The Future of Interoperability: How Will Cross-Chain Bridges and Trading Protocols Evolve?

Written by: Leland

Compiled by: 8btc

Too Many Bridges to Choose From

Have you ever taken the wrong bridge, ended up in the wrong place, and had to backtrack to reach your final destination, only to be stuck due to gas running out? As more blockchain interoperability protocols reach the mainnet, this will become a common issue if one is not careful. The consequences of crossing the wrong bridge can be far worse than a quick pivot. Users may have to wait days to return, assuming they have enough "fuel."

Generally, users pay with the native token of the original chain to transfer assets to the target chain. If they do not have the native token of the destination chain, they will be unable to pay to bridge back to the original chain.

With the explosive growth of blockchain and interoperability projects (+40), routing between chains will become the norm. Hundreds of billions of dollars are already locked in bridges across the ecosystem. But not all interoperability solutions are the same. Each company has its own trade-offs and must compete for market share.

Bridges Equal Swaps

Interoperability is key to how blockchains interact with each other. However, these protocols fall into two categories—bridge protocols and swap protocols.

Different forms of interoperability network construction

Typical Bridge

Users lock an asset on Chain A and then mint the same asset on Chain B. Some bridges are paired, connecting only two chains at a time. Others are more like networks, allowing users to transfer assets from one chain to multiple potential chains—the benefit being that if users cross the wrong bridge, they can bridge to the correct chain without having to backtrack too much. The last category is centralized bridges, such as WBTC or USDC or wrapped assets on BSC, where centralized entities issue assets on the chain.

Above: An example of user choice if they initially enter the wrong chain

Typical Swap

Swapping asset A on Chain 1 for asset B on Chain 2. Swaps do not transfer assets between blockchains. Technically, bridges do not transfer assets between blockchains either; during cross-chain activity, assets are locked on the original chain. For example, Thorchain does not allow users to transfer BTC to ETH, but rather swaps BTC for ETH. Users ultimately receive ETH on the Ethereum chain in exchange for BTC on the Bitcoin chain. However, if the desired asset is already on the target chain, users can swap USDC on Matic for USDC on Ethereum. Depending on the structure of the swap protocol, the counterparty may be an AMM or a market maker. Under certain conditions, the protocol may even cover the fees for users swapping assets to the new chain.

Note that interoperability solutions should also be compared in terms of trust assumptions, transfer times, liquidity, and dependency risks.

Path Dependency

Figure: xUSDC is not equal to yUSDC; an asset is defined by the bridge that brought it over

Because each bridge has its own set of contracts, assets are associated with the bridge they encounter. USDC brought by Bridge X becomes xUSDC, while USDC brought by Bridge Y becomes yUSDC. xUSDC and yUSDC each have a separate ERC20 contract, making them non-interchangeable.

This dynamic of bridging assets with different contract addresses than natively issued assets will lead to significant liquidity fragmentation. For example, USDC is natively issued on both ETH and Solana. If there is a massive spike in demand for USDC on Solana, and CENTER has not issued more USDC, users bridging USDC from ETH to Solana will find that this bridged USDC is not interchangeable with the natively issued USDC on Solana. This is a terrible user experience, and the only way to solve this issue is for CENTER to act as a centralized stable exchange, allowing users to quickly move USDC across chains.

From the perspective of users and developers, this is quite frightening. What happens when all applications use yUSDC, and a user crosses the wrong bridge, ending up with xUSDC? They will be forced to return and use the correct bridge. So in terms of applications, should developers integrate both or just one? If they integrate both, how should they evaluate these assets? Should they have the same parameters in the application, or should the risks and nuances of each bridge be considered?

If the market for a specific asset (like USDC) is large enough on a particular chain, then xUSDC and yUSDC may coexist. However, in general, we suspect that bridges will dominate the monopoly trend for specific assets. BTC on Ethereum is a case in point; historically, there have been a dozen competing standards, but currently, WBTC and HBTC account for 90% of the market share. We expect that the original issuers of an asset will have a strong influence over the bridges they support.

