Crypto Basics: What Are Wrapped Crypto Tokens?

What Are Wrapped Crypto Tokens?

Wrapped cryptocurrencies refer to a type of cryptocurrency or token that represents another existing crypto, just on a different blockchain or network from where they originated. In this way, it is possible to use Bitcoin on the Ethereum network, for example, by “wrapping” up the original Bitcoin, and then using the resulting “wrapped Bitcoin” on Ethereum.

In this Learn Crypto article, we’ll discuss and learn:

  • What wrapped crypto tokens are 
  • Why people wrap crypto and how this is critical to digital asset markets
  • What wrapped tokens can I find out there?
  • Risks to consider when using wrapped crypto tokens 

What wrapped crypto tokens are

If you’re an avid trader, or trade on decentralised exchanges (DEXs) a lot, then you might have come across certain types of tokens or cryptocurrency that look familiar, and yet are very different from the crypto it appears to be named as.

For example, you might find tokens with the “w” prefix like wBTC or wETH and even wDOGE. These are simply the wrapped version of that familiar crypto. Hence, wBTC is in fact wrapped Bitcoin (BTC) and wDOGE is actually wrapped Dogecoin (DOGE).

You might also come across the term “bundled”, and sometimes, the prefix could even look different, but in general, many of these cryptocurrencies with these single lower case alphabet could actually be a form of wrapped tokens. In a latter section, we’ll take a look at some of these examples.

Wrapped tokens can be seen as a representation of the original token or digital asset. The original token is “wrapped” into a new token on a different network. Wrapped tokens bear the necessary traits and characteristics that allow them to communicate with the wrapping network.

This resulting wrapped token can then be freely transacted on the new network while leaving the original token untouched.

This means that for every amount of wrapped token that is created, an equal amount of the original token must be wrapped and locked to the new network. In this way, one must wrap 2 bitcoin to create 2 wrapped Bitcoin (2 BTC is needed to create 2 wBTC).

Why people wrap crypto and how this is critical to digital asset markets

But why go through all the hassle of wrapping up a crypto? Why not just use the crypto directly?

To understand how wrapped tokens work and why people go through the process of creating wrapped crypto, we have to understand that blockchain applications and cryptocurrency systems like Bitcoin and Ethereum are actually completely separate communication networks.

While they do use some lines of codes that may seem very similar, the way they are written and the rules they follow are completely different. Think of it as different languages: we may recognise some similar phrases or even exact replicas of words in a foreign language, but the grammar rules and vocabulary are so different that we couldn’t really use our native language rules to speak another language.

This difference and independence of blockchain networks are crucial to ensure that they are all able to preserve their own independence and reliability. However, it also creates a lot of difficulties when trying to communicate information to each other.

Although some blockchains like Ethereum do have a significant number of compatible networks and can communicate with these, most other major crypto networks can only transact within their own channel. The Bitcoin network can only communicate with the Bitcoin network, for instance. The same goes for Dogecoin or Litecoin.

The sector that is dedicated to solving this type of problem of inter-blockchain communication is sometimes referred to blockchain interoperability.

Blockchain interoperability has improved vastly over the past several years. Today, for example, it is quite common for people to move their Bitcoin and Ethereum between different blockchains that aren’t native Bitcoin or Ethereum networks.

This is especially useful for people who like to trade on decentralised exchanges or DEXs, where many different networks communicate with each other to buy, sell or even loan various types of digital assets across multiple different blockchain networks.

Without the wrapping solution, to borrow ETH with BTC, you’d have to move your BTC to an exchange and deposit it directly as collateral in exchange for ETH. But in DEFI, if you wrap your BTC, you essentially still keep your BTC, using your wrapped Bitcoin instead to borrow ETH. Once you’re doing transacting, you can always redeem back your wrapped Bitcoin and receive your Bitcoin back on the original blockchain.

Wrapped tokens have become a critical part of this form of decentralised finance (DEFI), effectively allowing people to move almost any kind of asset between blockchains, using them across a wide crypto ecosystem made out of many different types of networks.

Wrapped tokens were created as a solution to this problem. With wrapped tokens, you can effectively move assets between blockchains and use them across the crypto ecosystem.

What wrapped tokens can I find out there?

Just as Bitcoin is probably the most popular cryptocurrency around, the most popular wrapped token is also based around Bitcoin. Wrapped bitcoin (wBTC), as of July 2022, is the biggest wrapped token in terms of market capitalization (over $5.6 billion according to CoinMarketCap). It commands roughly 80% of the maret share of wrapped tokens. The second largest wrapped token by market capitalisation also is linked to Bitcoin – renBTC.

Both wBTC and renBTC allow Bitcoin owners to interact with Ethereum-based DEFI protocols. Many people wrap their Bitcoin to contribute to liquidity pools on DEXs like Uniswap to earn commissions, for example. wBTC also supports the TRON network.

