If you are reading this, you have probably heard the term or even used wrapped tokens. But what exactly are they? How do they work? And are they secure?
In this article, we will answer all these questions and more. Let’s get started.
A wrapped token is a synthetic version of another cryptocurrency. In other words, they are a token which represents the value of another coin or token.
Blockchains are fragmented by design. For a token to be accepted on a blockchain, it must follow the standardised token rules for that blockchain. So most tokens are only accepted on one or a small number of blockchains. To enable tokens to be used on multiple chains, synthetic representations are created on blockchains other than the original; these are known as wrapped tokens.
Let’s use an example to break this down:
Imagine going to a store that only accepts store credits that you purchase online. One credit equals £1.
Fiat currency would therefore be incompatible with the store, but the store credits are incompatible with other places you would spend fiat. But the store credits represent fiat 1:1. Wrapped tokens essentially work in the same way.
Overall, wrapped tokens can serve multiple purposes, but they are mainly used to represent a cryptocurrency on a different blockchain.
If you have a token on one chain and want to receive the wrapped version on another, the easiest way is to use a bridge or cross-chain aggregator. However, if you want to receive a wrapped token on a chain that you already have cryptocurrencies on, you can use a DEX to make a swap.
For example, if you wanted to send BTC to the ETH chain and receive wBTC (wrapped Bitcoin), you would use a bridge or cross-chain swap.
But if you wanted to swap ETH for wBTC on the Ethereum blockchain. You could do this like any other token swap on UniSwap or any other DEX which supports the coin pair.
Wrapped tokens are basically crypto assets floating around on non-native blockchains. But this raises an important question, how do wrapped tokens affect the total supply of a crypto asset?
Because if will only 21 million BTC will ever exist, does this include wrapped tokens on other blockchains?
Earlier, we said wrapped currencies are a representation of the original currency. But they are more than that. They are usually backed 1:1 by the underlying asset. Without the backing, they would not hold the value of the underlying asset. Therefore, it would not have utility other than to mimic the original tokens’ price for synthetic exposure.
For the wrapped tokens to be backed 1:1, when a user bridges a token to a new blockchain, the bridge locks the original token in a smart contract and mints a wrapped version on the target chain. The original version is held in a smart contract until the token is returned to the original chain.
Fair warning: this section gets a little technical; if you are just here to understand the broader concept of bridging, you are free to skip ahead. But if you love to discover what is under the hood of crypto tech, keep reading.
Wrapped tokens are minted when a bridge sends a message to the receiver chain to mint or burn a token. The primary mechanism bridges use to do this is the notary bridge. Understanding this mechanism will help you better assess the risk of bridges.
The notary bridge model is the most common and easy-to-implement option. It consists of a wallet on the original and target chain. Funds are locked into the origin chain wallet when the user executes a swap.
A collection of nodes then validate the funds and send a message to the relayer to mint the wrapped currency on the target chain. There are two versions of this, the single and multi-signature notary model. Multi-signature is more secure as it is less vulnerable to an attack due to compromised private keys, but it does sacrifice speed to do so.
The nodes are a custodian of users’ funds, so this model requires their trust. We will discuss some of the dangers of this later on.
Wrapped tokens are a robust solution to one of cryptocurrency’s most significant issues: interoperability. This lack of interoperability between chains leads to fragmented liquidity.
One of the main issues of fragmented liquidity between chains is if a particular blockchain benefits from a new tool or dApp, other chains receive no benefit. But if tokens can move freely across chains, liquidity derived from a dApp on one chain can be spread across multiple. Thus developing the cryptocurrency ecosystem much further.
So that is how wrapped tokens provide value to the broader cryptocurrency ecosystem, but why do users need wrapped tokens in the first place?
There are two main reasons for this.
The most popular wrapped cryptocurrency is wrapped Bitcoin, with over a $3 billion market cap.
Many cryptocurrency investors choose to wrap their BTC using Ren or a similar tool. Usually, Bitcoin holders cannot earn on their assets. But by swapping their BTC to ERC-20 wBTC, they gain access to a wide range of financial instruments which allow them to earn yield on their Bitcoin assets.
Also, many cryptocurrency users have a Metamask or similar Ethereum Virtual Machine (EVM) wallet that does not support Bitcoin. Purchasing wBTC is an easy way to gain exposure to Bitcoin without setting up a Bitcoin wallet.
Although a wrapped cryptocurrency is backed 1:1 by the underlying asset, this does not mean it is as secure as the underlying asset. Besides the price and tokenomics, not much about a wrapped and original cryptocurrency is the same. For example, the source code is completely different.
Take Bitcoin vs wBTC, for example. The entire premise behind Bitcoin is that it is a P2P cryptocurrency which utilises a distributed ledger to prevent the need for an intermediary or 3rd party. However, wrapped currencies require a custodian to lock up the original asset until it is unwrapped.
For an investor’s Bitcoin to be secure, they need to keep their private keys safe and for the Bitcoin network to run as designed. Comparatively, for wrapped Bitcoin to be secure, there are multiple more considerations relating to the intermediary.
If any of these elements fail or are exploited, the underlying asset funds are lost, and users cannot unwrap their tokens. So it quickly becomes a liquidity crisis. If this happens, the wrapped asset will lose its peg to the original asset as people try to swap their wrapped token for other tokens on the network.
The main danger with wrapped currencies is that they are held in a custodian wallet. There are multiple ways these funds could be exploited or drained. As a matter of fact, half of all DeFi exploits occur on bridges which have custody of users underlying assets.
With this in mind, it is crucial to understand how to stay safe with wrapped tokens.
Choosing which bridge you want to mint your currency is paramount to its safety. Each bridge mints a different version of the original currency. For example, there are many wrapped currencies for Bitcoin, including wBTC and renBTC.
Making a decision on which bridge is the safest is a challenging task. Countless technical papers are written on the subject, each with different opinions.
However, as a rule of thumb, choose a bridge which does not hold the funds in a centralised wallet they have immediate access to. Centralised wallets dramatically increase the risk of stolen funds, leaving the wrapped tokens worthless.
Instead, choose a decentralised smart-contract bridge. This is a bridge where multiple decentralised nodes manage the underlying funds. However, there is more to bridge security than this criteria; check out this great article if you want to get deep into bridge security.