What are Wrapped Tokens: Moving Value Across Chains

(Photo by Jess Bailey on Unsplash)

As the blockchain industry grows, more technical standards and scaling technologies are being innovated to solve the blockchain trilemma. One new problem has cropped up, however–these networks cannot really communicate with each other. It’s like everyone speaking in a different language, except in this context, it’s different technical languages being spoken by each blockchain. This is where wrapped tokens come in, acting as bridges that allow value to seamlessly flow across different blockchains.

In this article, we explore what wrapped tokens are, how they work, and the benefits of using them for the average crypto investor.

What are Wrapped Tokens?

A wrapped token is a digital asset that represents another cryptocurrency. The original asset is locked in a secure vault on its native blockchain, and an equivalent amount of wrapped tokens are created on a different blockchain, according to the standards of this second blockchain, hence the term “wrapped.” These wrapped tokens hold the same value as the underlying asset and can be “unwrapped” (redeemed for the original asset) at any time.

Two of the most popular wrapped tokens are, uncoincidentally, those of the two biggest cryptocurrencies, Bitcoin and Ethereum:

• Wrapped Bitcoin (WBTC): The most popular wrapped token (circulating supply of 155,384 WBTC with a market cap of $10,072,323,733), allowing users to leverage Bitcoin in the Ethereum DeFi ecosystem.
• Wrapped Ether (WETH): WETH is another widely used wrapped token (total supply of 1,153,917 WETH with a market cap of $3,629,963,678) It represents Ethereum (ETH) but adheres to the ERC-20 token standard, enabling smoother integration with various DeFi protocols and applications built on the Ethereum blockchain.

What Problems Do Wrapped Tokens Solve?

Wrapped tokens exist to solve the problem of interoperability across blockchains i.e. tokens on one blockchain are not able to function on another blockchain because of differing technical standards. It’s just like how certain apps are built to operate on Android and not on iPhone.

Similarly, wrapped tokens create a bridge for value to be moved across blockchains. For example, Wrapped Bitcoin (WBTC) allows users to hold and trade BTC on the Ethereum blockchain, unlocking its potential for DeFi applications like lending, borrowing, and yield farming.

How Does the “Wrapping” Process Work?

While the exact wrapping process may differ across assets, this is a generalized description of how a token is wrapped:

1. Locking the underlying asset: When you want to wrap a token, you send it to a smart contract on the original blockchain. This smart contract acts as a secure vault, locking your original asset (e.g., BTC) in a multi-signature wallet or a decentralized custodian mechanism.
2. Minting wrapped tokens: Once the smart contract receives your original asset, it triggers the creation of an equivalent amount of wrapped tokens on the target blockchain. These wrapped tokens represent a claim on the locked underlying asset.
3. Record-keeping: The smart contract transaction is recorded on the blockchain, ensuring transparency and immutability. Often, the custodian publishes real-time proof-of-reserves, allowing users to verify that the wrapped tokens are backed by the corresponding locked assets.

The process of unwrapping is thus essentially a reversal of the above i.e. sending your wrapped tokens back to the original smart contract on the target blockchain. The smart contract then verifies the transaction and burns (destroys) your wrapped tokens. Subsequently, it unlocks and releases the equivalent amount of the underlying asset back to you on the original blockchain.

Technical mechanisms:

• Smart contracts: Wrapped token functionality relies heavily on smart contracts, self-executing code on the blockchain that automates the locking, minting, burning, and unwrapping processes.
• Multi-Signature wallets or decentralized custodians: Wrapped token projects often utilize multi-signature wallets requiring multiple parties’ approval for asset movement, or leverage decentralized custodian mechanisms that distribute the responsibility across a network of validators, to maximize storage security.

(Some wrapped token projects are backed by a consortium of trusted entities responsible for holding the underlying assets. Other projects explore the use of Decentralized Autonomous Organizations (DAOs) or other permissionless mechanisms to manage the custodian function, aiming for greater transparency and trust.)

Benefits of Wrapped Tokens (With an Example)

As explained earlier, wrapped tokens allow previously incompatible assets to participate in the functionalities of another blockchain. For instance, WBTC opens doors for DeFi enthusiasts who want to leverage their Bitcoin holdings.

