Wrapped tokens like WETH, WBTC and WSOL are key to decentralized finance (DeFi), as they make tokens universally compatible with different apps and networks. This makes it easy to develop apps since they only need to deal with a limited set of standards, and means users can use their digital assets across multiple contexts and even different blockchains. 

Not all tokens follow the same standards. Wrapping a token is the process of changing a token’s data into a format that fits a widely-used standard, most commonly ERC-20. This generally happens by locking up the native version of the token via a smart contract, and issuing the wrapped token in exchange. The wrapped asset follows the same rules as the majority of other tokens, allowing for broad compatibility with apps and even other networks. Let’s dive into how wrapped tokens work, how to wrap and unwrap them, and common examples you’ll encounter in web3.

The basics of wrapped tokens

Wrapped tokens are digital assets that represent another cryptocurrency. The original may be on a different blockchain, or in the same ecosystem but using a non-standard data structure. Because wrapped representations follow a widely-accepted standard, wrapped assets can be used in ways that would otherwise need to be purpose-built for the original asset. This helps to accelerate development and makes it easier for users to take part in DeFi.

How wrapping crypto works

To wrap a cryptocurrency, you typically deposit the token you want to wrap with a custodian or a smart contract. This locks the original asset in reserve and issues an equivalent amount of the wrapped token on the target blockchain, so the wrapped token is always fully backed by the original asset. At any point, the wrapped asset can be returned to the smart contract or custodian to receive the equivalent of the original asset, ensuring that wrapped tokens maintain the same value as the original.

The process for wrapped tokens using custodians or automated smart contracts is:

1. Deposit assets in custody: Native assets are locked in a secure vault or contract.
2. Minting wrapped tokens: An equivalent amount of wrapped tokens is issued on the target blockchain.
3. Unwrapping tokens: When the wrapped token is returned to the smart contract or custodian, the original asset is released and the wrapped token is burned.

Cross-ecosystem use cases: WBTC enables Bitcoin to operate on Ethereum by converting it into an ERC-20 token. This allows Bitcoin holders to participate in lending, borrowing, and yield farming on Ethereum. 

To mint Wrapped Bitcoin (WBTC), for example, Bitcoin is sent over the Bitcoin network to a custodian who stores it in a digital vault. Then, an equivalent amount of WBTC is issued to the depositor on the Ethereum network as an ERC-20 token. 

Intra-ecosystem use cases: Ethereum’s native gas token, Ether, doesn’t conform to the ERC-20 token standard, which most DeFi protocols are built to support. Wrapped ETH as an ERC-20 token is more widely compatible.

To wrap ETH into WETH, you send your Ether (ETH) to a smart contract, which mints an equivalent amount of WETH. Native ETH does not follow ERC-20 standards, so by wrapping it you gain a token that is more broadly compatible with decentralized applications, and developers don’t have to work out ways to handle native ETH as an exceptional case.

Wrapped tokens across networks

Blockchain networks are independent and each follows their own protocols and standards, limiting where your assets can be used. Wrapped tokens provide an elegant way to represent tokens from one network on another, so you can move liquidity around. 

If you were to have a lot of capital in Solana (SOL), for example, you can simply use an exchange smart contract to wrap SOL on Solana and mint WSOL on Ethereum, which can then be traded on multiple EVM networks using Matcha and or various other apps.

Common wrapped tokens

Below are some of the more prominent wrapped tokens that you may encounter:

Wrapped Ether (WETH): Ethereum's native currency, Ether (ETH) is used to pay for gas used  by transactions and smart contract interactions, but ETH isn't ERC-20 compliant as it preceded the standard by several years. Wrapping ETH into WETH therefore makes it compatible with ERC-20 standards, so it can be more widely used by DeFi protocols, though WETH cannot be used as gas for transactions or smart contracts.

Wrapped Bitcoin (WBTC): Bitcoin is not compatible with standard smart contracts. limiting its use in DeFi. To represent Bitcoin on the Ethereum network and open up potential use cases for the largest crypto asset, Bitcoin can be deposited with a custodian, in this case BitGo, who will in exchange issue WBTC, an ERC-20 token on Ethereum. 

Wrapped Solana (WSOL): Solana's native token, SOL, can be wrapped using a compatible exchange or the Wormhole bridge to become the ERC-20 token WSOL on the Ethereum network, enabling its use across Ethereum's ecosystem. WSOL cannot be used to pay for transactions. 

