Wrapping in crypto is when you represent a token or coin on one blockchain with a token on a different blockchain. For example, you might have wBTC on the Ethereum blockchain representing a real BTC on the Bitcoin blockchain. In this post, I will walk you through what wrapping crypto is and how it works in simple language.
How does wrapping work?
A key challenge with crypto is that blockchains do not speak to one another.
For example, you can’t check transactions on the Bitcoin Network by checking the Polkadot Network or the Ethereum Network.
But as competitors to Bitcoin developed they were missing a key component.
They didn’t have Bitcoin which was the mainstream currency that crypto traders wanted.
How do you get digital assets to move from one chain to another?
The answer is you can’t.
But if your blockchain can print crypto tokens then it can do something extraordinary.
It can create a token and name it wrapped Bitcoin, wBTC.
Fine, so now you have the original asset which is BTC on the Bitcoin Network, and a synthetic asset to represent it on another.
For example, wBTC on say Ethereum.
How do you ensure that one wBTC is worth one BTC?
The secret here is that you lock one BTC on the Bitcoin network while you use the wBTC token.
So you know that every wBTC on Ethereum represents a locked BTC on the Bitcoin Network.
The locked Bitcoins on the Bitcoin Network will only be released if you burn the same amount wBTC tokens on the Ethereum Network.
You can think of the locked BTC as being all wrapped up in a vault. Hence the term.
Infographic explaining crypto wrapping
Why is wrapping used in crypto?
Each blockchain has its own ecosystem of DeFi platforms built on top of it. The largest of these is the Ethereum ecosystem.
Ethereum does two cool things and almost every other blockchain since then has copied it.
- It allows you to issue tokens using the ERC-20 standard. Anyone can print ERC-20 tokens which is why you have so many random tokens some of which just try to ride on the popularity of a meme e.g. dogecoin.
- It has smart contracts. This means developers can automate protocols (See What Is a Protocol in Crypto:) and apps that they build on top of the Ethereum blockchain. For example, this is how Uniswap, a decentralized exchange emerged and how Compound, a lending and borrowing platform, was created.
Those of you who want to understand crypto and the DeFi space better can study my Crypto 101 tutorials.
They are free and don’t require registration.
Now imagine you want to participate in DeFi by lending your Bitcoin.
The Bitcoin Network doesn’t have any apps built on top of it.
How are you going to lend it?
Or say you want to buy Bitcoin on a decentralized exchange that is built on Ethereum like SushiSwap.
For that to happen you need Bitcoin on the Ethereum Network. But Bitcoin is on the Bitcoin Network not the Ethereum Network.
And this is how wrapping first emerged.
Another reason to use wBTC is that it is much faster than transacting in BTC.
Nowadays you can find wrapped versions of almost any token or coin on other blockchains.
An interesting side fact is that Ether is often wrapped on Ethereum.
Why does ETH get wrapped on Ethereum?
ETH is the native token of the Ethereum Network.
It is the coin that the blockchain issues to reward validators for verifying and adding new blocks of transactions to the Ethereum blockchain.
However, ETH itself is not an ERC-20 token.
So if you want to use ETH on any of the DeFi applications built on top of Ethereum you need to use the wrapped version of Ether called wETH.
For example, when you trade ETH for DAI on Uniswap you are only able to trade wETH.
Let’s take a close look at how wrapped coins are issued.
How are wrapped coins created?
For wrapped coins to be created you need a main entity who will be the custodian.
Since wBTC is the largest wrapped asset let me walk you through how it gets wrapped on Ethereum
The organization that created wETH was created by Kyber Network, Ren, and BitGo and is called WBTC DAO.
What does minted mean in crypto
DAO stands for Decentralized Autonomous Organization.
To understand how the WBTC DAO issues wBTC you need to understand the 4 parties that are involved in the process.
WBTC roles
- Custodian. This is a central entity whose job it is to lock up BTC in a digital vault and issue wBTC. There is only one custodian at the time of writing and its name is BitGo. This is a company based out of Palo Alto in the US, and its main service is taking custody of crypto assets and storing them safely. They can show on-chain proof of reserves to anyone who wants to cross-check that they have the same amount of BTC as wBTC
- WBTC DAO. DAO members control who does what through a multi-signature contract. For example, if all or a majority of DAO members sign they can choose to have a different custodian.
