What are Wrapped Tokens & how do they work?
What you'll learn:
- How wrapped tokens work
- Bitcoin and Ethereum examples
- Advantages and disadvantages
- Safety and security
If you are relatively new to cryptocurrency and are browsing the popular price comparison site Coinmarketcap to check the value of Bitcoin you’ll be confused to see more than one price. There is Bitcoin, ranked one by market capitalisation, and something called wrapped Bitcoin, ranked at #17 with a very similar, but not identical price. So what exactly are wrapped coins and why is the concept of tokenisation so important?
How do Wrapped Tokens work?
A wrapped token is a synthetic version of a cryptocurrency token that enables it to function on a separate blockchain while maintaining a price peg of 1:1.
Though that definition is accurate, it doesn’t make much sense without understanding a little bit about how blockchains work. So let’s step back and provide more context.
Bitcoin is both the first cryptocurrency and the first example of a blockchain. The Bitcoin blockchain (usually written with a big ‘B’) is a ledger of balances of the cryptocurrency bitcoin (usually written with a little ‘b’) maintained by a distributed network of global independent computers.
Along with a record of the Bitcoin blockchain, those computers - known as Nodes - run a piece of software - the Bitcoin Protocol - that includes all the rules for maintaining accurate balances of Bitcoin known as addresses, creating new bitcoin at a pre-programmed rate (through what is known as a consensus method) and enabling wallets to transact bitcoin.
This all happens without any central authority, which is the magic of decentralisation. You can read about How Bitcoin works in more detail elsewhere in the Learn Crypto knowledge base, but the key element to understand is that bitcoin the cryptocurrency, works based on a very specific set of rules, the Bitcoin Protocol.
Those rules are open source, so there are numerous examples of copy-cat versions of Bitcoin, which follow the same basic principles but tweak a certain element.
Bitcoin also inspired a whole host of new cryptocurrencies that follow different rules, with their own consensus methods and different approaches to recording balances. The most well known is Ethereum.
Ethereum is a blockchain-based system that supports an ecosystem of digital platforms that are interoperable because Ethereum is Turing Complete, with a specific language for writing Smart Contracts. It also includes a very specific set of standards for transferring value. You have probably heard of them: ERC-20, the most common standard for an Ethereum-based token, or ERC-721 for NFTs.
These standards are really useful because any Ethereum wallet can support any ERC-20 token, making transactions and exchange simple. This standard-based system is one reason why the Ethereum ecosystem has grown so fast because all the elements are composable; they can fit together like Lego blocks.
But what happens if, for example, you want to use Bitcoin within an Ethereum-based DEFI application, to gain interest or take out a loan? You can’t, because the two sets of rules aren’t interoperable. Bitcoin is not Turing Complete and cannot interact with Smart Contracts.
Think of it like trying to plug in a European electrical device in America, it isn’t possible without an adapter, because the underlying electrical networks work in different ways. So a wrapped token is like a plug adapter for cryptocurrencies from different blockchains.
How do Wrapped Bitcoin Tokens Work?
So now you hopefully have an idea of what a wrapped token is, you’re probably wondering how you wrap Bitcoin to use within the Ethereum ecosystem and then unwrap it back to plain old BTC?
To wrap Bitcoin you need to send it to a Custodian who will hold your BTC in a reserve, then for a fee will mint a synthetic wBTC on a 1:1 basis and send that to an Ethereum address that you provide. The actual mechanics are more complicated, but as a user, the process is that simple.
When you want to unwrap your wBTC, you send it back to the Custodian who burns it and releases the original BTC held in reserve.
BitGo are the biggest wrapped Bitcoin Custodian with over 274,000 BTC held in custody to produce an equivalent amount of wBTC with value over $12bn.
The benefits of wrapped tokens?
You can think of each blockchain as a silo of potential value. Sometimes a Bitcoin holder will want to use the value their BTC represents to realise an opportunity within a separate blockchain. The most obvious reason is trading.
