Bitcoin investors cannot use the coin on Ethereum, and neither can Ether holders access Binance Smart Chain. Blockchains do not automatically recognize non-native crypto assets or know what is happening to their counterparts. Wrapped tokens emerged as a clever workaround — they solve the interoperability issue of the cryptocurrency space. Discover how wrapped tokens work in our guide.
What are wrapped crypto tokens?
Wrapped tokens are pegged to other cryptocurrencies. At first glance, this should make them similar to stablecoins, which are pegged to fiat money. However, the purpose is unique — these assets create liaisons between blockchains. As of July 21, 2022, the top 5 wrapped tokens by market cap include three versions of Bitcoin:
Assets created in one environment cannot be simply transferred elsewhere due to the clash of native token standards. For instance, ERC-20, which is used on the Ethereum blockchain, determines the rules of compatibility with Ethereum-based services and platforms.
Any wrapped token is pegged to the value of the underlying asset, which is not native to the issuing blockchain. Typically, it can also be unwrapped — redeemed for the original asset — at any moment. All wrapped tokens are backed by an equivalent amount of the underlying currency.
Why is wrapped token called this way?
Take wrapped BTC, which is a tokenized version of Bitcoin. Pure Bitcoin only works on the Bitcoin blockchain, which limits your options. Enveloping it in a digital vault, or wrapper, enables bridging — token creation in other cryptocurrency environments.
The average user does not have to master the intricacies of the minting process, wrapping, or unwrapping. These tokens can be traded like other cryptocurrencies. For instance, you could buy crypto via the WBTC/BTC pair (Wrapped Bitcoin against Bitcoin) on popular exchanges.
Difference between stablecoins and wrapped tokens
One of the misconceptions about Tether (USDT) is that it is a wrapped version of the US dollar. Generally, the cryptocurrency does trade one-for-one with the fiat currency, similarly to how WBTC (wrapped Bitcoin) represents BTC.
Yet this does not mean there is one physical USD held for each USDT. The reserve is miscellaneous as it contains cash, its real-world equivalents, assets, and receivables from loans. The second aspect setting wrapped tokens apart is the technology behind them.
What are wrapped Bitcoin tokens?
In its wrapped form, Bitcoin can be adapted to different token standards — the ERC-20 token works on the Ethereum network, while the TRC-20 version works on Tron. This synthetic asset was designed to maintain a one-to-one peg, so token holders can use BTC on the other blockchains.
Normally, the creation of these non-native assets requires a custodian – some entity holding an equivalent amount of the underlying asset (in our example, one BTC for one WBTC minted). This could be a smart contract, a merchant, a DAO (Decentralized Autonomous Organization), or a multisig wallet. The custodian acts as the wrapper and the unwrapper.
Through wrapped tokens, investors combine exposure to the price of the coin with the benefits of decentralized finance (DeFi) protocols on the Ethereum blockchain. This way, they can earn profit. For example, they can
- earn fixed income (fixed interest rate) as lenders
- place their wrapped tokens in a vault to earn APY
How wrapped Bitcoin (WBTC) is created
So, how does one wrap their crypto? When users swap BTC for WBTC, this process is referred to as minting. The opposite — exchanging tokenized assets for the real thing — is called burning. Both processes are multi-stage and involve a custodian.
As of this writing, multisig keys on all Bitcoin deposited for WBTC minting are held by BitGo, Kyber Network, and Republic Protocol. Here is what the wrapping process includes.
- A merchant (for example, DeversiFi or Kyber) receives your request and performs KYC and AML checks.
- The merchant sends your BTC to the custodian, which locks it away.
- The custodian mints ERC-20 or TRC-20 tokens (WBTC) based on the exact amount of your BTC.
- The merchant receives the wrapped amount to their Ethereum address and provides them to you.
The unwrapping process, or burning, is similar: the merchant forwards your burn request to the custodian, and the latter releases an equivalent amount of BTC from the reserves. Custodians and merchants are added and removed by a DAO.
One flaw of WBTC is the degree of centralization, as you need a custodian to wrap and unwrap the coin. RenBTC, another popular token backed by Bitcoin, makes custody decentralized, trustless, and permissionless. This means anyone can mint and burn a wrapped token. Both WBTC and renBTC open access to DeFi products like stablecoin loans against their BTC.