The Battle of Standardized Contracts

Standardized asset contracts are the contracts that capture the attention of developers and users, the contracts that everyone will integrate. Users want only one version of an asset, not two or more versions of the same thing (no one wants to choose between xUSDC and yUSDC).

Bridges will compete with each other to have the standardized contract for specific tokens. For example, Matic's Plasma bridge occupies the MATIC token market, while the PoS bridge connects all other assets flowing between Ethereum and Matic. In the future, we expect more bridges to attempt to capture specific assets from general bridges. Aave already has a custom bridge for transferring aTokens from ETH to Matic to handle unique accounting.

We expect these new bridges to compete in various ways, such as being more secure or having similar network structures. But the design space is vast. Bridges can implement new functionalities, such as flash minting, native cross-chain governance, user/developer-friendly features (preventing users from sending tokens to contracts, allowing developers to use BatchCall to save gas, etc.), cross-chain function calls, and more. This can attract more attention away from generic all-purpose bridges. Additionally, some applications may follow Aave's approach and build custom bridges to handle special cases (governance, mechanisms, etc.) or to have more control over their assets. But then again, do DApps have the capability to build robust bridges? This is close to their core business.

Interoperability Economics

Each individual interoperability solution has different usage costs. Users pay fees on the original chain but typically receive assets for free on the target chain. For bridges, costs are often fixed, and the scale of transactions does not affect the cost of crossing. Swap protocols are different, or at least those using AMMs are. The depth of liquidity pools affects the price at which users move within them. For large transfers, it may make sense to take a slower but more cost-effective route.

Predictions for Interoperability

As bridges compete for market share, the competition will be fierce with the launch of dozens of bridging protocols. Initially, bridges will connect chains that are less interconnected and target assets that have not yet been bridged. However, this market is small and will close quickly. Ultimately, bridges will try to convince the market that their solution is the "safest," or they may start yield farming programs to attract liquidity.

Speed is not important for small transactions on bridges, as there are "fast bridges" or swaps. Bridges will not compete on speed, as there are swap protocols with much lower security that allow users to cross blockchains more quickly. One current version is the Hop protocol, where users trust oracles to relay their transactions across chains. For small transactions, the risk is relatively low. For large transactions, users may prefer a slower, cheaper, and more secure bridge. (And if the "fast bridge" lacks liquidity, users will be forced to take the slower bridge.)

Large users, yield seekers, and market makers will be the biggest consumers of bridges, with each blockchain being its own independent community. This is especially true when each chain has stronger native bridging capabilities. Ordinary users do not need to use bridges; only those trying to find the latest yield on the risk curve or professionals attempting to arbitrage assets and interest rates across chains.

Interoperability will break the reliance of crypto on atomicity, where the magic of a transaction on one chain lies in its atomicity. This is why flash loans can only exist in a blockchain environment. If any aspect of the transaction fails, the entire transaction is reverted. Look at DEX aggregators. Users either get all the assets they want, or the transaction fails; they do not have to worry about only getting half. Real-world applications do not have atomicity. Smart order routers—the IRL version of DEX aggregators—must build logic to handle lost swap connections or transaction failures. Interoperability will force developers to think differently when building cross-chain applications. Partial failure scenarios must now be considered.

Interoperability aggregators, with dozens of bridges and swap solutions. Many teams will attempt to build an aggregator to unify them. For these teams, this is an important technical and user experience issue.

Fiat-backed assets will remain centrally issued, only bridging to new chains, with fiat-backed assets like USDC being directly issued by CENTRE to other chains.

Bridging is useful if users already have assets on the target chain. If users do not have the native fee token, what is the point of introducing assets? Otherwise, the assets will be stuck. Users must obtain local gas tokens through centralized exchanges or swap protocols. We expect interoperability to potentially abstract gas or notify users to also swap/bridge the native asset of the target chain before introducing other assets.