The lack of cross-chain interoperability between blockchains is the reason why Bitcoin can’t operate on Ethereum.
Coins that exist on a given blockchain can’t be simply transferred to another.
Wrapped tokens are a way to circumvent this limitation and use non-native assets on a blockchain. The term wrapped represents an original asset that is put in a wrapper, a kind of digital vault that allows the wrapped version to be created on another blockchain.
What is a wrapped token?
A wrapped token natively lives on a blockchain it wasn’t issued initially on. It operates as a bridge between different blockchains. It is simply a tokenized version of another cryptocurrency.
Similar to how a stablecoin is pegged to the value of a fiat currency, a wrapped token is pegged to the value of another cryptocurrency.
Wrapped tokens aim to address the limitations of the lack of cross-chain interoperability between two blockchains. They make it possible to move the information between the two. You can easily trade wrapped tokens like any other asset.
How does it work?
Let’s consider an example of Wrapped Bitcoin (WBTC), an ERC-20 version of Bitcoin that makes faster and cheaper transactions possible. WBTC is 1:1 pegged to the value of BTC. For every WBTC that exists, there is a Bitcoin that a custodian is holding. In other words, by holding WBTC, you effectively hold BTC by proxy. It involves a 2-step process, as follows:
Step 1 – The merchant initiates the minting process by sending BTC to the custodian, an entity holding an equivalent amount of wrapped assets in the reserves.
Step 2 – The custodian then mints BTC on Ethereum and sends the equivalent amount of WBTC (1:1 pegged to the value of BTC) back to the merchant.
Similarly, the merchant can also send WBTC to the custodian and receive the equivalent amount of BTC in return.
By now, you must have understood that wrapped tokens on Ethereum are supposed to comply with ERC-20, a technical standard for issuing tokens on Ethereum.
Another interesting example is Wrapped Ether (WETH).
Since ETH was developed before the ERC-20 standard, it isn’t compliant with it. Many DApps require you to convert/swap Ether with an ERC-20 token. It gave birth to Wrapped Ether (WETH), a wrapped version of Ether compliant with the ERC-20 standard.
In simple words, WETH is a tokenized version of ETH on Ethereum.
The bottom line
Wrapped tokens allow an asset issued by one blockchain to live on another. They increase the liquidity and capital efficiency of centralized and decentralized exchanges. They can also bridge the gap between isolated liquidity on multiple chains and offer significantly faster transaction times and lower fees.
However, wrapped tokens require one to the custodian holding the funds and can’t be used for actual cross-chain transactions. Furthermore, the minting process can also be costly due to high gas fees.