What Are Wrapped Assets?

Bitcoin is the largest cryptocurrency by market capitalisation and the most widely held digital asset in the world. But Bitcoin has a fundamental limitation that prevents it from participating directly in the decentralised finance ecosystem that has been built on Ethereum and other smart contract platforms: Bitcoin lives on its own blockchain, and that blockchain does not support the smart contracts that DeFi protocols run on.

Wrapped assets solve this problem. A wrapped asset is a token that represents another asset on a different blockchain, backed by the original asset held in custody or managed by a smart contract, and designed to maintain a 1:1 peg with the underlying asset’s value. Wrapped Bitcoin on Ethereum allows Bitcoin holders to deploy their Bitcoin value in Ethereum-based DeFi protocols without selling their Bitcoin exposure.

Understanding what wrapped assets are, how different wrapping mechanisms work, what the specific risks of each approach are, and how wrapped assets fit into the broader DeFi ecosystem is increasingly important knowledge for any active cryptocurrency investor.

Why Wrapped Assets Exist

The blockchain ecosystem is fundamentally fragmented. Bitcoin operates on the Bitcoin blockchain. Ethereum operates on its own blockchain. Solana operates on another. Each blockchain has its own native assets, its own token standards, and its own ecosystem of protocols. Assets native to one blockchain cannot natively participate in protocols on a different blockchain.

This fragmentation creates a significant limitation for DeFi. The most valuable cryptocurrency, Bitcoin, cannot be used as collateral in Ethereum lending protocols like Aave, cannot provide liquidity in Uniswap pools, and cannot be deployed in any Ethereum-based DeFi application directly. This represents an enormous pool of capital that is structurally excluded from DeFi activity.

Wrapped assets bridge this gap by creating a token on the destination blockchain that represents the locked original asset. The wrapped token behaves like a native token on the destination chain, compatible with all smart contracts and protocols, while maintaining its economic linkage to the underlying asset through a custody or smart contract mechanism that ensures the peg.

How Wrapping Works: The Basic Mechanism

The core mechanism of asset wrapping involves locking the original asset somewhere and minting a corresponding token on the destination blockchain. When the wrapped token is redeemed, the original asset is released and the wrapped token is burned.

Using Wrapped Bitcoin (WBTC) as an example: a user who wants to obtain WBTC sends their Bitcoin to a designated custodian. The custodian holds the Bitcoin in reserve and a corresponding amount of WBTC is minted on Ethereum as an ERC-20 token. The user receives the WBTC and can deploy it in Ethereum DeFi protocols. When they want their Bitcoin back, they return the WBTC, which is burned, and the custodian releases the corresponding Bitcoin.

The total supply of WBTC in circulation should always equal the total Bitcoin held in reserve. This 1:1 backing is what maintains the peg: if 1 WBTC can always be redeemed for 1 Bitcoin, arbitrageurs will ensure the market price of WBTC stays at or very near the price of Bitcoin. If WBTC trades below Bitcoin price, arbitrageurs buy WBTC cheaply and redeem it for Bitcoin at par, closing the discount. If WBTC trades above Bitcoin price, arbitrageurs mint new WBTC by depositing Bitcoin and sell the WBTC at the premium, closing the premium.

Types of Wrapped Asset Models

Not all wrapped assets use the same mechanism, and the differences in how the underlying asset is secured have significant implications for the risk profile of each.

Centralised custodial wrapping. WBTC, the largest wrapped Bitcoin by market cap for much of its history, used a centralised custodian model where the Bitcoin reserves were held by BitGo as a regulated custodian. Merchants in the WBTC DAO network handled the minting and burning process with users. The custodial model provides a clear reserve structure and regulatory accountability but introduces a single point of failure: the custodian’s security, solvency, and regulatory status directly affect the backing of the wrapped token. In August 2024, BitGo announced it would transfer custody of WBTC reserves to a joint venture involving Justin Sun, which prompted significant community concern about custody risk and led to several DeFi protocols reducing or removing WBTC collateral acceptance.

Institutional custodial wrapping. cbBTC, Coinbase’s wrapped Bitcoin product launched in 2024, uses Coinbase as the custodian. Each cbBTC is backed 1:1 by Bitcoin held in Coinbase custody. The institutional backing of a major regulated exchange provides a different risk profile from a standalone custodian: Coinbase’s regulatory standing, insurance coverage, and institutional reputation provide a level of assurance, though the custodial concentration risk remains. cbBTC is designed to be used in DeFi on Ethereum and Base, Coinbase’s own Layer 2 network.

