A beginner's guide to understanding wrapped tokens and wrapped Bitcoin

A beginner's guide to understanding wrapped tokens and wrapped Bitcoin

Crypto enthusiasts might have heard of wrapped Bitcoin or wrapped crypto tokens. In this article, we explore the types of wrapped tokens there are in crypto, the point of wrapped tokens, and what they mean to you as a crypto trader and investor.

Blockchains like Bitcoin and Ethereum have different protocols, functionalities, and due to the fundamental difference in their algorithms, they cannot talk to each other. While this independence preserves individual blockchains’ sovereignty and security, it also challenges the existence of an interoperable ecosystem where data and information should be exchanged easily.

For instance, in decentralized finance (DeFi), where an efficient, smooth, and fast movement of funds is crucial, wrapped crypto tokens find a valid application.

Some more recent blockchains, like Polkadot, were created to overcome the interoperability issue. However, it became necessary to find a solution and allow communication between early networks like Bitcoin and Ethereum, which is why wrapped tokens were created.

Wrapped crypto tokens

Wrapped crypto tokens are cryptocurrencies pegged to the value of another original crypto or assets like gold, stocks, shares, and real estate and put to work on the DeFi platforms.

The original asset is ‘wrapped’ into a digital vault, and a newly minted token is created to transact on other platforms. Wrapped tokens allow non-native assets to be used on any blockchain, build bridges between networks and implement interoperability in the cryptocurrency space. 

They can represent anything from arts and collectibles, commodities, crypto assets, equity and stocks to fiat currencies and real estate. Since wrapped tokens are pegged to another asset, they necessarily need to be regarded and managed by a custodian entity that will wrap and unwrap the asset. We will see why this is also a limitation in the decentralized world of cryptocurrencies.

Wrapped Bitcoin denominated as wBTC were the first wrapped Bitcoin tokens used in the Ethereum blockchain through smart contracts, letting investors earn a fixed income. Besides Bitcoin, the list of wrapped tokens includes other assets mainly compliant with Ethereum ERC-20 and Binance Smart Chain BEP-20

Curious as it sounds, although ERC-20 tokens are issued in the Ethereum platform, ETH is not compliant with them as it was developed before them. Therefore, just like Bitcoin, Ether needs to be wrapped to comply with other ERC-20 token standards. A tokenized version of Ether on the Ethereum platform is thereby created.

Other blockchains like Cardano, Polkadot, and Solana have started to experiment with wrapped tokens to facilitate access to DeFi applications.

Some more recent projects include the bLuna, the wrapped Luna token that can be traded freely or used as collateral on other protocols on the Terra network, which is both a price-stable and growth-driven platform.

Types of wrapped tokens

It is widely conceded that stablecoins were the first type of wrapped tokens, despite a significant difference with the more established wrapped coins. A stablecoin like USDT (Tether), for example, is backed by approximately one dollar. However, Tether does not hold the exact amount of physical USD for each USDT held, and its reserves include assets of different nature: cash, cash equivalents, investments, receivables from loans, etc.

There are two types of wrapped tokens, cash-settled and redeemable. Cash-settled tokens cannot be redeemed for the underlying asset. On the other hand, redeemable tokens allow investors to exchange the wrapped token with the underlying asset. Other blockchains host wrapped tokens. Wrapped privacy coins, for example, are hosted in the Monero or ZCash blockchains.

How do wrapped tokens work?

Upon the request of merchants like ​​Airswap, CoinList, 0x, AAVE, or Maker, the custodian mints on a given platform like Ethereum, for example, the amount of the original token sent. 

By a similar process, when the wrapped token needs to be converted back into the original asset or a coin like Bitcoin, the user will request the custodian to release the token from the reserves. In simple words, for every wBTC that exists, for example, there is a Bitcoin that a custodian is holding.

The process of creating and managing wrapped tokens represents a limitation in crypto as the requirement of a custodian to trust for holding the funds defeats the purpose of an open and decentralized blockchain ecosystem. 

A custodian is still required since traders can’t independently use wrapped tokens for cross-chain transactions. However, technology is evolving rapidly, and we might attain some decentralized options soon.

Steps in the working of a wrapped token

Wrapped Bitcoin

When it was launched in January 2019, the first wrapped Bitcoin (wBTC) protocol was intended to bring Bitcoin potential and liquidity to the Ethereum network along with the flexibility of an ERC-20 token. 