To wrap their Bitcoin to wBTC, they would send BTC to a wBTC custodian who mints new wBTC at a 1:1 ratio. These custodians store their BTC. Upon redemption, wBTC is burned and the BTC is returned.

This 1:1 ratio thus is essentially a peg, which is why you might encounter the term “pegged” tokens when dealing with wrapped crypto assets.

Not all wrapped tokens work in this way. Wrapped Ether, or wETH is simply created on the same Ethereum network, but allows it to be transacted like a specific type of token (ERC20 token) much like all other crypto and utility tokens created on the Ethereum network.

Of course, it is also possible to buy wrapped tokens directly on DEXs. You could buy wBTC on an Ethereum-based DEX, for example, and simply redeem it to get actual BTC.

The value (or price) of wrapped tokens is usually very closely aligned to their original token since they are all pegged in equal ratio. When you think about the minting process as a “wrapping” process, you can think of redemption or burning as an “unwrapping” process.

As wrapped tokens are minted and redeemed (burned) or wrapped and unwrapped, an equilibrium is constantly being achieved between wrapped tokens and their underlying currency. For every X amount of wrapped tokens that are minted and in existence, there must be the equivalent X amount of original tokens held to back the value of their wrapped counterparts.

Other wrapping protocols or products

Coming back to the blockchain interoperability issue, there are many blockchain products or protocols that work specifically to improve interoperability. These are sometimes called “bridges”  since what they are doing is essentially creating bridges between different blockchain networks, to allow people to port digital assets across different blockchains.

Some examples of bridges are Polygon, Arbitrum, and Optimism, which are increasingly popular across DEFI networks and DEX aggregators. Their products or bridges attempt to simplify the wrapping process for the user and allow them to directly trade or swap assets from different blockchains, without going through the technical process of wrapping and redeeming.

Instead, these bridges create wrapped tokens and redeem them behind the scenes, sometimes with even lower costs and quicker speeds than manual bridging.

When using these, you may never even encounter wrapped tokens – at least, not visibly.

Risks to consider when using wrapped crypto tokens

There are at least two major risks to consider when deciding if wrapped cryptocurrencies are right for you. The first, and perhaps more relevant to most people, is the security of your wrapped tokens.

Security

When it comes to the security of individual blockchain networks, there can be arguments from many people about which blockchain is more secure.

Few people would question the security of Bitcoin or Ethereum – these are highly mature networks that continue to become increasingly difficult to attack and manipulate by malicious parties. This owes mainly to the type of algorithm that is securing them. Bitcoin and – until the new version launches in late 2022 – Ethereum both rely on the Proof of Work algorithm to secure their networks.

Currently, throughout most of the DEFI ecosystem, where wrapped tokens are used, networks use the Proof of Stake system, which can be considered less secure and more vulnerable to exploitation from hackers or thieves.

Bitcoin holders on the actual Bitcoin network feel that they are very safe from hacks, as the Bitcoin network is virtually impregnable to hacking attempts.

But wrapping protocols and bridging products have been known to fail, with users losing their wrapped tokens to exploits. For example, in February 2022, the massive Wormhole bridge was successfully exploited, causing users to lose 120,000 wrapped ETH or wETH (at the time, valued at over $320 million).

Vitallik Buterin, the co-founder of Ethereum, believes that some of these security limits of bridges are fundamental and cannot really be fixed, preferring instead a “multi-blockchain” ecosystem rather than cross-chain applications or blockchain interoperability which wrapping and bridging are all about.

“ ..it's always safer to hold Ethereum-native assets on Ethereum or Solana-native assets on Solana than it is to hold Ethereum-native assets on Solana or Solana-native assets on Ethereum.” – Vitalik Buterin

Centralisation

The other issue with using wrapped tokens is that it required a higher degree of centralisation. As explained earlier, to wrap a token, you must lock your actual crypto asset with a custodian, who mints and burns the wrapped tokens. This requires you to trust the intermediary to perform this wrapping for you – not an independent smart contract.

Buterin himself questioned the trustworthiness of these entities offering to take your coins in exchange for their various wrapped version, believing that increased use of them could encourage bad behaviour in terms of market consumption and manipulation.

“I’m worried about the trust models of some of these tokens. It would be sad if there ends up being $5b of BTC on Ethereum and the keys are held by a single institution.” – Vitalik Buterin

So if you do need to use wrapped tokens, or require wrapping your cryptocurrency, do ensure you’re using a mature wrapping product or bridge. Also, try not to hang on to your wrapped tokens too long unless you obviously need to do so – for instance, to contribute liquidity on a DEX swapping pool.

The sooner you can redeem or burn your wrapped tokens for your original ones, the better.

Of course, one can expect wrapping and bridging technology to improve, and security to also strengthen. As bridging and wrapping become easier and simpler, it may very well be that one day in the near future, we may all be able to move assets freely between blockchains without even realising that they actually don’t connect directly to one another.

Until then, wisely weigh your wrapping risks against holding your crypto assets. 

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