What Are Wrapped Crypto Tokens and How Do They Work?

What are wrapped crypto tokens?

Wrapped crypto tokens (also called wrapped coins) are tokens that, on a blockchain, represent the value of, or a claim on, an underlying crypto asset that originally exists on a different blockchain or in a different technical form. They make it possible to use that crypto in apps that can’t directly handle the original coin.

For example, Bitcoin is the native coin of the Bitcoin blockchain. A wrapped version of Bitcoin can exist as a token on Ethereum, so it can be used in Ethereum apps. That wrapped token is not the same thing as the original BTC. It’s a separate representation that follows Ethereum’s rules.

In a fully backed setup, one wrapped token matches one unit of the underlying crypto. The original crypto is then locked in a smart contract or managed by a custodian. A smart contract is a program on a blockchain that automatically carries out pre-set actions.

WETH is a well-known example. WETH is an ERC-20 token that represents native ETH. ERC-20 is a technical standard for tokens on Ethereum. That standard ensures crypto Wallets, dapps, and decentralized exchanges can work with a token in a consistent way.

The word wrapped by itself doesn’t mean a token is always fully backed or that it can be redeemed right away. The exact rules differ per token and per bridge. A bridge is a system that helps represent value across blockchains. That’s why how a wrapped token is stored, issued, and redeemed are important differences between wrapped tokens.

Key Takeaways

• Wrapped crypto tokens represent crypto on another blockchain or under another technical standard.
• A wrapped token is a separate representation, not the same as the original native coin.
• In a fully backed setup, one wrapped token usually corresponds to one unit of the underlying crypto.
• WETH makes native ETH usable as an ERC-20 token inside Ethereum apps.
• The word wrapped alone doesn’t guarantee backing, redeemability, or low risk.

How do wrapped crypto tokens work?

Wrapped crypto tokens usually work by locking up the original crypto and then issuing a matching token on a destination blockchain. This is often called lock-and-mint: lock means locking it up, and mint means creating new tokens.

With WETH, this happens completely on Ethereum through a smart contract. A user deposits ETH into the WETH contract. Then the contract issues the same number of WETH tokens. If someone later redeems WETH, they have the WETH tokens burned and receive the same amount of ETH from the contract.

For crypto that can’t be locked on the source chain using compatible smart contracts, a custodian may be needed. For BTC to Ethereum, for example, a custodian holds BTC while a wrapped BTC token is issued on Ethereum. With WBTC, only approved, identity-verified institutions are allowed to mint and burn WBTC.

Not every bridge uses lock-and-mint. Some systems use burn-and-mint. In that case, tokens on one blockchain are destroyed, and new tokens are issued on the other blockchain. Atomic swaps can also be used. In these, parties swap crypto under fixed technical conditions.

The crypto itself usually doesn’t literally travel from one blockchain to another. The value gets a new representation on the destination chain. The goal is for the wrapped token to keep the same value as the underlying crypto, but that’s not a guarantee for the market price. Lower trust, limited liquidity, or issues with redeeming can cause the price to drift.

Example: Someone locks 1 ETH in the WETH contract and receives 1 WETH. That WETH can then be used in a dApp that only handles ERC-20 tokens. Meanwhile, the original ETH stays locked in the contract.

Why are crypto tokens wrapped?

Crypto tokens are wrapped to make crypto usable in apps and networks that don’t directly support the original coin. This lets BTC, for example, be used as a token on Ethereum in dapps that handle Ethereum tokens.

WETH mainly solves a compatibility issue. Native ETH existed before the ERC-20 standard was introduced and doesn’t follow that standard. A lot of dapps expect a token with the same fixed functions as other ERC-20 tokens. WETH gives ETH that uniform format.

The ERC-20 standard describes, among other things, how tokens are sent, how a balance is checked, and how a user can give a smart contract permission to use tokens. Because of that, crypto Wallets and decentralized exchanges don’t have to build a totally new technical integration for every single token.

Wrapped tokens and bridges can also provide access to dapps and liquidity on other networks or Layer 2 networks. Liquidity is the amount of crypto available that users can trade with or use for other financial actions. Lower transaction costs can also be a reason to use a different network.

Wrapping doesn’t change the original BTC or ETH. It creates a separate token version that can function under the technical rules of the destination blockchain.

