What are wrapped tokens?

Wrapped tokens make it possible to use cryptocurrencies from one blockchain on a different blockchain. Because blockchains are separate systems, they can’t easily communicate with each other. It’s sort of like how different governments require different currencies: Just like you can’t spend your euros at a store in the US, you can’t use your bitcoin on the Ethereum blockchain.

Wrapped tokens solve for this incompatibility. Wrapping a coin allows it to be used on a non-native blockchain. Wrapping a token is essentially swapping one token for another token in an equal amount via a smart contract, or code on the blockchain that can store and send funds. Think of it like exchanging a dollar bill for four quarters. While they both represent the same value, quarters are compatible with a pinball machine, whereas the dollar bill isn’t.

You can buy wrapped tokens directly, or a merchant can convert your existing cryptocurrency into a wrapped token. The merchant sends your crypto to a custodian, who locks up your coin in a digital vault. Once the coin has been locked away, the custodian creates a wrapped token which represents your original coin, a process known as minting.

For example, if you wanted to use bitcoin on the Ethereum blockchain, your custodian would lock 1 BTC in a digital vault and mint 1 WBTC (a wrapped bitcoin token) on the Ethereum blockchain. You could then use your 1 WBTC—which represents a bitcoin locked away in a digital vault—on the Ethereum blockchain.

To exchange a wrapped token for its original unwrapped cryptocurrency, it must be destroyed. This process is called burning, where the custodian unlocks the original cryptocurrency and the wrapped token is destroyed.

• Interoperability: Wrapped tokens allow cryptocurrencies to be transacted on non-native blockchains, which might be faster or less expensive than their native blockchains. They also provide access to specific applications.
• Liquidity: Wrapped tokens increase capital efficiency by allowing tokens to be used in different ways on non-native blockchains, as opposed to remaining locked on their native blockchain.

• Fees: There are possible financial benefits to wrapped tokens, especially if wrapping a token allows you to use it on a blockchain with lower transaction fees. However, the minting process itself may trigger fees.
• Inequivalent value: While the wrapped token should theoretically have the same value as the original cryptocurrency it represents, in times of high volatility the value of a wrapped token could potentially be lower than the original coin.
• Contagion: Contagion is the spread of a financial crisis from one cryptocurrency to the other. By increasing interdependence among currencies, wrapped tokens increase the risk of contagion.

Stablecoins are conceptually similar to wrapped tokens, but their value is generally tied to a more traditional type of asset, like the US dollar or gold, whereas the value of wrapped tokens are tied to cryptocurrency.