What are wrapped tokens and why do we need them in DeFi?

If you struggle to wrap your head around the concept of wrapped tokens (pun intended), we are here to explain how they work and what they’re used for.

Coin wrappers - stock photo

Since the dawn of the crypto industry, blockchains’ ability to communicate with each other has been limited by architecture constraints. Wrapped tokens solve this problem by taking a token from one chain and issuing its “wrapped” version on the other chain.

This clever hack opens up new frontiers for cryptocurrency’s booming DeFi movement, although the issuance of wrapped tokens, as we will see later on, can pose significant security risks to the entire ecosystem. However, just as in the case of the blockchain trilemma, some tradeoffs have to be made.

But before we dive a bit deeper into how wrapped tokens are created and what risks they may pose for the DeFi ecosystem, let’s first look at what they aim to solve — the problem of blockchain interoperability.

The holy grail of DeFi: cross-chain interoperability

Essentially, blockchains can be thought of as distributed databases that are shared and updated by multiple nodes in a peer-to-peer network. Each node on the network carries a copy of all recorded and stored transactions and updates the record each time a new block is added to the chain.

To transact on the blockchain, one has first to set up a crypto wallet, which is an application that offers users a simple interface to interact with the network and a point for access to their digital assets. However, it’s important to understand that a crypto wallet doesn’t actually store cryptocurrencies like your physical wallet holds cash or credit cards. Instead, it holds the public and private keys that enable you to access and trade your coins that live on a blockchain. Basically, a crypto wallet stores cryptographical proof that you own your crypto, and how much of it. Once it is lost, there’s no way for you to move your funds from the network.

Now that we know that coins sit on the blockchain, it becomes much easier to understand the role of wrapped tokens. Since each blockchain is a separate database that doesn’t exchange information about your balance and transaction history with other networks, you can use your coins only on the native chain. Bitcoin sent to the Ethereum wallet (and vice versa) won’t be received by the intended recipient, and, what’s worse, will be lost forever.

When Satoshi Nakamoto created Bitcoin in 2009, blockchain was a nascent and experimental technology that very few — if any — people envisioned to become the foundation for a one trillion dollars worth industry in 2023. Having its origins as a niche product for cypherpunks and libertarians, Bitcoin wasn’t built for a future where multiple blockchains need to facilitate cross-chain transactions. And neither were the subsequent blockchains.

Read also: What are the (not so) different types of crypto tokens?

As a result, the crypto industry is largely fragmented, with multiple incompatible blockchains written in different programming languages and supporting different token standards. And as crypto went beyond the fringe libertarian movement and started benefitting from the capital injections brought in by the “suits” from traditional finance and VC, the interoperability problem grew more and more apparent.

To enable cross-chain transactions, wrapped tokens were introduced to the market. But how exactly do they function?

How wrapped tokens work

Long before Satoshi released their Bitcoin whitepaper, the TradFi industry faced the same problem blockchains try to solve with wrapped tokens: how to trade foreign stocks on national exchanges?

Foreign securities are freely traded on their respective exchanges through brokers and brokerage platforms, but getting them on a national exchange through direct listing can be really costly and time-consuming. Still, many investors are willing to have them in their portfolio, since international stocks are valuable for diversification and can net higher potential returns than domestic assets.

To bring its shares to foreign markets, the company can issue depositary receipts (DRs) in individual countries or multiple foreign markets at once. However, doing so would be impossible without assistance from a trusted intermediary — a foreign bank or broker takes custody of shares and reissues them on the home market. Once listed, DRs can be traded, settled, and held as if they were native to the market.

And this is precisely how wrapped tokens work too, except that instead of a centralized entity like a bank, the issuance is handled either by an automated smart contract (WETH) or a DAO composed of custodians and merchants (WBTC).

Let’s say you want to bring your bitcoin to the Ethereum blockchain. To mint WBTC (wrapped BTC), you should submit your request to the merchant, who will take your bitcoin and send it to the custodian in exchange for the equivalent amount of the newly created WBTC. Similarly, to retrieve your Bitcoin from the merchants, you should follow the same process but in reverse — send WBTC to the DAO and they will release the corresponding amount of BTC from custody. The received WBTC will be removed from the circulation to maintain a mint-burn equilibrium.

As a result, for every 100 WBTC minted, 100 BTC are being held, so the wrapped tokens are always backed 1:1 to the underlying asset.

Wrapped tokens vs stablecoins

Since wrapped tokens are designed to track the value of the asset they represent, this makes them conceptually similar to stablecoins. The difference is that the wrapped tokens’ value is tied to cryptocurrency, whereas stablecoins peg their value to more traditional assets like fiat currencies and precious metals that are stored off-chain (except algorithmic stablecoins, which are a newer breed of stablecoins backed by financial engineering rather than real-world assets).

Read also: The ultimate 101 guide to stablecoins

And just like stablecoins and traditional depositary receipts, wrapped tokens are a representation of an underlying asset, not actual tokens covered in some protective layer that allows to move them across chains — and this is precisely the root cause of most risks and limitations associated with this type of digital asset.

Limitations and risks of wrapped tokens

So, is it safe to use wrapped tokens? For most cases, the answer is yes — when you convert your existing cryptocurrency into a wrapped token, the probability of losing your funds is minimal. However, there are still certain risks you should be aware of if you plan to be a savvy crypto investor.

