Cross-chain Interoperability Is the Future of DeFi
One of the key factors hindering mass adoption of blockchain technology and Web3 today is its siloed nature. While users of one independent blockchain, say Ethereum, can seamlessly interact with the decentralized applications built on that particular blockchain—communicating with other blockchains, say Polkadot or Avalanche, is still difficult. As a result, users are forced to split their liquidity among different chains, while developers ineffectively spend time and resources on these separate chains.
One way that users currently interact among different blockchains is by swapping tokens through centralized exchanges (CEXs). CEXs operate much like a traditional stock exchange, where they facilitate buy and sell orders between different users. Say a user with MATIC, Polygon’s native token, wants to participate in DeFi on Ethereum. They will be unable to do so unless they go on a CEX, and exchange their MATIC for ETH. This is a time-consuming and cumbersome process, and users lose money in the gas fees.
By acting as a third-party custodian to a user’s funds, CEXs defeat the purpose of decentralization, which is crucial to the ethos of Web3 and blockchain. The recent bankruptcy of FTX, the world’s second-largest crypto exchange, and the subsequent losses that customers are facing clearly delineates the dangers of handing over controls of your crypto deposits to a centralized entity.
This is where cross-chain interoperability enters the conversation. It gives users and developers the freedom to choose how they want to interact with DeFi, without being constrained by the rules, and related assets of any one network. Let’s dive into what it means, why it is important for DeFi and its applications currently available.
What Is Cross-chain Interoperability?
To understand cross-chain interoperability, we need to first understand why two blockchains cannot interact with each other. A blockchain is essentially a shared ledger that keeps an immutable track of transactions that its users post. For two separate blockchains to share data amongst each other would require for those chains to agree on a single state for the blockchains and keep an immutable track of every subsequent transaction on the other. The amount of data that will need to be exchanged and stored for the two blockchains for this process makes it difficult to scale. And imagine doing this for each blockchain pair that wishes to interact with each other!
Cross-chain interoperability solves this problem by allowing different blockchains to exchange data and value. It essentially acts as a bridge between two blockchains, eliminating the need for a third-party intermediary like a CEX.
Why Is Cross-chain Interoperability Important for DeFi?
The DeFi ecosystem today is worth $40.82B, of which Ethereum accounts for nearly 58%. However, in a world where blockchain interoperability does not exist, users of non-Ethereum blockchains such as Polygon and Avalanche cannot participate in the value being created in the largest DeFi ecosystem. Think of every DeFi ecosystem as a separate economy, but those economies would not scale massively if they are unable to interact with each other.
Cross-chain interoperability can lead to a wider adoption of DeFi. By allowing users to freely access DeFi protocols across blockchain networks, it will create more value for them to interact with DeFi. This ease of access can, in turn, bring in more users to Web3 and DeFi. More users then lead to greater amounts of liquidity flowing into the DeFi ecosystem, allowing for larger lending, staking, yield farming, and borrowing operations.
Cross-chain interoperability also allows users to transcend the various limitations of individual blockchains; they now do not have to be limited by Ethereum’s higher gas fees, and other network’s fewer users and low liquidity. Developers too can create primitives that allow digital assets to be transferred across multiple chains.
True to their name, cross-chain bridges act as a gateway of exchange for data and assets between two different blockchains. They allow this exchange by locking an asset on one network, and minting a synthetic version of that asset on the destination blockchain.
For example, if a user wants to swap ETH for Polygon’s MATIC, a wrapped version of ETH compatible with the Polygon network will be created and sent to the user’s wallet. This ETH gets locked in a smart contract on Ethereum network and will always be equal to the amount of wrapped MATIC created. Upon bridging back, the wrapped MATIC is burnt and the unlocked ETH is put back into circulation.
MetaMask, the most popular crypto wallet, has recently launched a beta version of its bridging aggregator service. Called MetaMask Bridges, it helps a user find the best way to move their assets from one chain to another. Currently, it supports transfers of up to $10,000 across four EVM networks: Ethereum, Binance Smart Chain, Polygon and Avalanche. MetaMask Bridges vets third-party bridges it integrates with to ensure the process does not compromise on security and decentralization.
Cross-chain Trading Through DEXs
Users can also swap tokens through decentralized exchanges (DEX) using a mechanism called atomic swaps. Atomic swaps is a trustless peer-to-peer exchange method that is facilitated by smart contracts between two individual wallets.
Atomic swaps utilize the hashed timelock contract (HTLC), which sets a deadline for the transaction to be completed. For a successful swap to occur, both parties need to provide cryptographic proof that they have the assets they are looking to exchange. The HTLC smart contract ensures that if either of the parties does not provide the proof within a pre-decided timeframe, the digital assets will be returned to the original wallets.
A third, and probably most effective, way to enable cross-chain interoperability is through inter-blockchain communications (IBC) protocols. IBC allows independent blockchains to exchange data and assets directly, using smart contracts deployed on each of those chains. Currently, IBC is mainly used by the blockchains in the Cosmos ecosystem, which aims to build an internet of blockchains.
Another protocol that uses IBC is LayerZero. It aims to act as a base layer underpinning all blockchains, whether Layer1s or Layer2s, to allow different blockchains to communicate with one another.
Cross-chain Interoperability Risks
While there has been progress in enabling the flow of value across separate blockchains, some limitations remain.
For example, bridging is a complex mechanism since it navigates two completely separate blockchain ecosystems, built using different programming languages. This complexity creates opportunities for hacks and exploits. Vitalik Buterin has also expressed his reservations about bridging because of their security limitations.
Another vulnerability of the bridging process is the fact that it creates large asset pools locked in a single contract on one chain. This pooling of assets creates a centralized point of failure that hackers can then potentially attack. Bridging hacks account for 69% of all crypto funds stolen in 2022, according to data analytics firm Chainanalysis. Atomic swaps, on the other hand, can be cumbersome and require a user to undergo multiple steps in the process.
Despite the risks present in cross-chain interoperability mechanisms available today, they remain popular because they allow users to access the promise of DeFi and Web3 at lower costs and higher speed.
One way for organizations to access DeFi and cross-chain bridges is through MetaMask Institutional (MMI), the institution-compliant version of MetaMask. MMI provides organizations the widest access across EVM-compatible protocols. While MMI offers access to all EVM blockchains and Layer2s, an organization’s access to these is determined by the EVM chains supported by their chosen custodian.
MMI also offers reporting features such as snapshots and transaction notes on 13 EVM chains. Only MMI provides unrivaled access to DeFi without compromising on institution-required security, operational efficiency, or compliance requirements.
The implosion of the centralized crypto exchange FTX has woken up users to the importance of DeFi. In the week preceding November 15th, many DeFi protocols registered “double-digit percentage growth in users and transactions”, according to data analytics firm Nansen. As more users flock to DeFi, cross-chain interoperability emerges as the natural focus to ensure they get the most value out of their digital assets.