What are some examples of wrapped crypto tokens?

WETH, WBTC, and cbBTC are examples of wrapped crypto tokens, but their setups differ.

• WETH (Wrapped Ether): WETH is an ERC-20 token that represents native ETH. ETH is deposited into the WETH smart contract when WETH is created. When unwrapping, WETH tokens are burned and the ETH is released again.
• WBTC (Wrapped Bitcoin): WBTC is a multi-chain token setup tied to BTC held in custody. Approved, identity-verified institutions can mint and burn WBTC within this model.
• cbBTC (Coinbase Wrapped Bitcoin): cbBTC is a BTC representation offered by Coinbase that’s available on Base, Ethereum, Solana, and Arbitrum.

A token’s ticker isn’t enough to know what you’re getting. Different WETH variants can exist, and tokens with almost the same name can have a different contract, a different issuer, or different security features.

That’s why you should always check which blockchain a token is on and whether the contract address matches the token you want to use. A crypto Wallet can show multiple tokens with the same ticker, even though those tokens aren’t technically the same.

What role do wrapped tokens play in DeFi?

Wrapped tokens play a major role in Decentralized Finance (DeFi) because they can make crypto assets usable on blockchains where those assets don’t originally exist. A well-known example is Wrapped Bitcoin (WBTC), which lets Bitcoin’s value be used inside apps on Ethereum and other compatible networks.

A wrapped token usually represents another crypto asset at a 1:1 ratio. For example, 1 WBTC is meant to represent 1 bitcoin. The original bitcoin continues to exist outside Ethereum, while WBTC can be used as a token inside the Ethereum ecosystem.

This lets users use assets in DeFi protocols without those assets needing to be native to the same blockchain. Wrapped tokens are used for things like:

• Decentralized exchanges: wrapped tokens can be traded through liquidity pools and other trading mechanisms inside a DEX.
• Lending and borrowing: some DeFi protocols accept wrapped tokens as collateral for loans or make it possible to lend them out.
• Liquidity providing: users can add wrapped tokens to liquidity pools and, under certain conditions, receive rewards or trading fees.
• Yield strategies: wrapped tokens can be part of strategies where users combine different DeFi protocols in an attempt to earn yield.
• Use in smart contracts: because a wrapped asset can follow the same token standard as other tokens on the network, it can be used more easily by smart contracts and DeFi apps.

So the biggest benefit is interoperability. Bitcoin and Ethereum, for example, are separate blockchains with different technical rules. That means Bitcoin can’t be used directly by an Ethereum smart contract. By representing bitcoin in a compatible token form, its value can be used inside Ethereum-based DeFi.

But wrapped tokens also bring extra risks. The user isn’t only relying on the original blockchain, but also on the mechanism used to issue and back the wrapped token. With some wrapped tokens, a central custodian manages the underlying assets. Other solutions use smart contracts, bridges, or a combination of multiple parties.

If the backing isn’t managed correctly, a bridge gets hacked, or a smart contract has a vulnerability, the wrapped token can lose its peg to the underlying asset. That’s why a wrapped token isn’t the same as the original crypto asset, even if both are meant to represent the same value.

In DeFi, wrapped tokens mostly act like a technical bridge between assets and ecosystems. They make it possible to bring liquidity and value from one blockchain into apps on another blockchain, but they also add an extra technical dependency and sometimes a dependency on a counterparty.

How are wrapped crypto tokens unwrapped?

Wrapped crypto tokens are unwrapped by reversing the issuance process. This is also called unwrapping or redemption: the wrapped token disappears and the underlying crypto is released or paid out according to the system’s rules.

The practical path differs per token.

1. Check what type of wrapped token you have

   Look at which blockchain the token is on and which contract it’s tied to. This matters because WETH, WBTC, and other wrapped tokens can have different redemption processes.

2. Use the matching redemption route

   With WETH, a holder can convert WETH into the same amount of ETH through the WETH smart contract. The contract burns the WETH and releases the ETH.

   With WBTC, converting to native BTC goes through authorized merchants and custodians. In this model, a merchant has WBTC burned, after which the custodian releases BTC to the merchant’s Bitcoin address after confirmations. So the route for an individual holder depends on the service provider they use.

