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We’re still in the earliest years of cross-chain DeFi.
Different blockchains are significantly siloed, which you can tell by just looking at how Centralized Exchanges (CEXs) continue to be the most convenient way for users to swap coins between them. Albeit straightforward, this still is far from ideal, given that it does not rely on blockchain-native products and that users’ funds sit in exchanges’ hands.
Because of all of this, cross-chain interoperability has become the holy grail (and an over-used 'buzz phrase') in DeFi, as protocols try to move value seamlessly across different blockchains.
A peek into the world of cross-chain DeFi
Blockchains are like straight, parallel lines that do not cross, end, or cross paths. Although most of them may have similar underlying technologies, most independent blockchain networks are not compatible with one another. Like water and oil, they are immiscible – flowing side by side but never truly mixing.
The reason blockchains can’t “mix” is because a blockchain’s main purpose is to allow users to coordinate without communication to keep a shared ledger. Since each blockchain keeps track of its own ledger, making them mix would require both of the colliding chains to “agree” on a single state for each compatible chain, and track every subsequent move on the other. This process, as you might imagine, is far from efficient and introduces several different problems into the picture.
Because of the difficulty of upholding more than one ledger, even when a blockchain is forked, the newborn chain can only run side-by-side with the original.
The exclusive nature of Layer-1 blockchains poses a significant problem for DeFi protocols, which seek to take their services across several networks. There are many reasons for these issues, such as:
- Popular blockchains’ native assets, such as Bitcoin’s BTC, Ripple’s XRP, Polkadot’s DOT, etc. are incompatible with the most popular DeFi ecosystem, Ethereum.
- High fees in Ethereum make users migrate to other DeFi ecosystems that might be better prepared to meet periods of high demand.
- Yield-seekers trying to make the most of existing platforms across the board as opposed to limiting themselves to a single ecosystem.
Enter the million-dollar question: what is cross-chain interoperability and how can it be achieved?
Cross-chain interoperability is the ability of a blockchain network to speak with other blockchains with which they share a similar underlying technology to drive information sharing. Note that “cross-chain” refers to something different from “multi-chain”, which refers to a project operating simultaneously in several networks.
Through cross-chain bridges and communication channels, users could in theory seamlessly and securely move value via token bridges across different networks. Like two parallel lines finding a way to meet, its interoperability could unlock a way for different blockchain networks to speak to each other, with DeFi being the biggest benefactor.
Why is cross-chain interoperability so important for DeFi?
Before the days of cross-chain interoperability, DeFi protocols were also restricted to serving the crypto community of the blockchain on which they were built. There was no room for non-Ethereum users to participate in Decentralized Finance on the most popular blockchain ecosystem.
Because of a lack of interoperability, DeFi protocols were limited to only the original blockchain they were built on. As such, they inherited all the underlying challenges associated with their native network. For Ethereum, this meant slow transaction speeds and high gas fees. For a few others, it was low liquidity and a smaller customer base.
Cross-chain interoperability, therefore, changed the game for decentralized finance.
Projects no longer have to build for one network alone, as they can easily allow digital asset transfers across blockchains through bridges. Users can also complete cross-chain token swaps, deposit liquidity, collect and repay loans, farm new tokens without limitations, and transfer assets across networks at all times. Cross-chain interoperability also bridged previously disenfranchised participants into the world of DeFi, creating entry points for retail and institutional users alike.
In summary, with cross-chain interoperability, DeFi protocols can enjoy:
- Scalability: Utilizing several blockchain networks allows for greater scalability, faster transaction speeds and reduced gas fees.
- Greater adoption: When a DeFi protocol supports interoperability, it can access a greater pool of users across the different networks and provide DeFi services to everyone.
- Storage spread: A high number of users leads to higher storage costs for DeFi applications. When services are supported across several blockchains, DeFi protocols can spread storage costs evenly across networks.
- Liquidity spread: The more users a DeFi protocol can reach, the more liquidity is available for lending, borrowing, staking, etc. Cross-chain interoperability creates an avenue for a large inflow of liquidity across several blockchains.
Relevant cross-chain DeFi concepts
As DeFi applications and protocols continue to build for a future where it will be possible to effortlessly transfer wealth between multiple blockchains, several projects and concepts have carved a niche for themselves in decentralized finance. They have become integral parts of the DeFi ecosystem, helping drive cross-chain transactions and, ultimately, DeFi adoption. Some of them include:
Bridges: a pillar of cross-chain DeFi
Bridges are essential infrastructure in the cross-chain DeFi ecosystem – the fundamental framework behind asset transfers across multiple chains. Essentially, bridges lock assets on one network and mint the equivalent assets on the other. They can be unidirectional (allowing one-way transactions only) or bidirectional (allowing back and forth transactions across two networks).
The need for cross-chain bridges first emerged when the DeFi ecosystem started growing on the Ethereum network, while the Bitcoin network remained the biggest source of crypto liquidity. This lead to the creation of a wBTC bridge enabling the transfer of BTC from the Bitcoin to the Ethereum network. However, it’s worth noting that this bridge is a token-specific unidirectional bridge, meaning wBTC only supports Bitcoin and transfers the value from the Bitcoin to Ethereum network, not the other way around.
Some other popular cross-chain DeFi bridges include Multichain Bridge, cBridge, Portal (formerly Wormhole), and Poly Network. Bridges for smart contract blockchains tend to be of the more flexible kind, as they allow for two-way communication.
Cross-chain liquidity networks & decentralized exchanges
Even though cross-chain bridges bear the load of most cross-chain communications, they suffer from a range of issues. These include security concerns, the complexity of wrapped tokens, and the skepticism from several blockchain proponents.
