What Is a Wrapped Token and How Does It Work?

Digital assets have expanded financial markets, creating a need for different blockchain networks to communicate. This challenge led to solutions allowing assets from one blockchain to function within another, fostering a more connected digital ecosystem. These innovations are reshaping how digital value moves, enabling broader utility and accessibility across platforms.

What Wrapped Tokens Are

A wrapped token is a digital asset representing the value of another cryptocurrency or asset, existing on a blockchain different from its original network. This tokenized version maintains a 1:1 value peg with its underlying asset. The term “wrapped” signifies that the original asset is securely held, allowing its value to be mirrored and utilized elsewhere.

The primary purpose of wrapped tokens is to enable interoperability between disparate blockchain networks. Blockchains like Bitcoin and Ethereum operate on distinct protocols, preventing direct interaction between their native assets. For instance, Bitcoin cannot natively function on the Ethereum blockchain. Wrapped tokens bridge this gap, allowing an asset like Bitcoin to be represented and used within the Ethereum ecosystem, unlocking new functionalities.

This concept is comparable to stablecoins, which maintain a peg to a fiat currency. Wrapped tokens are usually pegged to another cryptocurrency. The underlying asset is locked away, and an equivalent amount of the wrapped token is minted on the target blockchain. This ensures the supply of wrapped tokens is always backed by an equal reserve of the original asset.

Wrapped tokens expand the utility of cryptocurrencies by allowing them to participate in activities on non-native blockchains. This cross-chain compatibility enhances liquidity and expands the range of services available to asset holders. A Bitcoin holder, for example, can access decentralized finance (DeFi) applications on Ethereum without needing to sell their Bitcoin.

How Wrapped Tokens Work

The process of creating a wrapped token, known as “minting,” involves securing the original asset and issuing its tokenized representation on another blockchain. A user deposits their native asset, such as Bitcoin, with a designated entity. This entity, often a custodian or a smart contract, then locks the original asset. Once secured, an equivalent number of wrapped tokens are created on the desired blockchain, typically following a standard like Ethereum’s ERC-20.

Conversely, to convert a wrapped token back to its original asset, a process called “unwrapping” or “burning” occurs. The user sends the wrapped token back to the custodian or smart contract. The wrapped token is then destroyed, and the corresponding original asset held in reserve is released back to the user. This minting and burning mechanism ensures the total supply of wrapped tokens always matches the amount of the underlying asset held in reserve, maintaining the 1:1 peg.

The entity holding the original assets can be a centralized custodian, such as a financial institution, or a decentralized mechanism like a smart contract or a network of validators. Centralized models rely on a trusted third party, while decentralized models use automated smart contracts or a distributed network to manage asset locking and token issuance. Transparency is often provided through on-chain proof of reserves, allowing verification that wrapped tokens are fully backed.

From a tax perspective, the Internal Revenue Service (IRS) treats virtual currency as property for federal tax purposes. Transactions involving wrapped tokens, such as their acquisition, disposition, or exchange, may result in taxable gains or losses. Taxpayers are required to recognize these gains or losses on their federal income tax returns, adhering to the same principles that apply to other property transactions.

Common Wrapped Tokens and Their Applications

Wrapped tokens are widely used to enable cross-chain functionality. One prominent example is Wrapped Bitcoin (WBTC), which allows Bitcoin holders to utilize their BTC within the Ethereum ecosystem. As an ERC-20 token, WBTC integrates Bitcoin’s value into Ethereum’s network of decentralized applications (dApps), including decentralized exchanges (DEXs) and lending platforms.

Similarly, Wrapped Ethereum (WETH) serves a comparable purpose for Ether (ETH). While ETH is native to the Ethereum blockchain, it was developed before the ERC-20 token standard. To interact seamlessly with ERC-20 compatible dApps and protocols, Ether often needs to be “wrapped” into WETH, making it fully compliant. This allows ETH to be used more flexibly in various DeFi applications that specifically require ERC-20 tokens.

Beyond these leading examples, other wrapped tokens exist to bring assets from various blockchains into different ecosystems. These include:
Wrapped Binance Coin (WBNB) for the Binance Smart Chain
Wrapped Litecoin (WLTC)
Wrapped Matic (WMATIC)

Each of these wrapped tokens extends the utility of its native asset, allowing it to participate in a broader range of decentralized financial activities on compatible blockchains. The practical applications of wrapped tokens center on enhancing liquidity and enabling participation in Decentralized Finance (DeFi). By converting assets into wrapped versions, users can lend their holdings to earn interest, borrow other assets against their wrapped collateral, or provide liquidity to decentralized exchanges. This allows asset holders to generate yield or engage in trading strategies without divesting from their original cryptocurrency. Wrapped tokens facilitate seamless cross-chain transfers, promoting a more interconnected digital economy.