A wrapped token is a cryptocurrency token pegged to the value of another crypto. It’s called a wrapped token because the original asset is put in a wrapper, a kind of digital vault that allows the wrapped version to be created on another blockchain.
What’s the point? Well, different blockchains offer different functionality. And they can’t talk to each other. The Bitcoin blockchain doesn’t know what’s happening on the Ethereum blockchain. However, with wrapped tokens, there can be more bridges between different blockchains.
Ever found it frustrating that you can’t use BTC on Ethereum? ETH on Binance Smart Chain? Coins that exist on a given blockchain can’t be simply transferred to another.
Wrapped tokens are a way to circumvent this limitation and use non-native assets on a blockchain.
A wrapped token is a tokenized version of another cryptocurrency. It’s pegged to the value of the asset it represents and typically can be redeemed for it (unwrapped) at any point. It usually represents an asset that doesn’t natively live on the blockchain that it’s issued on.
You could think of a wrapped token as being similar to a stablecoin in that it derives its value from another asset. In a stablecoin's case, that’s usually fiat. In a wrapped token’s case, it’s usually an asset natively living on another blockchain.
As blockchains are distinct systems, there isn’t a good way to move information between them. Wrapped tokens increase interoperability between different blockchains – the underlying tokens can, in essence, go cross-chain.
It’s worth noting that if you’re an ordinary user, you don’t have to worry about the wrapping and unwrapping process; you can just trade these wrapped tokens like any other cryptocurrency. For example, this is the WBTC/BTC market on Binance.
How do wrapped tokens work?
Let’s use WBTC as our example, a tokenized version of Bitcoin on Ethereum. WBTC is an ERC-20 token that’s supposed to hold a one-to-one peg to the value of Bitcoin, allowing you to effectively use BTC on the Ethereum network.
Wrapped tokens typically require a custodian – an entity that holds an equivalent amount of the asset as the wrapped amount. This custodian can be a merchant, a multisig wallet, a DAO, or even a smart contract. So, in WBTC’s case, the custodian needs to hold 1 BTC for each 1 WBTC that is minted. Proof of this reserve exists on-chain.
But how does the wrapping process work? A merchant sends BTC for the custodian to mint. The custodian then mints WBTC on Ethereum according to the amount of BTC sent. When the WBTC needs to be exchanged back to BTC, the merchant puts in a burn request to the custodian, and the BTC is released from the reserves. You can think of the custodian as the wrapper and unwrapper. In WBTC’s case, adding and removing custodians and merchants is performed by a DAO.
While some in the community may refer to Tether (USDT) as a wrapped token, this isn’t exactly the case. While USDT generally trades one-for-one with USD, Tether does not hold the exact amount of physical USD for each USDT circulating in their reserves. Instead, this reserve is made up of cash and other real-world cash equivalents, assets, and receivables from loans. However, the idea is very similar. Each USDT token acts as a kind of wrapped version of a fiat USD.
Wrapped tokens on Ethereum
Wrapped tokens on Ethereum are tokens from other blockchains that are made to be compliant with the ERC-20 standard. This means that you can use assets that are not native to Ethereum on Ethereum. As you’d expect, wrapping and unwrapping tokens on Ethereum costs gas.
Benefits of using wrapped tokens
Even though many blockchains have their own token standards (ERC-20 for Ethereum or BEP-20 for BSC), these standards can’t be used across multiple chains. Wrapped tokens allow non-native tokens to be used on a given blockchain.
In addition, wrapped tokens can increase liquidity and capital efficiency both for centralized and decentralized exchanges. The ability to wrap idle assets and use them on another chain can create more connection between otherwise isolated liquidity.
And lastly, a great benefit is transaction times and fees. While Bitcoin has some fantastic properties, it isn’t the fastest and can sometimes be expensive to use. While that’s fine for what it is, it can cause some headaches sometimes. These issues can be mitigated by using a wrapped version on a blockchain with faster transaction times and lower fees.
Most of the detail in this blog was taken from an article by the same name from the Binance Academy. All credit to Binance academy. https://academy.binance.com/en