Cross-chain liquidity networks and decentralized exchanges (DEXs) aim to solve the problems faced by bridges and enable users to swap one network’s native token to another network’s native token (e.g. swap BTC for ETH without bridging assets, that is, an atomic swap) through a cross-chain AMM model.
With cross-chain interoperability and robust, intelligent algorithms, liquidity networks & DEXs can power native token swap transactions across different blockchains. They also enjoy high liquidity. Famous examples include ThorChain, Gravity DEX, and Polkadex.
Cross-chain staking protocols
Previously, DeFi staking protocols were limited to their native chains. With cross-chain interoperability, users can now stake assets across various networks, participate as validators, and enjoy staking rewards from each network. Cross-staking protocols enable users to earn passive income and contribute to network security across blockchains.
Cross-chain lending protocols
Lending and borrowing have always been a critical part of Decentralized Finance. Implementing these lending protocols across blockchains, users can borrow assets or supply liquidity for borrowers from one blockchain network to the other. Popular cross-chain lending protocols include Compound Finance, Aave Protocol, and Abracadabra.
The present state of DeFi interoperability
Cross-chain DeFi has gone beyond being a buzz phrase, as several projects are leaning towards facilitating blockchain interoperability. While interoperability has helped drive DeFi adoption on a grand scale and move billions of dollars in liquidity into Decentralized Finance, several factors remind us that the DeFi ecosystem is still in its early days.
Unsolved bridge vulnerabilities
Bridges have also become viable targets for hackers looking to exploit large liquidity pools, and the continued attacks threaten the entire DeFi ecosystem.
According to Chainalysis, funds from cross-chain protocol hacks represented 69% of all the funds stolen in the crypto space in 2022. Recently, hackers attacked cross-chain bridge Nomad and stole over $100 million, representing the seventh major crypto bridge hack this year. Earlier in 2022, a heist on Wormhole (a bridge between Ethereum and Solana) resulted in a $320 million exploit, while the Axie Infinity sidechain Ronin was exploited in March, resulting in the loss of over $622 million.
It’s worth noting that bridge security is a major pending assignment for the crypto community. This is because several factors make bridges inherently attractive for attackers. The most common bridge design requires locking native assets on the source chain and minting wrapped-assets on the destination blockchain. Since this model results in a large pool of assets locked on the source chain in a single contract/wallets, malicious actors only need to focus on a single contract to direct their efforts for a potential high reward.
Furthermore, as Vitalik Buterin (Founder of Ethereum) has repeatedly stressed, bridges are prone to other security issues, such as their vulnerability in the event of 51% attacks. Vitalik argued in a Reddit post that, in the case of a blockchain network getting 51% attacked, the native assets in user wallets remain safe, whereas bridged assets’ value is prone to getting diluted.
Overreliance on Ethereum and the EVM
Beyond security threats, interoperability is still not mainstream in DeFi. The dApp concentration on Ethereum remains high (78% of all decentralized finance applications are Ethereum-native), and most dApps do not support cross-chain interoperability.
Another barrier limiting the proliferation of interoperable applications is EVM-compatibility.
EVM stands for Ethereum Virtual Machine, a virtual component that is contained in every Ethereum node which takes in smart contracts (usually written in high-level languages like Solidity) and converts them into EVM bytecode.
EVM-compatibility means creating a code execution environment that supports EVM bytecode, therefore enabling Ethereum developers to migrate their smart contracts from Ethereum to other chains without having to write code from scratch. Some of the most popular EVM-compatible chain are Polygon, BSC, and Avalanche. Since not all blockchain networks are EVM-compatible, this creates a barrier for developers as their smart contracts cannot be deployed on non-EVM compatible chains. This also puts pressure on developers to stay grounded on EVM-compatible chains, since otherwise they might not be able to port their applications outside their host chain.
Privacy concerns associated with Layer-1 blockchains
Because of the public-open nature of bridges, enabling DeFi interoperability may also come at the expense of privacy, transparency, and individual autonomy. Privacy is already a concern for most blockchain network users, but when their transaction records are spread across several blockchains, it becomes even more worrying. Furthermore, guaranteeing seamless interoperability between private and public chains represents its own set of challenges.
With security, privacy, and slow adoption threatening the progress of DeFi interoperability, Panther proposes a series of alternatives to help cross-chain interoperability go private, finding its next breakthrough.
Cross-chain interoperability: What does the future hold?
Although cross-chain interoperability in DeFi is getting the much-needed traction it deserves, there is yet a lot of ground to cover before it becomes a norm in the crypto space. Several leading decentralized applications do not support transactions through different blockchains, while those that already do face a plethora of challenges.
Cross-chain bridges are the bedrock of DeFi interoperability, and they have increasingly come under attack from hackers recently. While they have helped drive scalability in DeFi, solutions across different blockchains increase privacy and transparency risks, and some known bridges even demand KYC verification from potential users.
In the future, decentralization will continue to gain a foothold in crypto. Blockchain interoperability will play a significant role in leveling the DeFi playing field for users and protocols. The excess liquidity on Ethereum is also likely to spread across other blockchain networks. Similarly, the development of more blockchain-agnostic solutions like Panther Protocol (which aims to build industry-standard private bridges that interconnect DeFi through a series of Multi-Asset Shielded Pools) will be a catalyst for widespread DeFi adoption through interoperability.
Panther is a decentralized protocol that enables interoperable privacy in DeFi using zero-knowledge proofs.
Users can mint fully-collateralized, composable tokens called zAssets, which can be used to execute private, trusted DeFi transactions across multiple blockchains.
Panther helps investors protect their personal financial data and trading strategies, and provides financial institutions with a clear path to compliantly participate in DeFi.