Decentralised smart contract wrapping. Some wrapped asset protocols use smart contracts rather than centralised custodians to hold reserves and manage minting and burning. This removes the single custodian risk but introduces smart contract risk as covered in our risks of DeFi investing resource: if the smart contract holding reserves has a vulnerability, it can be exploited to drain the backing without the custodian being involved. The cross-chain bridges that facilitate many wrapped asset mechanisms often use decentralised smart contract models.

Liquid staking tokens as wrapped assets. Liquid staking tokens like stETH (from Lido) and rETH (from Rocket Pool) function similarly to wrapped assets: they represent Ethereum that has been staked with validators, with the liquid token usable in DeFi while the underlying ETH earns staking rewards. As covered in our what is a validator in crypto resource, these tokens combine wrapping mechanics with staking yield generation.

WBTC: The Original Wrapped Bitcoin

WBTC was launched in January 2019 as a collaborative project between BitGo, Kyber Network, and Ren Protocol, and became the dominant wrapped Bitcoin on Ethereum for several years. At its peak, billions of dollars worth of Bitcoin was locked as WBTC, making it a significant source of Bitcoin liquidity in the Ethereum DeFi ecosystem.

WBTC as an ERC-20 token is fully compatible with all Ethereum DeFi protocols. WBTC has been used extensively as collateral in lending protocols like Aave and Compound, as a liquidity pairing asset in Uniswap and Curve pools, and as a base asset in yield farming strategies. The tokenomics are straightforward: it is a 1:1 representation of Bitcoin with no additional features or yield generation.

The 2024 custody transition controversy reduced WBTC’s dominance as major DeFi protocols reduced their WBTC collateral acceptance limits, creating space for alternative wrapped Bitcoin products including cbBTC and others to gain market share. This episode illustrated how centrally-custodied wrapped assets carry governance and counterparty risk that can affect their usability in DeFi protocols even without the peg breaking.

cbBTC: Coinbase’s Wrapped Bitcoin

cbBTC was launched by Coinbase in September 2024 as a regulated institutional alternative to WBTC. Each cbBTC is backed 1:1 by Bitcoin held in Coinbase custody, with reserve attestations published regularly to verify backing.

cbBTC is available on Ethereum mainnet and on Base, Coinbase’s Layer 2 network, and is designed for use in DeFi protocols on both networks. Its institutional backing quickly attracted significant total value locked as DeFi protocols that had reduced WBTC exposure added cbBTC as an accepted collateral asset.

The risk profile of cbBTC centres on Coinbase as the custodian. Coinbase is a publicly listed, regulated exchange with significant regulatory oversight. The custodial risk is therefore tied to the regulatory and operational status of a major institution rather than a standalone custody provider. The tradeoff is that all custodial concentration risk remains: cbBTC holders are dependent on Coinbase’s continued operation and solvency, which is a different risk profile from holding Bitcoin directly in self-custody as covered in our not your keys not your crypto resource.

Wrapped Ether (WETH)

Wrapped Ethereum (WETH) is a specific case of wrapping that addresses a technical incompatibility within the Ethereum ecosystem itself rather than between different blockchains.

Native ETH on Ethereum predates the ERC-20 token standard and does not conform to it. Most DeFi protocols and automated market makers are built to work with ERC-20 tokens, not native ETH. WETH is an ERC-20 wrapper around native ETH: depositing ETH into the WETH contract mints WETH at a 1:1 ratio, and burning WETH releases the underlying ETH. No custodian is involved: the WETH smart contract holds the ETH and manages the minting and burning process automatically.

Most DeFi interfaces automatically wrap ETH to WETH when needed for protocol interactions, making the conversion invisible to users. Understanding that WETH and ETH are economically equivalent but technically distinct helps explain why many DeFi positions are denominated in WETH rather than ETH.

Wrapped Assets and Cross-Chain Bridges

Many wrapped assets are created through cross-chain bridge protocols rather than through dedicated wrapping services. As covered in our cross-chain bridges explained resource, bridges lock assets on the source blockchain and mint corresponding tokens on the destination blockchain, which is functionally the same as wrapping.

Bridged versions of assets are effectively wrapped assets: bridged Bitcoin on Solana, bridged USDC on Arbitrum, or bridged ETH on Polygon are all wrapped assets created through bridge mechanisms. Each bridge has its own security model, custody approach, and risk profile. Bridge exploits, where vulnerabilities in the bridge smart contracts or validator networks allow attackers to drain locked assets, have been among the largest individual hacks in DeFi history. As covered in our risks of DeFi investing resource, bridge risk is one of the most significant risk categories in cross-chain DeFi activity.

Using Wrapped Assets in DeFi

For investors who want to deploy Bitcoin value in DeFi through wrapped assets, the process typically involves obtaining the wrapped token through an exchange or wrapping service, then interacting with DeFi protocols using that token.