As you can see from the graph below, burning of the ERC-20 token can outpace minting or the other way around. In December 2021, more tokens got burnt due to falling yields in decentralized finance and increased trading on conventional crypto exchanges.
What is wrapped Ether (WETH)?
Any ERC-20 token is compatible with the Ethereum blockchain, as the same technical standard guards issuing tokens on it. These digital assets can serve different purposes, but wrapping and unwrapping them always require gas (a specific amount of ETH), just like other transactions on this network.
The second largest cryptocurrency by market cap is an interesting example, as it appeared before ERC-20. Thus, while pure ETH is used for transaction fees on the network, it is not accepted by Dapps. Ethereum-based DeFi platforms use smart contracts to accommodate direct exchange between users, so any tokens traded must conform to the same standard.
This is why wrapped Ether (WETH) emerged. As a tokenized version, it conforms to the ERC-20 standard and allows direct trading against other Ethereum-based altcoins. Holders of wrapped ETH can also pledge their funds to DeFi protocols.
How wrapped Ether is created
Holders trade Ether for its tokenized version using a smart contract or a digital wallet, such as MetaMask. In the future, the Ethereum team hopes to phase out WETH by making the underlying coin compatible with ERC-20 or by modifying the standard.
Wrapped tokens on Binance Smart Chain (BSC)
To become compatible with Binance Smart Chain, non-native tokens must conform to BEP-20. Wrapping is done using the Binance Bridge. Upon completion, the tokens can be traded or used in yield farming.
Aside from Bitcoin and Ether, BSC works with a wide range of cryptocurrencies, including XRP (Ripple), BCH (Bitcoin Cash), and Polkadot (DOT). Compared to wrapping on Ethereum, the gas cost is significantly lower.
Benefits of using wrapped tokens
Connecting different blockchains is not the only function of these digital assets. Wrapped tokens benefit users and the crypto industry in three ways:
- Interoperability. Wrapping makes cryptocurrencies recognizable for non-native blockchains. For example, Bitcoin holders can take advantage of different decentralized options.
- Increasing liquidity and capital efficiency. Connections between otherwise separate pools of liquidity are advantageous for both centralized and decentralized exchanges.
- Faster and cheaper transactions. By moving their assets from one blockchain to another, holders save time, cut costs, and earn more yield. For example, BTC is not the fastest or cheapest blockchain. Thanks to wrapped Bitcoin, users can access shorter transaction times and lower fees on other blockchains.
Limitations of using wrapped tokens
Despite their merits, these tokenized assets have a few controversial facets. Unfortunately, the crypto ecosystem is yet to see a wrapped token with perfectly trustless minting and redemption.
- As a custodian must hold the funds underlying your wrapped token, trust can be an issue.
- Despite the standard compatibility, such assets are still unfit for genuine cross-chain transactions – that is, transactions without an intermediary (custodian).
- Minting on blockchains with substantial gas fees can be costly, and slippage may occur.
Rise of bridge hubs
As new blockchains appear, the number of bridges required for smooth operability rises exponentially. This problem could be solved by cross-chain bridge hubs — central bridges connected to multiple chains.
For instance, Darwinia aims to become the main bridge hub of Polkadot. Meanwhile, the Portal Token Bridge (previously Wormhole) supports Ethereum, Solana, Terra, Binance Smart Chain, and Polygon.
This technology is still evolving, so bridges and wrapped tokens are here to stay — at least for the foreseeable future.
To sum up
In simple words, wrapped tokens allow holders to move the value of their crypto assets between different blockchains. Wrapping solves a major predicament as these ecosystems do not communicate. Adapting crypto to another token standard unlocks the benefits of their respective blockchains, such as higher speed, lower transaction fees, and yield opportunities.
However, minting usually requires trusting a centralized custodian holding your underlying assets (RenBTC is an exception). Another downside is the manual effort to wrap and unwrap tokens for a given blockchain. Finally, high gas fees amplify the costs.
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The information provided by CoinLoan (“we,” “us,” or “our”) in this text is for general informational purposes only. All investment and financial opinions expressed by CoinLoan in this text are from the personal research and open information sources and are intended as educational material. All outlined information is provided in good faith. However, we make no representation or warranty of any kind, express or implied, regarding the accuracy, adequacy, validity, reliability, availability, or completeness of any information in this text.