Wrapped BNB (WBNB): Binance Coin (BNB) is another native token used for transaction fees and other perks. It can be wrapped as WBNB to make it compatible with applications and usable in other ecosystems, though as with other wrapped native assets, it can not be used to pay for fees until unwrapped.

Wrapped Staked Ether (wstETH): This example differs significantly from the rest, as it is a wrapped staking derivative with a more niche use-case. Lido's stETH is a liquid staking token representing a staked Ether position. It accrues staking rewards over time through token rebasing (the amount of tokens you hold increases automatically). Wrapping stETH into wstETH gives you the option of holding a non-rebasing version where the balance remains constant but exchange rate changes to reflect staking rewards, a format that is more widely supported by DeFi applications.

The benefits of wrapped tokens

Wrapped assets are useful for the reasons outlined above, but the reasons why an asset needs to be wrapped can differ widely. The original use case was that ETH as a native asset used to pay for transactions was not compatible with the ERC-20 token standard. However, for WBTC, the main usecase is cross-chain compatibility, while liquid staking tokens might have a wrapped version that helps avoid the need to manage rebasing. 

In each case, a key motivation is that developers want to be able to standardize how tokens are handled, so being able to wrap a token helps avoid the need to handle these edge cases. It does come with drawbacks, however, as wrapped tokens often lack the utility of the native asset, such as paying for transactions fees, governance voting, and so on. 

In general, there are three benefits to consider:

Interoperability: Wrapped tokens bridge the gap between isolated blockchains, enabling assets to interact across multiple ecosystems. For example, WSOL and WBTC enable users with capital on Solana or Bitcoin to participate in Ethereum-based DeFi.

Liquidity: By wrapping assets, idle or isolated funds can be brought into new ecosystems and be put to work through liquidity provision across different blockchains, increasing market depth and capital efficiency.

DeFi participation: Users can leverage their assets in various DeFi protocols and retain a constant equivalent value, without needing to exchange them for another asset which may be subject to different market forces. That means you can access financial mechanisms such as lending, borrowing, and yield farming, without altering your original portfolio and regardless of the asset's native blockchain. It also simplifies app development.

Risks of wrapped tokens

Custody risk: Custodians managing reserves may pose a single point of failure. Examples like BitGo’s custody reorganization have highlighted the importance of transparency in managing asset reserves.

Smart contract vulnerabilities: Smart contracts used to wrap and unwrap tokens may be exploited, as seen in past attacks on DeFi protocols where flaws in minting or redemption mechanisms were abused. This can cause the wrapped asset to lose its peg to the original asset and decrease in value, or prevent it from being unwrapped entirely.

Utility issues: As mentioned above, wrapped tokens are often limited in how they can be used. Governance tokens, native gas tokens, and other assets with specific utility will generally not work in their wrapped form and must first be unwrapped to their native form.

Liquidity challenges: During extreme market events, redemption bottlenecks can create temporary liquidity issues for wrapped tokens, making it difficult to unwrap or affect the 1:1 redemption ratio.

Imitation assets: Not all wrapped tokens that appear to represent other assets are legitimate. Imitation tokens, unlike wrapped tokens, may lack backing and not be redeemable for the expected asset, instead existing to scam users.

Looking ahead at the future of wrapped tokens

Wrapped tokens are pivotal in DeFi, solving compatibility issues and bridging value between networks. For this reason, wrapped tokens are likely to exist in many forms for a long time. In some areas, however, there are innovations which may reduce the need for wrapping:

• Trustless bridges: Several projects are working on enabling native cross-chain communication through native multi-chain assets and protocols that can abstract away the need for wrapping.
• Non-rebasing LSDs: Liquid staking derivatives come in many forms, and in many cases platforms will give users a choice of rebasing or non-rebasing tokens, rather than implementing a wrapping mechanism.
• Expanded support for native assets: While supporting native assets increases development effort, it can be worth it in the case of high-market-cap tokens such as ETH, BTC and SOL, where native support could increase users for the protocol or app. 

Ultimately, wrapping tokens is a means to enhance compatibility and maintain momentum as the space develops. Some form of data transformation will always be needed as tokens continue to become more complex and serve more niche use cases. Next time you need to unwrap an EVM-based asset, you can do it directly on Matcha.