A wrapped token is a cryptocurrency token pegged to the value of another crypto. It’s called a wrapped token because the original asset is put in a wrapper, a kind of digital vault that allows the wrapped version to be created on another blockchain.
Wrapped tokens are a way to circumvent this limitation and use non-native assets on a blockchain.
What is a wrapped token?
A wrapped token is a tokenized version of another cryptocurrency. It’s pegged to the value of the asset it represents and typically can be redeemed for it (unwrapped) at any point. It usually represents an asset that doesn’t natively live on the blockchain that it’s issued on.
You could think of a wrapped token as being similar to a stablecoin in that it derives its value from another asset. In a stablecoin's case, that’s usually fiat currency. In a wrapped token’s case, it’s usually an asset natively living on another blockchain.
As blockchains are distinct systems, there isn’t a good way to move information between them. Wrapped tokens increase interoperability between different blockchains – the underlying tokens can, in essence, go cross-chain.
How do wrapped tokens work?
Let’s use Wrapped Bitcoin (WBTC) as our example, a tokenized version of Bitcoin on Ethereum. WBTC is an ERC-20 token that’s supposed to hold a one-to-one peg to the value of Bitcoin, allowing you to effectively use BTC on the Ethereum network.
Wrapped tokens typically require a custodian – an entity that holds an equivalent amount of the asset as the wrapped amount. This custodian can be a merchant, a multisig wallet, a DAO, or even a smart contract. So, in WBTC’s case, the custodian needs to hold 1 BTC for each 1 WBTC that is minted. Proof of this reserve exists on-chain.
But how does the wrapping process work? A merchant sends BTC for the custodian to mint. The custodian then mints WBTC on Ethereum according to the amount of BTC sent. When the WBTC needs to be exchanged back to BTC, the merchant puts in a burn request to the custodian, and the BTC is released from the reserves. You can think of the custodian as the wrapper and unwrapper. In WBTC’s case, adding and removing custodians and merchants is performed by a DAO.