Understanding the Risks of Wrapped Assets and How Atomic Swaps Offer a Better Solution

If you've used Bitcoin in DeFi, you've likely encountered wrapped tokens. These digital stand-ins allow Bitcoin to participate in ecosystems built on different blockchains. Although convenient, these tokens pose a fundamental problem because every wrapped token requires trust in a third party to hold your real Bitcoin. But first let’s help you understand why wrapped tokens exist, how they work, and what risks they carry. This guide is essential for anyone serious about trying to use Bitcoin in DeFi.

Why Wrapped Tokens Exist

Bitcoin, Ethereum, BNB Chain, Solana, and other blockchains don't speak the same language. Each runs on its own architecture with different rules and capabilities. When you want to use Bitcoin on a blockchain designed for smart contracts and DeFi applications, you face a fundamental incompatibility problem.

Wrapped tokens emerged as a solution. They're essentially IOUs that represent Bitcoin on different blockchains. When you wrap Bitcoin, you deposit your real Bitcoin with a custodian who then issues you an equivalent amount of wrapped Bitcoin on the target blockchain. This wrapped version can move freely through that blockchain's DeFi ecosystem, but it's not actually Bitcoin. It's a token that promises you can redeem it for Bitcoin later.

How Wrapped Tokens Work

The wrapping process follows a straightforward pattern across most implementations. You send your Bitcoin to a custodian who locks it in reserve. The custodian mints an equivalent amount of wrapped tokens on the target blockchain and sends them to your address. You can now use these wrapped tokens as if they were native to that specific blockchain.

When you want your Bitcoin back, you reverse the process. You send the wrapped tokens back to the custodian, who burns them and releases your original Bitcoin. In theory, every wrapped token is backed one-to-one by real Bitcoin sitting in the custodian's vault.

Common examples include WBTC (Wrapped Bitcoin) on Ethereum, custodied by BitGo with billions in total value. RBTC on Rootstock (RSK), which uses a two-way peg with Bitcoin. BTCB on BNB Chain, issued by Binance. sBTC on Stacks, using a decentralized peg mechanism. Each uses different mechanisms, but all share the same fundamental structure: someone holds the real Bitcoin while you use a representative token somewhere else.

The Trust Problem

Wrapped tokens require you to trust that the custodian actually holds the Bitcoin they claim to hold, won't get hacked, won't freeze your funds, and will give your Bitcoin back when you want to unwrap. This introduces counterparty risk into what's supposed to be a trustless system.

For centralized wrapped tokens like WBTC and BTCB, you're trusting specific entities (BitGo, Binance) with your Bitcoin. While these organizations have strong reputations, you're still dependent on centralized custodians. If they experience security breaches, regulatory intervention, operational failures, or simply change their rules, your wrapped tokens could lose their backing. You're no longer holding Bitcoin. You're holding a promise.

This isn't theoretical. Centralized custodians have failed before. Mt. Gox collapsed with 850,000 Bitcoin. QuadrigaCX locked users out of $190 million. FTX collapsed with billions in customer funds. Celsius froze withdrawals and filed for bankruptcy. Every time you use a wrapped token, you're accepting similar risks as if holding all your funds on a centralized exchange. 

Beyond catastrophic failures, wrapped tokens introduce operational dependencies. Wrapping and unwrapping take time and incur fees. Custodians can implement KYC requirements, blacklist addresses, or pause operations during maintenance. What was supposed to be permissionless suddenly has gatekeepers.

Even "decentralized" wrapped tokens that use multi-signature wallets or validator sets instead of single custodians still require trusting that group of entities. Bridge protocols attempting to create decentralized wrapping systems have become prime targets for exploits. Over $2 billion has been stolen from bridge hacks, making them one of the riskiest components in DeFi.

The Regulatory Risk

Wrapped tokens create regulatory exposure that native cryptocurrencies avoid. Custodians operating wrapped token systems fall under financial regulations in their jurisdictions. They can be compelled to freeze funds, report transactions, or deny service to users from certain countries.

If regulators decide that wrapped tokens require additional licensing or restrictions, the entire system could face shutdowns. Users might find themselves unable to unwrap their tokens or forced through lengthy verification processes. The decentralized promise of crypto breaks down when your Bitcoin can only move with permission from a regulated entity.

How Mintlayer Eliminates the Trust Problem

Atomic swaps offer a fundamentally different solution. Instead of wrapping Bitcoin and trusting a custodian, atomic swaps enable direct peer-to-peer exchanges between different blockchains without intermediaries. The technology uses Hash Time-Locked Contracts (HTLCs) to create cryptographically secured escrow that either completes the swap for both parties or their  cryptocurrencies are fully returned. There's no middleman holding your funds, no custodian to trust, and no wrapped tokens.

When you swap Bitcoin for ML (Mintlayer's native token) or any MLS-01 token using atomic swaps, your Bitcoin never leaves the Bitcoin blockchain until the trade completes. The swap is trustless because the cryptography guarantees that either both sides get what they agreed to, or the transaction is voided and everyone keeps their original assets. No one can steal funds mid-transaction, and no custodian can freeze or censor the trade.

This is what makes RioSwap, Mintlayer's atomic swap DEX, fundamentally different from other decentralized exchanges. Traditional DEXs on Ethereum, BNB Chain, or Solana require wrapped Bitcoin because they operate entirely within their own ecosystems. RioSwap facilitates direct Bitcoin trades without ever creating a wrapped version. Your Bitcoin stays as Bitcoin throughout the entire process.

For users, this means participating in DeFi without giving up custody or trusting third parties. For Bitcoin holders who've avoided DeFi because of wrapped token risks, atomic swaps remove the barrier. You get the functionality of wrapped tokens without any of the trust requirements.

Conclusion

Wrapped tokens solved an important problem by allowing Bitcoin to interact with other blockchain ecosystems, but they introduced trust dependencies that contradict some of Bitcoin’s core principles. Every wrapped Bitcoin, regardless of which blockchain it's on, represents a custodian who must be trusted and a potential point of failure.

Atomic swaps eliminate these compromises. By enabling direct blockchain-to-blockchain trades without custodians or wrapped tokens, they preserve Bitcoin self custody while unlocking DeFi functionality. As Bitcoin DeFi matures and institutional capital enters the space, the infrastructure that wins will be the infrastructure that maintains security and self-custody while delivering functionality. Wrapped tokens were a necessary step in crypto's evolution, but they're not the final answer.