Collateral in lending protocols. WBTC, cbBTC, and other wrapped Bitcoin tokens are accepted as collateral in DeFi lending and borrowing protocols as covered in our lending and borrowing crypto explained resource. Depositing wrapped Bitcoin as collateral allows borrowing stablecoins or other assets against the Bitcoin position without selling it.

Liquidity provision. Wrapped Bitcoin paired with stablecoins or Ethereum in automated market maker pools generates trading fees for liquidity providers. The impermanent loss dynamics of providing liquidity in volatile asset pairs as covered in our automated market maker explained resource apply equally to wrapped Bitcoin pools.

Yield strategies. Wrapped assets can be deployed in yield farming and staking strategies through popular DeFi protocols that accept them as deposits. As covered in our staking vs farming resource, the yield from these strategies involves protocol risk on top of the custodial or bridge risk of the wrapped asset itself.

The Risks of Wrapped Assets

Wrapped assets introduce specific risks that holding the underlying asset directly does not carry.

Custodian or bridge failure. For custodially-backed wrapped assets, the custodian’s failure, insolvency, or regulatory shutdown could affect the redeemability of the wrapped token. The wrapped token might trade at a discount to the underlying asset or become entirely unredeemable if the custodian cannot release reserves. As covered in our risks of keeping crypto on an exchange resource, custodial counterparty risk applies to wrapped asset custody in the same way it applies to exchange custody.

Smart contract vulnerabilities. For decentralised bridge and wrapping mechanisms, smart contract exploits can drain the locked reserves backing the wrapped token, destroying the peg. This has occurred in several high-profile bridge exploits affecting wrapped assets on multiple networks.

Peg deviation. While arbitrage mechanisms normally maintain the peg tightly, during periods of market stress or custodian concern, wrapped assets can trade at a meaningful discount to their underlying asset. A holder of WBTC who needs to exit during a period of peg stress may receive less than the equivalent Bitcoin value.

Regulatory risk. Custodially-backed wrapped assets are subject to the regulatory environment of the custodian’s jurisdiction. Regulatory actions against the custodian could affect the wrapped asset’s operation and redemption.

Compounded DeFi risk. Deploying wrapped assets in DeFi protocols adds protocol risk on top of the wrapping risk. A position in a lending protocol using wrapped Bitcoin as collateral carries the risk of the lending protocol’s smart contract, the risk of the wrapping mechanism, and the market risk of the underlying asset simultaneously.

Tax Treatment of Wrapped Assets in Australia

The tax treatment of wrapped assets in Australia is an area that requires careful attention given the ATO’s treatment of cryptocurrency transactions.

Wrapping Bitcoin into WBTC or cbBTC may be treated by the ATO as a disposal of Bitcoin and acquisition of a new asset (the wrapped token), potentially triggering a capital gains tax event at the time of wrapping, depending on whether the ATO treats the wrapped token as substantially the same asset or a distinct new one. The same consideration applies when unwrapping back to the original asset.

Given that the tax treatment of wrapped assets is not definitively settled in ATO guidance as of the knowledge cutoff, professional advice from a tax accountant with cryptocurrency expertise is strongly recommended before undertaking wrapping and unwrapping activity. As covered in our cryptocurrency tax Australia and ATO crypto reporting resources, maintaining complete records of all wrapping and unwrapping transactions, including the AUD value at each step, is essential regardless of the ultimate tax treatment.

Key Takeaways

Wrapped assets are tokens that represent another asset on a different blockchain, backed by the original asset through custodial or smart contract mechanisms, designed to maintain a 1:1 peg with the underlying asset’s value. They exist to enable assets native to one blockchain to participate in DeFi protocols on another. WBTC and cbBTC are the most prominent wrapped Bitcoin products, using centralised custodian models with different risk profiles. WETH wraps native ETH into ERC-20 format for DeFi compatibility within Ethereum itself.

Risks of wrapped assets include custodian failure, smart contract vulnerabilities, peg deviations, regulatory exposure, and compounded DeFi risk when wrapped assets are deployed in protocols. Tax treatment of wrapping and unwrapping transactions in Australia is unsettled and requires professional advice. Wrapped assets are powerful tools for accessing DeFi yield on Bitcoin value, but the risk stack is meaningfully higher than simply holding the underlying asset in self-custody.

For everyday investors who want to understand how wrapped assets work and how they fit into the broader DeFi ecosystem before deciding whether to use them, our Runite Tier Membership provides the education and frameworks to make that assessment confidently. For serious investors who want personalised guidance on incorporating wrapped assets and DeFi strategies into a professionally structured portfolio, our Black Emerald and Obsidian Tier Members receive direct specialist support. Find out more at shepleycapital.com/membership.