms receipt of your deposit, they mint an equivalent amount of wrapped tokens (like WBTC) on the target blockchain.
- Release: These newly created wrapped tokens are then sent to your wallet on the new blockchain, ready to use.
When you want your original tokens back, you simply reverse the process—a procedure called "unwrapping" or "burning":
- Return: You send your wrapped tokens back to the custodian.
- Burn: The wrapped tokens are destroyed (burned).
- Release: The equivalent amount of the original cryptocurrency is returned to your wallet.
This process ensures a 1:1 backing between wrapped tokens and their underlying assets, similar to how stablecoins maintain their value through reserves. For every wrapped Bitcoin (WBTC) in circulation, there's one real Bitcoin held in reserve by a custodian.
Benefits of wrapped crypto
Cross-chain compatibility
The most obvious benefit is interoperability. Wrapped tokens allow assets from one blockchain to participate in activities on completely different networks. Bitcoin holders can participate in Ethereum-based DeFi without selling their Bitcoin, while Ethereum users can access the value and liquidity of Bitcoin without leaving their preferred ecosystem.
Expanded DeFi possibilities
Before wrapped tokens, assets like Bitcoin were essentially locked out of the booming DeFi space. Now, billions of dollars worth of previously idle assets can earn yields, serve as collateral for loans, or provide liquidity to trading pools.
Enhanced functionality
When assets like Bitcoin get wrapped as ERC-20 tokens on Ethereum, they gain new capabilities:
- Smart contract interaction: Bitcoin doesn't natively support complex smart contracts, but wrapped Bitcoin on Ethereum can interact with any Ethereum smart contract.
- Faster settlements: Bitcoin transactions typically take about 10 minutes to confirm, while Ethereum transactions complete in seconds or minutes, making wrapped Bitcoin potentially more practical for everyday transactions.
Liquidity boosts
By making assets usable across multiple blockchains, wrapped tokens significantly increase market liquidity. The same value can now participate in various ecosystems without being split across different platforms.
Common types of wrapped tokens
Wrapped Bitcoin (WBTC)
The most popular wrapped token by market cap, WBTC brings Bitcoin's massive value onto the Ethereum blockchain. Each WBTC is backed by one Bitcoin held in reserve. This has allowed billions of dollars worth of Bitcoin to participate in Ethereum's DeFi ecosystem.
Wrapped Ether (WETH)
Interestingly, even Ethereum's native currency (Ether) has a wrapped version. Why? The original Ethereum token (ETH) predates the ERC-20 standard that most Ethereum tokens follow. WETH makes ETH compatible with dapps that require the standard ERC-20 format.
Other Notable Wrapped Assets
As cross-chain functionality becomes increasingly important, we're seeing more wrapped versions of various assets:
- Wrapped AVAX (WAVAX) on Ethereum
- Wrapped UST (Terra stablecoin) on various chains
- Wrapped tokens of various layer-1 cryptocurrencies
How to use wrapped tokens in DeFi
Lending and borrowing
Platforms like Aave, Compound, and MakerDAO allow users to deposit wrapped assets as collateral to borrow other cryptocurrencies. This means you can leverage your Bitcoin holdings to access stablecoins or other tokens without selling your BTC.
Liquidity provision
Decentralised exchanges like Uniswap and SushiSwap rely on liquidity providers to enable trading. By providing wrapped tokens to these liquidity pools, users can earn trading fees and additional rewards.
For example, the WBTC/ETH pool on Uniswap has consistently been one of the largest liquidity pools, enabling billions in trading volume between Bitcoin and Ethereum.
Yield farming
Many DeFi protocols offer incentives for users who provide liquidity or lend assets. Wrapped tokens allow users to participate in these "yield farming" opportunities across multiple blockchains, potentially maximising returns.
Risks involved
Custodial risks
Most wrapped tokens rely on custodians to hold the original assets, introducing an element of centralisation and trust. If the custodian is compromised or acts maliciously, your wrapped tokens could become worthless.
For instance, WBTC relies on BitGo as its primary custodian. While BitGo maintains high security standards, this represents a potential single point of failure in an otherwise decentralised system.
Smart contract vulnerabilities
Wrapped tokens, like all blockchain assets involving smart contracts, face potential security risks. Bugs or exploits in the smart contracts governing wrapped tokens could lead to fund losses.
Minting and redemption friction
The process of wrapping and unwrapping tokens often involves fees, waiting periods, and minimum amounts. These friction points can make wrapped tokens less practical for smaller transactions or quick trades.
Bridge attacks
Cross-chain bridges, which facilitate the creation of many wrapped tokens, have been frequent targets for hackers. Several high-profile attacks have resulted in millions of dollars in losses.
The future of wrapped tokens
Decentralised wrapping mechanisms
The industry is moving toward more decentralised wrapping processes that reduce reliance on centralised custodians. Projects like tBTC and renBTC are exploring new models where custody is distributed among multiple parties or managed entirely by smart contracts.
Multi-chain integration
As blockchain ecosystems evolve toward greater interoperability, wrapped tokens are likely to play a crucial role in creating seamless experiences across multiple chains. Users may eventually interact with different blockchains without even realising they're using wrapped assets behind the scenes.
Standardisation and regulation
As wrapped tokens become more integrated into mainstream finance, we can expect more standardised practices and potentially increased regulatory attention, particularly around reserve verification and consumer protection.
Bridging the blockchain islands
Wrapped tokens have essentially built bridges between previously isolated blockchain islands, creating a connected DeFi landscape where assets flow freely across networks. They give users remarkable flexibility – allowing them to use Solana's speed while accessing Ethereum's rich application environment.
While these tokens solve major interoperability challenges, it's worth remembering their trade-offs. The centralized custody model goes against blockchain's decentralization principles, and security risks exist.
Though we'll eventually see more sophisticated cross-chain solutions emerge, wrapped tokens currently serve as the vital connectors powering our increasingly interconnected crypto economy.
This article is for general information purposes only and is not intended to constitute legal, financial or other professional advice or a recommendation of any kind whatsoever and should not be relied upon or treated as a substitute for specific advice relevant to particular circumstances. We make no warranties, representations or undertakings about any of the content of this article (including, without limitation, as to the quality, accuracy, completeness or fitness for any particular purpose of such content), or any content of any other material referred to or accessed by hyperlinks through this article. We make no representations, warranties or guarantees, whether express or implied, that the content on our site is accurate, complete or up-to-date.