Inequivalent value

The first thing you should know is that wrapped tokens, just like stablecoins, can briefly lose their peg. Although wrapped tokens are designed to always be redeemable 1:1 against an underlying cryptocurrency through a smart contract or official merchants, they also trade at open markets, which means that the price can fluctuate. This is especially true in times of high volatility and panic among investors.

For instance, the largest wrapped version of bitcoin on the Ethereum blockchain, WBTC, traded at 2% discount in mid-November as investors feared that the token may not be fully backed by Bitcoin reserves on news that the now-bankrupt trading firm Alameda Research was the top WBTC merchant.

In most cases, the price gap caused by market panic is quickly closed by arbitrage traders who pick up discounted wrapped tokens and redeem them 1:1 with the merchants. However, if arbitrageurs deem the risk of no redemption too high, they won’t step in to save the peg and the gap will continue to widen.

Dishonest custodians

As you can see, many wrapped tokens — including WBTC — are sensitive to centralization, since they depend on the merchants and custodians that issue them, which creates space for power abuse and dishonest practices.

“I’m worried about the trust models of some of these tokens. It would be sad if there ends up being $5b of BTC on Ethereum and the keys are held by a single institution,” Vitalik Buterin opined about this limitation of wrapped tokens.

WBTC’s primary custodian is BitGo, a centralized firm. On December 15, the company denied Alameda’s withdrawal attempts to redeem 3,000 WBTC, alleging that the security details used in the request “didn’t match the process.” As BitGo was waiting for the requested proof of identity, Alameda declared its insolvency and never took custody of the Bitcoin held by the firm.

Market contagion

As wrapped tokens increase interdependence between blockchains, the risk of market contagion grows as well. For instance, if one protocol token bridge is compromised, all DApps using its wrapped token are left vulnerable to a liquidity crisis.

Precisely this type of credit contagion happened during Terra/Luna collapse in May, when DeFi projects associated with TerraUSD (UST) suffered losses of more than 80%. Cosmos ecosystem was also hit by UST depeg, and its tokens like Mirror Protocol (MIR), Osmosis (OSMO), and Kava (KAVA) corrected sharply due to their connection to Terra.

Vulnerabilities in cross-chain bridges

The solutions that allow users to wrap their tokens to move them across blockchains — the so-called token bridges — are notoriously known for being a lucrative target for cybercriminals. According to data by Token Terminal, hackers stole over $2.5 billion through vulnerabilities in bridges between 2020 and 2022.

Such a mind-boggling figure is due to one fundamental flaw of token bridges: since they rely on the security of the chains they connect, any bug discovered within the chain leaves bridges vulnerable to exploits. And the more chains one bridge connects, the riskier it becomes to use it.

Read also: Why are cross-chain bridges such a weak spot in blockchain security?

According to Vitalik Buterin, the high level of interdependency between blockchains would mean that a 51% attack on one small-cap chain can cause a wide contagion, putting at risk even those chains that are virtually immune to such an attack due to the high costs of launching it.

“My argument for why the future will be *multi-chain*, but it will not be *cross-chain*: there are fundamental limits to the security of bridges that hop across multiple ‘zones of sovereignty’,” he concluded.

Examples of wrapped tokens

Undoubtedly, the prime example of wrapped tokens is WBTC — the first wrapped version of Bitcoin on Ethereum. The project was jointly started by Kyber, Ren, and BitGo and is currently operated by the WBTC DAO. However, there are other tokenized representations of Bitcoin, namely:

renBTC by RenBridge (formerly Republic Protocol)

HBTC by cryptocurrency exchange Huobi

sBTC by Synthetix protocol

pBTC by pNetwork

oBTC by BoringDAO

Similarly to wrapped Bitcoin, there are wrapped versions of other popular cryptocurrencies, including:

renZEC (wrapped Zcash)

WXMR (wrapped Monero)

WMATIC (wrapped MATIC)

renDOGE (wrapped Dogecoin)

WFIL (wrapped Filecoin)

WBNB (wrapped BNB)

renBCH (wrapped Bitcoin Cash)

WCELO (wrapped Celo)

Finally, Binance Smart Chain (BSC), a smart contracts blockchain by crypto exchange Binance that rivals Ethereum, designed a range of its own wrapped assets, BTokens, that allow users to convert their crypto assets onto Ethereum and explore its burgeoning DeFi ecosystem. They are:

BDOT (wrapped Polkadot)

BBTC (wrapped Bitcoin)

BETH (wrapped Ether)

BXRP (wrapped XRP)

BUSDT (wrapped Tether)

Final thoughts on wrapped coins

As a concept, wrapped tokens may seem like an ingenious idea — they effortlessly connect otherwise incompatible chains, thus increasing the capital efficiency of the DeFi industry. In practice, however, the number of bridges needed to facilitate cross-chain communication grows exponentially as more blockchains are created. Then there’s also a persistent threat of centralization and numerous security concerns that will only increase as blockchains become more interdependent.

Still, for the foreseeable future, wrapped tokens and bridges will most likely remain a key solution to the much-needed interconnection between multiple blockchain ecosystems.