- Merchants, exchanges, and wallets can initiate the minting of new wBTC and the burning of wrapped tokens. The process is done by the custodian but think of the merchants as the distributors. Merchants will also take care of all the KYC (Know Your Customer) and AML (Anti-Money Laundering) processes. Both merchants and exchanges will charge transaction fees for their service in addition to the network fees you will need to pay.
- Users: Users like yourself. When you want to issue wBTC you go to a merchant or exchange.
At the time of writing, there are 163,000 wrapped BTC worth $4.5Bn in total.
This provides an immense amount of liquidity to decentralized exchanges.
But there is a big problemo with wrapping BTC
Risks of wrapping in crypto
The biggest concern is counterparty risk.
Wrapped assets were created to help decentralized apps gain more momentum and liquidity.
But what is the point of a decentralized ecosystem of apps if they rely to a large extent on a for-profit company?
BitGo is a single point of failure. Should anything go wrong the whole market collapses.
This is why hardcore bitcoin holders prefer BTC in its original form and look down upon all other blockchains.
Side note: There is a blockchain that has found a way to get around the wrapping issue and allows users to trade tokens across chains directly. For more on this check out What is Thorchain Crypto?
The counterargument here is that
- Anyone can check BitGo’s reserves at any time
- Yes, BitGo issues wBTC and stores BTC but the DAO members are there to keep a check on BitGo.
- Smart contracts govern the deposit and minting of wrapped tokens based on the deposited underlying assets. They also ensure the transparent and auditable custody of the underlying assets through cryptographic proofs.
So far the market has voted in favour of this process.
In fact, this is how one of the main components of the cryptocurrency space works.
Crypto bridges
A bridge in crypto allows you to port your crypto from one blockchain to another.
What happens in practice is that your original cryptocurrency gets locked in a smart contract on the original blockchain while a wrapped crypto token is minted on the other.
The largest bridge is Wormhole.
Wormhole supports multiple blockchains including Solana, Ethereum, Polygon, Cosmos, and Binance Smart Chain.
One of the biggest challenges with bridges is that they keep getting hacked.
But bridges are definitely the next evolution of blockchain technology.
FAQs
What is the point of wrapped ethereum?
Ethereum (ETH) is not an ERC-20 token. This means that if you have built an app on top of Ethereum that is ERC-20 compatible your crypto users won't be able to use ETH on it. For example imagine not being able to trade ETH for USDT on Uniswap. However you can trade wETH for USDT instead. And since wETH is pegged to ETH all is good.
What are the risks of wrapped tokens?
The main risk is that the trusted third party that is responsible for storing the original token securely gets hacked or absconds with the funds.
Why buy wrapped crypto?
Wrapped crypto allows you to use a familiar token of your choice in a blockchain that is not compatible. For example say you want to join a DAI liquidity pool on Trader Joe. But Trader Joe is built on Avalanche and DAI is an ERC-20 token issued on Ethereum. In this case you would need to use a wrapped version of DAI on Trader Joe. Alternatively you would need to use a version of Trader Joe built on Ethereum if that exists.
Does wrapped ETH increase in value?
Wrapped ETH is pegged 1:1 to the value of ETH. It does exactly whatever ETH does provided the peg holds.
Is wrapped Bitcoin worth it?
If you want to use DeFi protocols then wrapped Bitcoin is the only option. You do need to be aware though that wBTC is not BTC and there is a risk to holding wBTC. As long as you trust the custodian, BitGo, who backs wBTC with BTC you are good to go.
Is wrapping crypto taxable?
In theory yes since you are swapping one token for another. At the time of the swap you should declare any capital gains on the sale if your BTC.
Who owns wrapped Bitcoin?
The merchant or exchange with whom you traded wBTC for BTC is the owner of the wrapped crypto. The original BTC is stored safely by BitGo but there are more than 10 WBTC DAO members who own the multi-sig who oversee the process.
What is the most popular wrapped token?
The most popular is WETH ($5.5Bn) followed by WBTC (4.7Bn). Everything else pales in comparison.
More articles from Elemental Crypto’s Basics series
- What is the difference between bitcoin and crypto?
- What does it mean to stake Ethereum?
- What is a crypto address?
- Why is cryptocurrency worth anything?
- What is slashing in crypto?
- What does a physical Bitcoin look like?
- What is a crypto faucet?
- How does earning interest on crypto work?
- How does crypto lending work?
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