What is a wrapped token: modifying tokens for blockchain interoperability

What if you wanted to use Bitcoin within the Ethereum ecosystem, perhaps to access DeFi (decentralized finance) services, but realized that Bitcoin can’t natively move outside its blockchain. This is where wrapped tokens come in.

By representing one asset on a different blockchain, wrapped tokens enable a seamless experience that unlocks new possibilities for crypto interoperability.In this article, we’ll explore how wrapped tokens work, spotlight their benefits, and look at the possible future for wrapped tokens.

TL;DR

• Wrapped tokens represent other forms of token, allowing them to be used on different blockchains.

• They’re important in DeFi, letting assets be used across multiple blockchains.

• Token minting involves locking the original asset, while redeeming it releases it.

• Custodial trust and smart contract issues pose security risks, so audits are needed.

• Future improvements could include bridging and better token interoperability.

What is a wrapped token?

Wrapped tokens are a clever solution for making assets like Bitcoin usable on blockchains like Ethereum. They’re tokens that represent another asset on a different blockchain.By creating wrapped tokens, developers make it possible to use Bitcoin or other non-native digital assets across multiple networks, opening up new possibilities for crypto interoperability.

Let’s say you want to use Bitcoin on Ethereum’s DeFi platforms. Bitcoin itself is native to the Bitcoin blockchain, meaning you can’t just transfer it to Ethereum directly. But you can “wrap” Bitcoin to create — or mint — Wrapped Bitcoin (WBTC), an Ethereum-compatible token representing Bitcoin’s value.

When Bitcoin is wrapped, a custodian — usually a third party or a smart contract — holds an equivalent amount of Bitcoin in reserve. This way, each WBTC is backed 1 to 1 by real Bitcoin, making sure its value remains the same as the actual asset.When you no longer need WBTC, you can redeem it, and the custodian releases the original Bitcoin to you while “burning” the wrapped token.

Despite their convenience, wrapped tokens rely heavily on custodians, making security a key challenge. Some wrapped tokens, like WBTC, require a trusted third party to hold the asset, while others use decentralized approaches to reduce reliance on any single entity.

Why are wrapped tokens important to blockchain interoperability?

Wrapped tokens play a significant role in DeFi and blockchain interoperability by enabling otherwise isolated assets to be compatible with platforms outside their native chains.

In TradFi (traditional finance), using assets in multiple systems is the norm, but blockchains are naturally more restricted. Wrapped tokens bridge this gap by allowing cross-chain compatibility without transferring assets directly between chains. Here’s how they benefit DeFi.

Lending and borrowing

Wrapped tokens give you access to various DeFi applications. By wrapping Bitcoin as WBTC, you can lend your Bitcoin on Ethereum-based DeFi platforms, earning interest while retaining Bitcoin’s exposure.

Liquidity provision

Wrapped tokens are vital to liquidity pools, which are a core part of DeFi. Wrapped assets in these pools contribute to a cross-chain liquidity network. This helps decentralized exchanges run better and gives more people access to liquidity.

Interoperability

Wrapped tokens improve blockchain interoperability, allowing assets to be shared across networks. This creates a more connected ecosystem where assets can interact across different chains.

How are wrapped tokens created and what are their security risks?

Creating wrapped tokens involves ensuring each token represents a real asset held in reserve. The token creation process starts when the original asset, like Bitcoin, is sent to a crypto custodian, a trusted institution, or a decentralized platform.

A custodian locks an asset and mints a wrapped version on another blockchain to maintain its value. When the holder wants the original asset, the wrapped asset is burnt, and the custodian releases the original asset.However, security risks are involved in this process, especially concerning smart contract risks and the trustworthiness of custodians. Let's look at some of the main security concerns.

Custodial trust

Centralized custodians hold the actual asset backing the wrapped token, meaning users must trust them to secure the asset and prevent misuse. If a custodian fails or is hacked, it can result in a loss of value for all wrapped token holders.

Smart contract vulnerabilities

Wrapped tokens often rely on smart contracts to manage the minting and burning processes. If these smart contracts contain vulnerabilities, attackers could exploit them to mint counterfeit tokens or drain locked assets. The infamous 2021 Poly Network hack, where over $600 million was stolen, highlighted these risks.

Decentralized custodian limitations

Although decentralized platforms do help to reduce custodial risk, they face their own limitations with coordination and security.

Is token auditing the answer to wrapped token risks?

Regular token audits help to preserve the security of wrapped tokens by checking that reserves match circulating tokens and verifying smart contract security. However, they don’t eliminate all risks.

You need to understand these risks before engaging with wrapped tokens. Regular audits and choosing reputable custodians are essential steps to help protect against potential issues in the token creation process. Token security methods are continuing to evolve, as projects strive for safer, more decentralized solutions for wrapping assets.

What are some popular wrapped tokens?

Now that we understand how wrapped tokens work and some of the risks to be aware of, what are some of the major wrapped tokens available today?

Wrapped Bitcoin (WBTC)

WBTC lets Bitcoin holders use Ethereum-based DeFi services without selling their Bitcoin. They can do this by converting their BTC to WBTC and using it to lend, borrow, or trade in Ethereum’s DeFi ecosystem. WBTC has become very popular and is one of the leading use cases for wrapped tokens.

Wrapped Ether (WETH)

Although Ether (ETH) is Ethereum’s native token, it doesn’t fully comply with the ERC-20 standard that many DeFi protocols use. WETH was created to make ETH compatible with ERC-20, making interacting with decentralized applications and smart contracts on Ethereum easier. This is particularly useful in trading and liquidity pools, where WETH is widely used as a paired asset.

renBTC

Another popular Bitcoin-backed token on Ethereum, renBTC offers a decentralized approach to wrapping Bitcoin. Unlike WBTC, which relies on a custodian, renBTC uses a network of nodes to manage Bitcoin reserves. This provides a more trustless option for Bitcoin holders.

What's next for wrapped tokens?

Wrapped tokens are valuable for expanding the reach of digital assets across blockchains, but they come with limitations that impact their scalability and security. A major issue with wrapped tokens is their reliance on custodians.

Many wrapped tokens need centralized custodians to hold the original asset. This creates a point of trust and risk. If there are technical issues or a security breach, assets could be compromised, limiting the effectiveness of this solution.

As blockchain technology evolves, there are ongoing efforts to address these challenges and improve the future of wrapped assets. One promising area is decentralized bridging, where no single custodian holds the wrapped asset. Decentralized solutions like renBTC already use networks of nodes to manage wrapped tokens, reducing reliance on any one entity.

Meanwhile, research into blockchain innovation is opening doors for more secure and user-friendly wrapped tokens. For example, platforms like Polkadot and Cosmos are exploring ways to make interoperability more efficient.

If these developments succeed, they could lead to a new generation of wrapped tokens that are safer and easier to use across different blockchains.

The final word

Wrapped tokens provide an answer to the interoperability limitations encountered by blockchain users, presenting a way for token holders to use their assets across different chains.

Although security risks do exist, the potential for wrapped assets is clear, and developments are continuing to address limitations and improve the usability of wrapped tokens.

Interested in learning more about other blockchain interoperability fixes? If so, check out our guide on Movement Network and Wormhole.