Wrapped Token

Bitcoin is the best known cryptocurrency, but it cannot natively run on Ethereum or use Ethereum apps. So how do people use Bitcoin in Ethereum's lending and trading platforms? The answer is wrapped tokens, which let an asset travel to a blockchain it was never designed for.

What Does Wrapped Token Mean?

A wrapped token is a token that mirrors the value of another asset. It is created on one blockchain to represent an asset that lives somewhere else, or that does not follow the local token standard. The original asset is locked up in reserve, and an equal amount of the wrapped version is created. Wrapped Bitcoin (WBTC) on Ethereum is one of the most famous examples, with each WBTC designed to be backed by one real bitcoin.

Think of it like a coat check at a theater. You hand over your coat, and you receive a ticket. The ticket is not your coat, but it represents it, and you can trade it back for the coat whenever you want. A wrapped token is that ticket, while the original asset waits safely in storage until you redeem it.

Why Wrapped Tokens Exist

Blockchains are built separately and cannot easily talk to each other. Each one has its own rules, token standards, and apps. This lack of interoperability means assets are usually stuck on the chain where they were created.

Wrapped tokens solve this by bringing a version of an asset onto a new network. Once wrapped, the asset can be used in that network's apps, such as lending platforms, exchanges, and liquidity pools. This unlocks new uses for assets that would otherwise sit idle in a wallet.

Wrapping for Token Standards

Wrapping is not only about moving between chains. Ether (ETH), the native coin of Ethereum, was created before the ERC-20 token standard and does not follow it. Many apps are built to handle ERC-20 tokens, so ETH is often converted to Wrapped Ether (WETH), an ERC-20 version that apps can process in the same way as other tokens. Unlike WBTC, WETH is created by a smart contract on Ethereum itself, with no outside custodian.

How Wrapping Works

The exact process depends on the wrapped token, but the general idea is similar. Here is a simplified version of the steps:

• Deposit: You send the original asset, such as bitcoin, to a custodian or a smart contract that will hold it.
• Lock: The original asset is held in reserve so it cannot be spent elsewhere while the wrapped version exists.
• Mint: An equal amount of the wrapped token is created on the destination blockchain and sent to your wallet.
• Use: You can trade, lend, or provide liquidity with the wrapped token just like any other token on that chain.
• Unwrap: When you want the original back, the wrapped tokens are returned and destroyed, or "burned," and the original asset is released.

This process is often handled by a bridge, a service that connects two blockchains. In many cases you do not wrap tokens yourself. You simply buy the wrapped version on an exchange from someone else who already did.

Types of Wrapped Token Custody

The key question with any wrapped token is who holds the original assets. This affects how much trust you need to place in the system.

Custodial Wrapping

Some wrapped tokens rely on a company or group of companies to hold the reserves. Users must trust that the custodian really holds the assets and will release them on request. Custodians often publish proof of reserves so anyone can verify the backing on the blockchain.

Smart Contract Wrapping

Other wrapped tokens use smart contracts or networks of independent operators to lock and release assets. This reduces reliance on a single company, but introduces risk from bugs in the code or flaws in how the operators are chosen.

Benefits of Wrapped Tokens

Wrapped tokens have become an important part of the crypto ecosystem for several reasons:

• Access to more apps: Assets like bitcoin can be used in DeFi platforms on other chains.
• Better liquidity: Bringing large assets onto busy networks adds more capital to trading and lending markets.
• Faster or cheaper transactions: Some destination networks offer lower fees or quicker confirmations than the original chain.
• Standardization: Wrapping assets into a common token format makes them easier for apps and wallets to support.

Risks of Wrapped Tokens

A wrapped token is only as reliable as the system backing it. Before using one, understand the main risks:

• Custodian risk: If the custodian is hacked, mismanages funds, or fails, the wrapped tokens may lose their backing.
• Smart contract and bridge risk: Bridges have been among the most targeted systems in crypto, and some have suffered large hacks.
• Depegging: If people lose confidence in the backing, a wrapped token can trade below the value of the asset it represents.
• Extra steps and fees: Wrapping and unwrapping can involve fees and waiting times.

When you hold a wrapped token, you are not holding the original asset directly. You are holding a claim on it. Choosing well-established wrapped tokens with transparent reserves and a long track record can help reduce, though never fully remove, these risks.

Useful Links

• What are Ethereum token standards?
• What is decentralized finance?
• What is Bitcoin?
• What is a crypto bridge?