3. Keep network fees in mind

   For on-chain wrapping, unwrapping, and bridge transactions, you usually need network fees. On Ethereum, these gas fees are paid in native ETH. So you can’t use WETH to pay the gas fees for an Ethereum transaction.

4. Check whether your destination is supported

   Some platforms can automatically convert received wrapped tokens inside an appropriate account into the underlying crypto. That’s a platform process and doesn’t mean every external address can receive native BTC. So only send a token to a network and address that support that token.

What are the risks of wrapped crypto tokens?

Wrapped crypto tokens often add extra risks on top of the risk of the underlying crypto. The token can depend on a custodian, bridge, smart contract, validator group, destination blockchain, and available liquidity.

A bridge, for example, can add an extra layer between two blockchains. If that layer doesn’t work properly or gets attacked, the wrapped token can run into problems with issuance, transfers, or redeemability. With trusted bridges, operators or validators can theoretically block transfers. If they collude maliciously, user funds can be at risk.

Bugs in smart contracts are also a risk. A mistake in the code can lead to lost crypto or incorrect token issuance. On top of that, user error can have serious consequences. If you send tokens to the wrong network, the wrong contract, or an unsupported address, you can lose them. ERC-20 tokens sent to a contract that can’t process them can get stuck permanently.

A proof-of-reserves overview or on-chain dashboard can give insight into reserve addresses and the number of tokens issued. But it doesn’t remove all risks. For example, it doesn’t tell you everything about control over private keys, legal restrictions, operational errors, or the practical ability to redeem tokens.

How does counterparty risk happen with wrapped crypto tokens?

Counterparty risk happens when the value or redeemability of a wrapped token depends on people or organizations outside the blockchains involved. Think of a custodian, issuer, merchant, multisig signers, or external validators.

A custodian is a party that manages crypto for someone else. With a custodial wrapped BTC token, that party has to actually manage the underlying BTC and release it according to the redemption rules. If they don’t, the wrapped token can lose redeemability. That can also put pressure on its peg to BTC’s value.

With a trusted bridge, users trust the operator or validator group to store crypto correctly and execute bridge instructions properly. A validator group is the set of parties that confirms transactions or events in that kind of system. These parties can theoretically block transfers or, if they collude, put funds at risk.

WETH is built differently. The underlying ETH is locked in the WETH smart contract, and the mint and burn steps happen on-chain. That reduces the classic risk of a central custodian, but it doesn’t make WETH risk-free. Security still depends on the smart contract and the Ethereum protocol.

What role do smart contracts play with wrapped crypto tokens?

Smart contracts can automate the issuance, burning, transfer, and redemption of wrapped crypto tokens. They execute the pre-set rules as soon as a user makes a valid on-chain transaction.

With WETH, the smart contract receives ETH and creates the same amount of WETH. During unwrapping, the contract receives WETH, burns those tokens, and releases ETH. This means no separate custodian is needed for those specific steps.

With bridges, smart contracts on both the source and destination blockchain can handle the steps around lock-and-mint or burn-and-mint. The contracts must correctly determine when new tokens can be issued or when crypto can be released. With some bridges, a custodian or validator group is still needed alongside the contract code to confirm events outside the contract.

Smart contract code is an additional attack surface. One bug in a bridge contract can expose crypto to hacks. Also, the wrapped token’s smart contract, the bridge contract, and the contracts of external dapps are separate components with their own risks and possible admin rights.

Finally, a wrong interaction can lead to loss, even without a hack. ERC-20 doesn’t require the receiving contract to confirm receipt. If a user sends tokens to a contract address that can’t process them, the tokens can stay stuck.

Final thoughts

Wrapped crypto tokens make it possible to use crypto on another blockchain or within a technical standard that fits better with dapps, crypto Wallets, and decentralized exchanges. WETH, for example, shows how native ETH can function as an ERC-20 token, while wrapped BTC tokens can make BTC usable on other networks.

How it works depends on the setup. Some tokens, like WETH, use a smart contract on the same blockchain. Other models use a bridge, custodian, or authorized merchant to manage the underlying crypto and issue the wrapped tokens.

That extra layer creates more ways to use crypto, but it also introduces new risks. So always check the blockchain, the contract address, the redemption process, and the role of any external parties before you use wrapped tokens.