Most trading by volume happens on centralised exchanges - like Coinbase, Binance or Kraken - and is based on fiat, Stablecoin or Bitcoin pairs. If however, you hold Bitcoin and want to trade a much broader range of currency pairs you can wrap your Bitcoin and then trade wBTC on a decentralised exchange across an exponentially larger range of pairs.
There are two main reasons for investors to understand trading pairs: Some cryptocurrencies can only be bought with other cryptocurrencies, so knowledge of cryptocurrency pairs is necessary to expand your crypto holdings beyond the most common coins. And, knowledge of crypto trading pairs gives savvy crypto investors the chance to exploit arbitrage opportunities — i.e., to profit from differences in asset prices between markets.
All that ‘Turing complete’ means is that Solidity is a programming language capable of programming for any hypothetical computation. Thus, in theory, any computer application can be programmed in Solidity and run on the Ethereum platform. This language, therefore, is what Ethereum’s ‘smart contracts’ are written in.
Not only that, but you can get exposure to a much broader range of yields, loans and opportunities to ‘farm’ for value with your wrapped version of Bitcoin.
Wrapping is now available for the native tokens of pretty-much every main blockchain, providing a level of interoperability. You can wrap tokens for use on the Binance Smart Chain, or the rapidly growing Polkadot ecosystem.
Strangely enough, you can wrap Ethereum to create wETH, and use that with ERC-20 compatible digital applications, because Ethereum’s native currency (ETH) was created before the ERC-20 token standard was introduced.
One of the biggest challenges facing Ethereum is scalability. It has become a victim of its own success, with the cost of Smart Contract execution (like minting an NFT), prohibitively high.
Wrapping and bridges offer an alternative. Wrap your ETH and use it on another blockchain with faster and cheaper transactions, creating a more efficient market for overall computational demand. Where’s the downside in that?
Disadvantages of token wrapping?
If we go back to Coinmarketcap and compare the prices for native BTC and wBTC you’ll find that the peg between them isn’t exactly 1:1, this is because the minting and burning process isn’t 100% efficient. That price difference is known as slippage which means that you will potentially lose value as you wrap and unwrap tokens.
The whole process of wrapping and unwrapping also incurs fees which makes using wrapped tokens more expensive than transacting natively. You’ll have to justify the cost in terms of the additional value you can realise in terms of yield that for example, wBTC can generate as opposed to using the unwrapped version within the Bitcoin ecosystem.
Are Wrapped Tokens Safe?
More concerning than slippage is the underlying risks posed by the wrapping process, which for Bitcoin, the biggest wrapped market, has to go through centralised Custodian.
Because Bitcoin is not Turing Complete wrapping cannot be automated via Smart Contract, so wrapping happens through centrally controlled programs like BitGo.
This means that a decentralised asset can becomes more centralised. BitGo currently holds 1.4% of the total Bitcoin supply as collateral for wBTC. This leaves it open to potential abuse and manipulation, as there is just one point of failure.
At the moment demand is so great from native Bitcoin owners that they are willing to live with this compromise and how it skews distribution.
Vitalik Buterin, Ethereum’s founder, was fairly prophetic when he talked about some of the dangers:
“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.”
In February 2022 Buterin’s fears became a reality with the Wormhole hack. Wormhole is a token bridge between Ethereum and several other blockchains, including Solana.
The Solana side of the bridge was exploited for the loss of 120,000 Wrapped Ether (wETH) tokens valued at the time at around $326million.
This exploit casts doubt over the viability of the whole bridging/wrapping concept and narrows the potential for blockchain interoperability. It would make a bullish case for so-called layer 0 blockchains, Polkadot or Cosmos, which support multiple interoperable layer 1 blockchains, who in turn support digital applications.
Nevertheless the demand for wrapped coins, such as wBTC and wETH remains high, and until those blockchains can directly interact with each other are likely to remain an important part of the wider crypto ecosystem.