How wrapped tokens create bridges between blockchains

The problem: isolated assets on closed networks

Imagine owning Bitcoin but wanting to exploit DeFi opportunities on Ethereum. Or holding ETH while wishing to access liquidity pools on Solana. Frustrating, isn't it? The current blockchain system creates silos: each network operates in isolation, and your cryptocurrencies remain confined to their original blockchain.

This limitation hinders capital efficiency and forces users to choose between their preferred asset and the DeFi ecosystem that interests them.

The solution: wrapped tokens

A wrapped token is essentially a digital representation of an asset from another blockchain. It maintains a 1:1 parity with the asset it represents and can be exchanged for it at any time.

Wrapped Bitcoin (WBTC) perfectly illustrates this concept. It is a token on Ethereum that represents bitcoin. Each WBTC corresponds to exactly 1 BTC held in reserve. This allows holders to use the value of bitcoin directly on Ethereum, without waiting days to make inter-blockchain transfers or pay exorbitant fees.

How does the wrapper and unwrapper mechanism work?

The process relies on a custodian: a trusted entity that holds the original asset in reserve. This custodian can be a merchant, a decentralized autonomous organization (DAO), a multisignature wallet, or even a smart contract.

Here is how the wrapper-unwrapper cycle executes:

1. Wrapping Phase: A user sends BTC to the custodian. In return, the custodian issues WBTC on Ethereum in an equivalent amount. The user receives their wrapped token.

2. Usage Phase: The user can now trade, lend, or use their WBTC in any Ethereum DeFi protocol.

3. Unwrapping phase: When the user wishes to retrieve their original BTC, they request the custodian to “burn” ( destroy ) their WBTC. The custodian then unlocks the corresponding BTC from their reserves.

The proof that the custodian indeed holds the reserves exists publicly on the blockchain. This is what creates trust in the system.

Which blockchains support wrapped tokens?

Initially focused on Ethereum ( using the ERC-20) standard, wrapped tokens have spread to almost all major blockchains:

• BNB Chain
• Solana
• Avalanche
• And many others

A particular case deserves mention: Wrapped Ether (WETH) on Ethereum. Since ETH is not natively an ERC-20 token, WETH wraps ETH to make it compatible with smart contracts and applications that adhere to this standard. This illustrates that wrapping is not limited to inter-blockchain assets; it can also solve technical compatibility issues.

The concrete benefits

Multiplied Liquidity: An asset can be used across multiple blockchains simultaneously. This enhances capital efficiency, as the same asset generates returns across multiple DeFi ecosystems.

Seamless Interoperability: Wrapped tokens connect networks transparently, enabling swaps, value transfers, and composable operations across blockchains.

Access to New Markets: Users discover DeFi protocols, farming strategies, and staking opportunities on networks they otherwise would not have explored.

Fee Reduction: Depending on the context, wrapped tokens can offer cheaper and faster transactions than direct transfers on the original blockchain.

Risks Not to Be Ignored

Dependence on custodians: Many wrapped tokens rely on trust in third parties. If a custodian is compromised, the reserves can disappear. This recreates a centralized point of control in an ecosystem that is supposed to be decentralized.

Smart Contract Vulnerabilities: The codes that manage wrapping and unwrapping may contain bugs or exploitable vulnerabilities.

Technical Complexity: Handling wrapped tokens requires an understanding of the different blockchains and their specificities.

Fees and slippage: High transaction fees and price slippage during swaps can erode economic profits.

Regulatory uncertainty: The legal framework surrounding wrapped tokens varies by jurisdiction and is constantly evolving.

Where do you use wrapped tokens on a daily basis?

Inter-blockchain Trading: Quickly swap assets between networks without going through a centralized exchange platform.

Liquidity Provision: Deposit wrapped assets into liquidity pools on various blockchains and earn trading fees.

DeFi Collateral: Use wrapped tokens as collateral to borrow other assets or access lending protocols.

Scalability of NFTs: NFTs can also be wrapped and transferred between blockchains, opening up new possibilities for creators and collectors.

The Future: A Fragmented Liquidity Reconnecting

Wrapped tokens are much more than just a technical trick. They symbolize the evolution towards a more interconnected and efficient blockchain ecosystem. They allow liquidity to flow freely between networks, creating a global market where capital is deployed where it generates the highest returns.

However, their growth depends on resolving trust and security issues. As new decentralized bridge solutions emerge and wrapping standards evolve, one can expect even deeper integration between blockchains.

For users, the message is simple: understanding how wrapped tokens work and the associated risks is essential before using them on a large scale.