While the original BTC could not be used for decentralized finance (DeFi) transactions, a wrapped Bitcoin could replace the original asset and transact within the DeFi ecosystem or any other decentralized application within the Ethereum network.

A wrapped Bitcoin is a significant addition to the cryptocurrency world. While the value of the wBTC is the same as the original Bitcoin, the functional aspect is accrued enormously and increases the possibility of employing Bitcoin for other use cases like DeFi. 

In plain words, a BTC holder can lend Bitcoin through smart contracts by simply connecting their wallet to a decentralized platform and earning a fixed interest rate per year. At the same time, borrowers use their crypto as collateral, which automatically goes to the lender if they default. 

By using this type of financing, investor lenders can still get some returns even in bear markets when the value of the asset drops. 

How do wrapped Bitcoin tokens work?

Three actors have primary roles in the creation and management of the wBTC protocol:

The DAO (Decentralized Autonomous Organization) comprises 17 members from the DeFi space who will hold a multi-sig (multi-signature) contract to add or remove wBTC merchants and custodians.

The merchants are administrators who trigger the minting process by sending a certain amount of BTC to the custodian and requesting the minting of the equivalent amount in wrapped tokens, according to investors’ and traders’ demands.

The custodians are like vaults that provide reliability and security to wBTC and ensure that all wBTC are fully backed and verified through on-chain proof of reserves. They mint BTC and send the equivalent amount of wBTC (one to one pegged to the value of BTC) back to the merchant.

In essence, the merchant transfers real BTC to a custodian address of the Bitcoin blockchain where it is locked. Once it receives the real BTC, the custodian address mints the equivalent amount in wBTC on Ethereum. 

When the reverse happens and the wBTC needs to be converted back into real BTC, the ERC-20 BTC token is burned (destroyed), and the locked BTC on Bitcoin is released. The minting and burning of tokens are tracked and verifiable on the blockchain.

The need for such a token arose with the growth of DeFi, which is now worth billions of dollars going into lending, options, derivatives, and other types of financial applications. The demand for using BTC in DeFi as an underlying asset was such that it had to be converted into an ERC-20 compatible token to participate in the ecosystem, mainly developed on Ethereum. 

It’s possible to view the complete order book of wBTC trading here. Depending on the protocol or organization behind them, wanBTC, renBTC, sBTC, WBTC, tBTC are all examples of ERC20-based BTC tokens minted on Ethereum.

Is wrapped BTC safe?

From a technical perspective, a wrapped Bitcoin token is safe. It will likely be in custody in safe platforms like Ethereum or Binance Smart Chain, and once converted into an ERC-20 or BEP-20 token, it will hold the security of the related network.

One of the significant flaws in wrapped BTC tokens is the need to trust the custodian that holds the underlying asset.  If the custodian unlocks and releases the real Bitcoin to someone else, token holders of the ERC-20 compatible wrapped BTC would be left with a worthless asset. 

The way Bitcoin is held determines the level of security provided. A centralized custodial bridge that holds Bitcoin is an organization that promises to mint ERC-20 tokens on Ethereum, for example. The centralized entity must be trusted that they will hold the BTC and not run away with it. Users must ensure these organizations are at least backed up by guarantees and insurances in case something goes wrong.

A decentralized smart-contract-managed bridge would be the best choice in the decentralized world of crypto. No need to trust any third party, only trust the code of immutable time-stamped smart contracts.

The security of wrapped BTC bridges (cross-chain connections) has represented a heated argument across the DeFi community for a long time in that custodians must be relied upon for keeping the real BTC locked. 

Are wrapped tokens a good investment?

Wrapped tokens are increasingly regarded as a good investment in the cryptocurrency world, where decentralized finance will undoubtedly play a significant role. In just over one year, about $800 million worth of Bitcoin was converted into wBTC, which gives an idea of the current capitalization of the industry.

According to Arcane Research, the amount of Bitcoin locked on the Ethereum blockchain has increased to 189,000 BTC in 2021. It is estimated that a record 1% of Bitcoin's circulating supply of 18.73 million is now used in DeFi through wrapped Bitcoin tokens.

Wrapped tokens increase liquidity and capital efficiency for both centralized and decentralized exchanges due to the facility to move the assets across multiple chains that would remain isolated otherwise.

Another advantage is that the quick transaction times and lower fees that wrapped tokens offer are particularly beneficial for slow blockchains like Bitcoin or Ethereum. 

In contrast with other assets, wrapped tokens also offer fractionalized ownership that allows owners to buy and hold a tiny fraction of the asset.