What are wrapped tokens?
Wrapped tokens are blockchain-based tokens used to represent a cryptocurrency or asset on a different blockchain. The original asset is either locked in a smart contract or held by a custodian, allowing its value to be used on another network.
For example, WBTC (wrapped Bitcoin) represents BTC (Bitcoin) on the Ethereum network, extending BTC’s utility into decentralized finance (DeFi) applications and other use cases.
Wrapped tokens improve interoperability between blockchains, enhancing the accessibility of decentralized networks.
Wrapped tokens differ from synthetic tokens (e.g., sBTC on Synthetix). Wrapped tokens are typically backed 1:1 by the original underlying asset, while synthetic tokens are derivatives whose value is pegged algorithmically or through collateral unrelated to the original asset.
How do wrapped tokens work?
Wrapped tokens are created and redeemed through mechanisms such as custodial wrapping, non-custodial wrapping, and bridge protocols.
Custodial wrapping (e.g., WBTC)
Custodial wrapping involves a trusted third party (custodian) holding the original asset and issuing wrapped tokens on another blockchain. This process requires trust in the custodian and includes the following steps:
- Deposit: Users send the original asset (BTC) to a verified custodian.
- Verification and minting: After confirming the deposit, a separate smart contract mints an equivalent amount of wrapped tokens (WBTC) on the target blockchain.
- Redemption: To recover the original asset, users go through another verification process and burn their wrapped tokens before the custodian releases the original asset.
Non-custodial wrapping (e.g., WETH)
Non-custodial wrapping allows users to convert native tokens into wrapped tokens through a smart contract without relying on a third party. This process ensures complete user control and consists of the following:
- Deposit: Users send their tokens (ETH) to a smart contract.
- Minting: The contract immediately issues an equivalent amount of wrapped tokens (WETH).
- Unwrapping: Users burn their wrapped tokens through the same smart contract and instantly receive the original tokens.
Bridge protocols (e.g., Wormhole)
Wormhole's token bridge facilitates cross-chain asset transfers using a lock-and-mint mechanism. This process locks the original asset on the source chain, and a wrapped version is minted (created and issued) on the destination chain through the following steps:
- Attestation: The original token's metadata is verified and certified on the source chain, ensuring the token's properties are consistent and trustworthy when transferred to other chains.
- Locking: The native token (e.g., ETH on Ethereum) is locked in a smart contract on the source chain and essential properties are preserved—name, symbol, and decimal precision.
- Message emission: A message detailing the transfer is sent to the destination chain through Wormhole’s Guardian Network (a group of decentralized nodes that observe the state of multiple blockchains). Guardians verify the transfer and sign the message to confirm its validity.
- Verification and minting: On the destination chain, the transfer message is verified using the Guardian Network’s signatures. Once verified, the wrapped asset (e.g., WETH) is minted on the destination chain (e.g., ZKsync).
- Burning and unlocking: To recover the original asset, the user initiates a redeem transaction, which burns the wrapped token on the destination chain. The Wormhole protocol then verifies the event and submits a request to unlock the originally locked asset on the source chain, returning it to the user’s wallet.
Examples of wrapped tokens
Wrapped Bitcoin (WBTC):
- A tokenized version of Bitcoin on the Ethereum blockchain, backed 1:1 by BTC held by a custodian.
- Enables Bitcoin to be used in Ethereum-based DeFi protocols, such as lending, borrowing, and decentralized exchanges (DEXs).
- WBTC has achieved billions of dollars in market capitalization, indicating significant adoption in DeFi.
Wrapped Ether (WETH):
- Native ETH is not ERC-20 compliant, restricting its direct compatibility with Ethereum-based DeFi protocols designed specifically for ERC-20 tokens.
- WETH, an ERC-20 token managed by a smart contract, allows ETH to integrate into decentralized applications (dApps) and other protocols on the Ethereum network.
Wrapped Solana (WSOL):
- A wrapped version of Solana's native SOL token that complies with Solana Program Library (SPL) token standards.
- Allows SOL to be used in dApps and protocols that require SPL token compatibility.
Advantages of wrapped tokens
Wrapped tokens provide utility across blockchain ecosystems and drive innovation through:
Cross-chain interoperability
- Facilitates seamless movement of assets between blockchains.
- Supports communication and value transfer between previously isolated ecosystems (e.g., WBTC on Ethereum).
- Enables developers to create applications leveraging multiple blockchains' strengths, like combining Bitcoin's store-of-value with Ethereum's DeFi capabilities.
Enhanced DeFi accessibility
- Brings non-native assets into DeFi protocols on other blockchains.
- Allows participation in lending pools, yield protocols, and other DeFi services.
- Expands portfolio diversification opportunities by accessing new markets.
Optimized DEX integration
- Ensures smooth integration with DEXs by aligning with token standards (e.g., ERC-20, SPL).
- Creates novel trading pairs (e.g., WBTC paired with ETH or stablecoins).
- Enables liquidity provision in pools, generating transaction fees and rewards.
- Provides expanded access for non-native assets to be traded.
- Increases liquidity and reduces slippage (the difference between expected and actual trade prices due to market volatility) during trades.
Security risks and limitations
While wrapped tokens enable cross-chain functionality, they introduce several security considerations:
Custodial risks: Custodial wrapped tokens (like WBTC) require trusting a centralized entity (such as BitGo) to hold the underlying assets. If the custodian becomes compromised, insolvent, or acts maliciously, users' backing assets could be lost or frozen.
Smart contract vulnerabilities: Non-custodial wrapped tokens rely on smart contracts that may contain bugs or exploitable vulnerabilities. Even audited contracts can have undiscovered issues that might lead to asset loss.
Bridge security: Bridges are prime targets for attacks, often resulting in significant losses. Since native tokens are locked in smart contracts, vulnerabilities can be exploited. For example, in the Wormhole exploit of February 2022, attackers stole approximately $320 million in wrapped ETH by exploiting a validation flaw in the protocol.
Decentralization trade-offs: Many wrapped tokens rely on centralized entities or small validator groups, which conflict with blockchain's principles of decentralization.
Regulatory considerations
The regulatory landscape for wrapped tokens varies based on implementation. Users should conduct due diligence regarding the regulatory status of wrapped token providers. For example, custodians like BitGo that secure assets for wrapped tokens are subject to regulatory oversight. These entities typically must comply with KYC (Know Your Customer) and AML (Anti-Money Laundering) regulations in the jurisdictions in which they operate.
