Understanding wrapped tokens: the bridge between blockchains

The issue of asset segmentation

Imagine owning bitcoins but only being able to use them on the Bitcoin network. You would miss out on Ethereum's thriving DeFi ecosystem or Solana's enticing yields. This is precisely the frustration experienced by early cryptocurrency users. Wrapped tokens were born out of this constraint: they offer an elegant solution to the inter-blockchain interoperability problem by allowing assets to “travel” and operate across multiple networks.

Definition and Fundamental Operation

A wrapped token is essentially a “wrapped” digital version of a native cryptocurrency from another blockchain. It maintains a 1:1 parity with the original asset and can be reconverted (unwrapped) at any time. Wrapped Bitcoin (WBTC) perfectly illustrates this concept: it is an ERC-20 token on Ethereum that represents bitcoin held in reserve.

The mechanism relies on a custodian—a trusted entity that can be a merchant, a multisignature wallet, a decentralized autonomous organization (DAO) or a smart contract. This entity holds the original assets in an amount equivalent to that of the issued tokens. When a user wishes to create WBTC, they send BTC to the custodian, who then issues the corresponding tokens on Ethereum. The reverse works the same way: sending a request for destruction (burn) of the wrapped token releases the reserves.

The concrete advantages of this technology

Wrapped tokens transform access to decentralized finance. First, they drastically improve liquidity by allowing assets from various blockchains to be used on multiple platforms simultaneously. A Bitcoin wallet thus becomes usable on Ethereum for lending-borrowing operations or yield farming.

Next, the interoperability they create is revolutionary: the different networks (Ethereum, BNB Chain, Solana, Avalanche, and others) connect through this means, creating a more efficient capital that flows freely. Users can then lend, borrow, vote on governance protocols, or participate in liquidity pools, regardless of the blockchain of origin of their funds.

Finally, the fees and transaction speed often benefit from this approach, especially during swaps on DEXs or decentralized exchange platforms where wrapped tokens circulating natively provide a better user experience.

The risks and limitations not to be underestimated

However, this flexibility comes at a price. Dependence on trusted third parties represents the major risk: if the custodian is compromised, the reserves can be lost, creating centralized control points in a system that is supposed to be decentralized.

Smart contracts managing the wrapping and unwrapping process can also contain critical vulnerabilities. A bug or a poorly detected flaw can immobilize or destroy funds. The regulatory question, still evolving according to jurisdictions, adds an additional layer of uncertainty.

Add to that the high transaction fees and potential price slippage during trades, and some of the promised advantages fade away for small holders.

Use cases shaping the ecosystem

In practice, wrapped tokens serve several essential functions. Trading and inter-blockchain transfers become seamless: a user can swap WBTC for other assets without reverting to the Bitcoin network. Liquidity providers deposit these wrapped assets into DEX pools to generate fees.

DeFi protocols using wrapped tokens as collateral offer loans and yield farming to users. Even more innovatively, NFTs can also be wrapped and circulate across different platforms, expanding use cases.

Diversity of supported blockchains

Although Ethereum initially dominated with wrapped ERC-20 tokens, this technology has spread to BNB Chain, Solana, Avalanche, and many others. WETH (Wrapped Ether) represents a particular case: since ETH was not initially an ERC-20 token, it had to be wrapped to facilitate interactions with smart contracts adhering to this standard.

In summary

Wrapped tokens are the silent architects of modern decentralized finance. They expand access to fragmented liquidity and transform siloed assets into versatile resources flowing freely between networks. However, before manipulating them, it is crucial to understand the inherent risks of their centralized structure and the technical vulnerabilities they may carry. They are not a one-size-fits-all solution, but a powerful tool to be wielded with discernment.