What Are They And How Do They Work?

Imagine a gamer using an Xbox console who wants to connect with a friend using a PlayStation. The first difficulty the player will encounter is the incompatibility of the two platforms. By design, gamers using Xbox or PlayStation can only interact with other players on the same platform. To override this design, the gamer will have to connect using a game that enables cross-play. This is also how blockchains work. Crypto assets on the Bitcoin blockchain cannot be transferred to the Ethereum blockchain because of incompatibility. To override this, the investor would need a version of crypto assets that can cross blockchains. This is where wrapped tokens come in. 

What Are Wrapped Tokens?

Wrapped tokens are versions of cryptocurrencies that can be transferred from their native blockchains and used on other networks. An ERC-20 wrapped BTC (denoted as wBTC) is a Bitcoin that is compatible with the protocol on the Ethereum blockchain, enabling it to be transferred (from the Bitcoin network) and used as an ERC-20 token on the Ethereum network. 

There are also TRC-20 versions of wrapped BTC, which allows it to interact with native tokens on the Tron blockchain.

Wrapped tokens are pegged in a 1:1 ratio to the crypto assets that are created from them. This means that 1 BTC equals 1 wBTC, and the price of wBTC will reduce if the price of BTC drops.

How Are Wrapped Tokens Created?

Wrapped tokens are created through a process of locking and minting. The user is required to lock the underlying crypto with a third party that provides blockchain bridging services. 

Where the crypto is locked and how their wrapped version is minted depend on the type of bridge the investor is using:

1. Wormhole Portal Bridge

Wormhole Portal is a non-custodial bridge service that allows investors to lock their underlying assets in a smart contract. In return, the portal mints a wormhole-wrapped token, which can be swapped for a native token on the target blockchain of their choice. This means that if an investor wants to transact with Ethereum DeFi but has Bitcoin, Wormhole will let them connect their Bitcoin wallet to their portal, lock it in a smart contract in exchange for a Wormhole ERC-20 wrapped token, and then transact with this token on the DeFi.

Wormhole Portal is also a bidirectional token bridge that allows investors to send wrapped tokens between the Ethereum and Solana blockchains.

2. BitGo

BitGo is a crypto investment platform that offers custodial token bridging services for Bitcoin. To mint the wrapped token, investors are required to lock their BTC using the proof-of-reserve option on BitGo’s platform. Bitcoin will be added to the reserve and an ERC-20 version of BTC (denoted as wBTC) will be sent to the Ethereum wallet address provided by the investor.

To keep the protocol transparent, the total value of BTC locked and the amount of wBTC released to users are displayed on the platform’s dashboard. This is to help investors confirm that all wBTC is backed by a corresponding Bitcoin. BitGo’s reserve is monitored by its DAO, which ensures that the platform’s bridging service remains decentralized.

All wBTC minted with BitGo can be used in its associated crypto exchanges and Dapps (including Compound, MarkerDAO, Airswap, and Hydro Protocol). 

3. RenBridge

RenBridge Protocol allows users to wrap not just the native crypto of a blockchain but also stablecoins and generic assets (like LP tokens ($UNI)). This means that ERC-20 USDT can be wrapped to renUSDT and made compatible with any of the 7 blockchains supported by Redbridge (which include Solana, Avalanche, Arbitum, Fantom, Binance Smart Chain, and Polygon blockchains).

RenBridge also allows users to wrap an already wrapped renASSETS and transfer it to another blockchain. So if a user wants to make an ERC-20 renBTC compatible on the Binance Smart Chain, they don’t have to transfer it back to the Bitcoin chain as BTC first; instead, they can burn the ERC-20 renBTC on the Ethereum blockchain and re-wrap it as a BEP-20 renBTC. This helps them save time and reduce transaction fees.

The underlying asset on each token bridge can be released by burning the wrapped token, which removes it from circulation. Both minting and burning wrapped tokens incur a fee on all bridges; this is aside from the network fee of the origin and target blockchains. To help you reduce costs, some bridges, like RenBridge, implement a minimum amount an investor can wrap.

Other Types Of Wrapped Tokens

1). Wrapped Ether (wETH)

Ether was built as the utility token of the Ethereum blockchain; developers who want to build decentralized applications on the network will pay for transaction fees in Ether. However, after building these applications, they create their utility or reward tokens following the ERC-20 standard. This means that users who want to interact with the application will have to use the dApp’s native tokens or another token that complies with the ERC-20 standard. However, Ether was not built to follow ERC-20 standards.

Wrapped Ether (wETH) expands the function of ETH on the Ethereum blockchain by making it compatible with ERC-20 standards. This allows it to be used not just to pay fees but for lending, borrowing, investing, and providing liquidity for dApps and decentralized exchanges built on the Ethereum blockchain.

2). Wrapped NFTs

NFTs on the Ethereum blockchain are created following the ERC-721 standard, which makes them non-fungible tokens. What this means is that, inherently, NFTs are not exchangeable. One CryptoPunk NFT can’t be sold for another CryptoPunk NFT, even if both pieces are from the same collection. This means that if a trader with a collection of 50 NFTs wants to sell all their NFTs, they cannot list the order under a single transaction call because all of them are not equal. Each piece in the collection would require a different order with a floor price (based on their rarity).

Wrapping NFTs creates an ERC-20 version for the NFT, which allows them to be exchanged with other ERC-20 tokens. So a Wrapped Kitty NFT can be exchanged for a Wrapped Punk NFT. The trader can then burn the wrapped token to release the original NFT.

Conclusion

Although wrapped tokens increase the functionality of crypto assets and can lead to wider adoption, there are still concerns about how secure they are. 

Like other crypto assets, the security of wrapped tokens depends on whether the bridging service provider holds custody of the underlying crypto or not. Non-custodial providers that lock the crypto in a smart contract are safer than custodial providers who keep it in a vault or reserve.

Steve Anderson is an Australian crypto enthusiast. He is a specialist in management and trading for over 5 years. Steve has worked as a crypto trader, he loves learning about decentralisation, understanding the true potential of the blockchain.

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