Interoperability Protocols
Note: Data in this section last updated March 13th, 2022
What are Interoperability Protocols?
While Ethereum remains the dominant chain in DeFi, its share has declined from over 95% to under 55% (as of early March 2022) due to the emergence of several “alternative L1s” such as Solana, Binance Smart Chain, Avalanche, and Terra.
While arguably good for the long-term health of the ecosystem, this explosion of smart contract platforms has created significant short-term problems. Perhaps most pressing is the problem of interoperability.
Because blockchains have different protocols, they cannot communicate with each other. While this independence has many benefits, it also creates significant challenges for users that want to move tokens and / or data between chains.
Interoperability protocols are systems designed to solve this problem by allowing the transfer of information and assets between two or more blockchains.
How Do Interoperability Protocols Work?
There are four main types of interoperability solutions:
Atomic Swaps: Atomic swaps allow two parties to directly trade tokens from different blockchains via a virtual escrow account
Wrapped Assets: Wrapped assets are a synthetic version of one blockchain’s token designed for use on another blockchain. For example, wrapped Bitcoin is an Ethereum token that represents Bitcoin on the Ethereum blockchain
Cross-Chain Bridges: Cross-Chain bridges transfer tokens directly from one blockchain to another
Cross-Chain Swaps: Like an interoperable version of Uniswap, cross-chain swaps use liquidity pools to trade assets between different blockchains
To understand these solutions better, let’s look at some of the most popular interoperability protocols:
What are Atomic Swaps?
Atomic swaps were one of the earliest interoperability solutions.
These swaps use smart contracts to allow two parties to directly trade tokens from different blockchains without using a centralized intermediary.
To perform an atomic swap, each user locks their tokens up in a virtual safe known as a Hashed Timelock Contract (HTLC), and when both tokens have been received the trade is executed. The HTLC is also time-based, meaning that both parties must satisfy their end of the deal within a predefined time frame.
While the direct nature of atomic swaps ensures that they are decentralized, they are extremely inefficient as potential users need to find a willing counterparty for every trade.
What are Wrapped Assets?
A wrapped token is simply a synthetic version of a token designed for use on another network. Wrapped Bitcoin (wBTC), for example, is pegged to the price of Bitcoin but designed to work on the Ethereum network.
The process of wrapping uses a “lock and mint” system. When a user transfers assets from Blockchain A to Blockchain B, those assets are “locked” on Blockchain A via a smart contract. Once locked, identical copies of these tokens are “minted” (i.e. created) on Blockchain B. If the user wants to get her original tokens back, then the copies on Blockchain B are destroyed and she can resume using the tokens on Blockchain A.
Unfortunately, many existing wrapping services require a third-party custodian to orchestrate the “lock and mint” system and, as such, are centralized.
One project trying to fix this is Ren Protocol, which is attempting to create a decentralized wrapping service by relying on a network of 10,000 nodes to provide storage space and custody user assets.
What are Chain Specific Bridges?
Chain-specific bridges are dedicated bridges that operate directly between two blockchains. For example, Polygon’s PoS bridge allows users to transfer assets from Ethereum to Polygon and vice versa.
Like wrapped assets, the PoS bridge uses a “lock and mint” system. When you deposit funds into a bridge, they are locked on Ethereum and copies are created on Polygon.
Most major blockchains have chain specific bridges, with Polygon, Avalanche, Ronin (the chain for the game Axie Infinity) and Arbitrum being the most popular bridges for Ethereum.
The main drawback to chain specific bridges is that they are generally limited to the two chains in question, making them difficult to scale.
What are Cross-Chain Swaps?
Much like an interoperable Uniswap, cross-chain swaps use a series of liquidity pools to trade native assets between different blockchains.
One prominent example of such a protocol is Thorchain. Thorchain’s pools are composed of three assets – the tokens that a user wants to trade and RUNE, the network’s native token.
So if a user wanted to swap Bitcoin for Ethereum, the trade would first go through a Bitcoin-RUNE pool, and then a RUNE-Ethereum pool.
There are a few downsides to this method, however:
Swaps can take a long time because they effectively require three transactions: Asset A to the A-Rune liquidity pool, the A-Rune liquidity pool to the B-Rune liquidity pool and the B-Rune liquidity pool to asset B
Unlike Uniswap, where swaps can be bundled into large transactions, trades on Thorchain lack composability
Who are the Key Players in the Interoperability Solutions Market?
Wrapped Bitcoin and Multichain are the most popular bridges as of March 2022, representing almost 75% of the total value locked in interoperability solutions.
What is the Future of Interoperability Solutions?
Interoperability remains an unsolved problem – the market is nascent and there are several potential solutions. Unfortunately, all have tradeoffs and none have achieved escape velocity.
Given the likelihood of a multi-chain future, however, this is an area to keep a close eye on. In the coming months, it is likely that we will see an influx of new players, and will also see existing solutions continue to evolve.
Many would argue that this is one of the holy grails of the space, as a protocol that can efficiently solve this problem will likely garner a 12-figure enterprise value.
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