What Are Wrapped Tokens in Cryptocurrency? A Simple Breakdown

Imagine you have Bitcoin, but you want to use it on Ethereum to earn interest, trade on decentralized exchanges, or borrow money - without selling it. That’s where wrapped tokens come in. They’re not new coins. They’re digital representations of existing cryptocurrencies, locked up on one blockchain and mirrored on another. Think of them like a voucher: you hand over your Bitcoin, get a token that acts like Bitcoin on Ethereum, and when you’re done, you trade it back for your original Bitcoin.

How Wrapped Tokens Work

Here’s how it actually happens:

1. You send your Bitcoin (say, 1 BTC) to a trusted custodian - often a group of companies like BitGo, Kyber, or Ren.
2. That custodian locks your Bitcoin in a secure digital vault.
3. On Ethereum, a smart contract mints 1 WBTC (Wrapped Bitcoin) and sends it to your wallet.
4. Now you have WBTC - it looks and acts like any other ERC-20 token on Ethereum.
5. When you want your Bitcoin back, you burn the WBTC. The smart contract triggers the release of your original BTC from the vault.

This 1:1 backing is critical. Every WBTC should always equal one real Bitcoin. That’s why audits matter. Companies like Chainlink and CertiK check that the locked Bitcoin matches the number of WBTC in circulation. If they don’t match, the whole system breaks.

Why People Use Them

Most wrapped tokens are used in DeFi - decentralized finance. Bitcoin holders who want to earn yield have had zero options until wrapped tokens came along. Now, with WBTC, you can:

• Lend it on Aave and earn 3-5% APY
• Provide liquidity on Uniswap and collect trading fees
• Use it as collateral to borrow USDC or ETH

As of October 2023, WBTC alone had over $10 billion locked in DeFi protocols. That’s more than 78% of all Bitcoin used in DeFi. Without wrapped tokens, Bitcoin would be stuck on its own chain, unable to participate in the booming Ethereum ecosystem.

It’s not just Bitcoin. Wrapped ETH (WETH) lets Ethereum be used on chains that don’t support its native format. Wrapped Litecoin (WLTC), Wrapped Solana (WSOL), and even wrapped fiat like USDC (on 8+ blockchains) follow the same model. In total, wrapped tokens had over $12.7 billion locked in late 2023.

The Downside: Centralization and Risk

Wrapped tokens aren’t perfect. Their biggest flaw? They rely on custodians. Someone has to hold your real Bitcoin. That’s a central point of failure.

Back in November 2022, a bug in the RenBridge protocol trapped $96 million in wrapped tokens for three days. Users couldn’t unwrap. No one could fix it until developers rolled out a patch. That’s not the kind of thing that happens with native assets.

Also, you pay fees. Wrapping or unwrapping typically costs 0.1-0.3%. That might sound small, but on $10,000, it’s $10-30. Plus, transactions can take 15-60 minutes depending on network traffic. And if you pick the wrong token or set slippage too low, your transaction can fail.

Security isn’t guaranteed either. The Wormhole bridge was hacked in 2022, losing $325 million. While that wasn’t a wrapped token issue per se, it shows how fragile cross-chain bridges can be.

Even regulators are watching. The SEC has flagged wrapped tokens as potential securities if the custodian has too much control. The EU’s MiCA rules require 1:1 backing and regular audits - which most major wrapped tokens already do.

Wrapped Tokens vs. Other Cross-Chain Solutions

There are other ways to move assets between chains:

• Atomic swaps: Peer-to-peer trades without intermediaries. Great in theory, but barely used - fewer than 100 daily transactions across all networks.
• Bridges like Wormhole: Allow direct transfers, but have been hacked multiple times.
• Sidechains (like Polygon): Create their own ecosystems. You can’t bring Bitcoin in - you have to mint new tokens.

Wrapped tokens win on simplicity and liquidity. They plug directly into existing DeFi apps. You don’t need to learn new interfaces. Your MetaMask wallet works the same. That’s why WBTC dominates: it’s the most trusted, most liquid wrapped asset on Ethereum.

Who Uses Them and Why

On Reddit’s r/ethfinance, users regularly post about earning 4% APY on their Bitcoin via WBTC - something impossible before. One user made $3,200 in 48 hours by exploiting yield differences between Aave and Compound.

But not everyone is happy. Reviews on Trustpilot show 41% of complaints are about slow customer support. Another 37% say the verification process is confusing for beginners.

Institutional players are jumping in too. Fidelity’s Bitcoin Fund now uses WBTC for Ethereum-based settlements. Circle reports $4.2 billion in wrapped USDC across blockchains in just one month.

Most usage? 68% goes into lending and yield farming. 22% is for trading across chains. Only 10% is used in NFT markets.

What’s Next?

The industry knows the centralization problem needs fixing. The WBTC consortium is moving toward a DAO - a decentralized governance model. By Q2 2024, BitGo’s control over custody will drop from 100% to 35%. Other projects like Chainlink’s CCIP are building trust-minimized bridges that don’t need custodians at all.

Ethereum’s upcoming Cancun-Deneb upgrade will lower wrapping costs by 40-60%. That could make it cheaper and faster to move assets between chains.

But experts don’t think wrapped tokens are going away anytime soon. Vitalik Buterin called them a “necessary evil” in 2022 - and still called them essential in October 2023. He says they’ll keep bridging liquidity for at least 3-5 years while native cross-chain tech catches up.

For now, wrapped tokens are the most practical way to unlock Bitcoin’s potential in DeFi. They’re not perfect. But they work. And until something better comes along, they’ll keep running the show.