Wrapped tokens: blockchain limitation disruptors

Wrapped tokens that feature assets to be used behind the native blockchain or original design are gaining widespread application across DeFi platforms.

A wrapped token is an asset representing the value of a blockchain’s native asset on another blockchain. A wrapped token’s value is pegged 1:1 to an underlying asset meaning that, for instance, the price of one wETH (wrapped ETH) should be one ETH.

How do wrapped tokens work?

Wrapping involves locking a number of tokens as collateral in order to give them the functionality of another blockchain token standard. Once wrapped, a token lives on one chain while representing another chain, and its value is pegged to the underlying asset. For instance, BTC converted into WBTC, interacts as an ERC-20 token, enabling users to do everything they want within the Ethereum ecosystem, but its price remains tied to BTC.

Wrapping also enables native currencies, such as ETH and BNB, to be compatible with ERC-20 tokens in the case of wETH and with BEP-20 tokens for WBNB.

A 1:1 peg might resemble the approach used in stablecoins. However, wrapped tokens are fundamentally different since stablecoins’ value is tied to that of fiat currencies via off-chain monetary reserves, unchecked by an automated protocol.

The whole wrapping process can be handled through smart contracts. A user sends tokens to a smart contract, which holds them in order to mint an equivalent amount of wrapped assets at a 1:1 ratio. To unwrap the original tokens, users need to simply trade them back to the smart contract.

Meanwhile, wrapping BTC for the use on the Ethereum blockchain relies on WBTC DAO, which governs merchant and custodian listings for WBTC on Ethereum by using a multi-signature contract. The process of minting the equivalent locked amount is similar, with the difference that the custodian and merchant are those responsible for wrapping and unwrapping. The merchant receives a request from a user, performs KYC procedures to verify the user’s identity and initiates the minting process after transferring the tokens. Minting is handled by the custodian. To convert wrapped tokens back, a user puts in a burning request to release the locked amount from the merchant’s reserves.

The limitations that the usage of wrapped tokens might hypothetically face are related to the fact that some wrapped tokens are centralized, since, for instance, BitGo is the custodian of WBTC.

How to get wrapped tokens and unwrap them?

While details of the wrapping process might seem complex, the process of receiving wrapped tokens to your crypto wallet is quite straightforward. On 1inch, you get wrapped ETH in a regular swap — just select wETH as the token you’re buying. You can receive wETH not only in exchange for ETH but also for other tokens. Users can also exchange any tokens for WBTC and vice versa.

Why are wrapped versions of tokens essential?

With the evolution of DeFi, users have been empowered with more and more features, limited only by blockchain interoperability issues. For instance, it is impossible to interact with BTC on Ethereum. Meanwhile, a bitcoiner may not want to invest in other assets, yet wishes to generate revenue with protocols that don’t support BTCs. With WBTCs, such users can use their assets as collateral for lending and borrowing, derivatives trading and earning yield from depositing WBTC.

In the case of BTC, wrapping allows for bringing bitcoin liquidity to decentralized platforms, which benefits both users and projects. At the moment of writing, 217,358 BTC were locked on Ethereum, according to Dune.

When it comes to ETH, not all dApps natively supporting ERC-20 tokens — a standard for tokens issued on Ethereum — can seamlessly integrate with ETH. This is because ETH is a native currency of Ethereum, but not a token created using a smart contract on the network, like ERC-20 tokens. To be moved in the same way as other tokens, ETH needs to be wrapped. As the ERC-20 version of ETH, wETH facilitates interaction with many protocols. An example can be found in a situation of bidding on an item on an NFT marketplace that doesn’t accept ETH as collateral. A user might be confused about what ERC-20 tokens to buy and how many. Besides, some of them may not be needed later. That is where wETH comes into the play as an alternative to purchasing other tokens. According to Coinmarketcap, the trading volume of wETH in early 2023 exceeded $7 bln on some days, which represents strong market interest in this asset.

Wrapping can also be used for non-fungible tokens, giving them additional characteristics. Wrapped NFTs can facilitate swapping on decentralized exchanges. If a user, for instance, wants to sell their entire collection of NFTs at once rather than each item individually, it would be handy to do so in a single trade. The examples of wrapped NFTs are WCK (wrapped Crypto Kitties) and Wrapped Punks, which can be exchanged 1:1 with original NFTs. They established a basic minimum value for all collectibles and provided liquidity to the market.

Another benefit of wrapped NFTs is that they can be placed across various marketplaces. Just like regular crypto tokens, NFTs are issued in different standards and on different blockchains. Meanwhile, their wrapped versions allow for listing on various platforms, extending their audience and increasing value.

Overall, the ability to wrap an asset or exchange tokens for wrapped assets compatible with desired networks improves users’ interaction with DeFi projects.