Here’s how it may look like:

Let’s imagine Sarah, a long-time Bitcoin holder, is interested in exploring the potential returns offered by DeFi but doesn’t want to sell her BTC. Here’s how wrapped Bitcoin (WBTC) can help her achieve this:

1. Wrapping the Bitcoin:

• Sarah decides to participate in a DeFi lending protocol on the Ethereum blockchain that offers attractive interest rates for deposited assets. However, the protocol only accepts tokens on the Ethereum network, not Bitcoin directly.
• To bridge this gap, Sarah sends a portion of her Bitcoin (say, 1 BTC) to a reputable custodian service that supports the WBTC project.
• The custodian securely locks her 1 BTC in a multi-signature wallet or a decentralized vault.

2. Entering the DeFi Space with WBTC:

• In exchange for locking her Bitcoin, Sarah receives an equivalent amount of WBTC (in this case, 1 WBTC) on the Ethereum blockchain. This WBTC represents her claim on the locked 1 BTC.
• Now, Sarah can seamlessly deposit her 1 WBTC into the DeFi lending protocol. The protocol recognizes WBTC as a valid asset and allows her to earn interest on the deposited amount.

3. Earning Rewards and Unwrapping (Optional):

• Over time, Sarah accumulates interest on her 1 WBTC deposit in the DeFi protocol. This interest is typically paid out in another cryptocurrency supported by the protocol.
• If Sarah wants to access her original Bitcoin holding again, she can simply withdraw her 1 WBTC from the lending protocol.
• By sending her 1 WBTC back to the custodian service, Sarah initiates the unwrapping process. The smart contract verifies the transaction and burns her 1 WBTC.
• In return, the custodian unlocks and releases her original 1 BTC back to her Bitcoin wallet.

Through this process, Sarah leverages the WBTC bridge to participate in the DeFi space without ever selling her Bitcoin. She essentially “rents out” her Bitcoin through the lending protocol while retaining ownership.

WBTC allows Sarah to earn passive income on her Bitcoin holdings in the form of DeFi interest, something not possible with traditional Bitcoin storage (yet).

It’s important to remember that Sarah is still exposed to the price fluctuations of Bitcoin. If the price of Bitcoin goes up, her 1 BTC will be worth more when she unwraps it. Conversely, if the price goes down, she will receive less value in Bitcoin for her WBTC.

Risks of Wrapped Tokens

While wrapped tokens expand the uses cases of cryptocurrencies and offer exciting possibilities, there are inherent risks to consider:

• Counterparty risk: The security of wrapped tokens relies on the custodian holding the underlying asset. Centralized custodians holding the underlying assets are a single point of failure. If the custodian goes bankrupt, suffers a hack, or mismanages the assets, users might lose their wrapped token value without recourse.

In the worst-case scenario, a malicious custodian could potentially issue wrapped tokens without holding the corresponding underlying assets, essentially creating a fraudulent system.

• Smart contract risk: Wrapped tokens are often managed by smart contracts, which can be vulnerable to bugs, hacks or exploits. This highlights the importance of using well-audited and battle-tested smart contracts.
• Operational Risks: Technical issues with the smart contracts or the custodian infrastructure could cause delays in minting or redeeming wrapped tokens, impacting users’ ability to access their assets.

Other considerations include transaction fees, as minting, unwrapping, and trading wrapped tokens often involve transaction fees on both the original and target blockchains. As such, users should factor these fees into their overall strategy.

Finally, when wrapped tokens are used in DeFi applications like lending pools, users might experience impermanent loss if the price of the underlying asset fluctuates significantly.

In Conclusion

By understanding these risks and conducting thorough research on specific wrapped token projects and their underlying custodians, users can make informed decisions and participate in the wrapped token ecosystem with a greater sense of security. As the blockchain landscape continues to evolve, wrapped tokens are expected to play a critical role in fostering interoperability and collaboration between different networks. By breaking down the walls between blockchains, wrapped tokens pave the way for a more unified and efficient future for the cryptocurrency ecosystem.