In-depth understanding of DeFi cross-chain bridge

As DeFi users begin to move from the Ethereum mainnet to lower cost chains, the need for cross-chain bridge infrastructure is escalating. While some bridges have been launched at this point, most are still in the research phase. Since then, the number, size, and scale of cross-chain bridges have multiplied, and we now conclude who is the market winner and the strategic winner. These industry leaders form the central battleground in the multi-chain world we wrote about last fall — and will reflect on it later this year. Now, Denis takes a closer look at what’s going on behind the scenes. – Chris

The cross-chain bridge industry has rapidly matured. The number of cross-chain bridges has exploded over the past nine months, and together they now account for about 10% of TVL in smart contracts (according to Dune Analytics dashboards and DefiLlama data by Eliasimos). Putting this rapid growth into the current industry situation, Polygon Bridge has a TVL of $4 billion and is now second only to DeFi giant Curve Maker.

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Taking a step back, bridges were first conceptualized after the emergence of a second blockchain, as the emergence of multiple blockchains sparked discussions about how to connect them. WBTC is the first successful cross-chain bridge that connects the two most important blockchains, Bitcoin and Ethereum, albeit through a centralized entity. Then in late 2021, the pace of development of cross-chain bridges picks up as new cross-chain bridges emerge intensively. This article, written by Dmitriy Berenzon from 1kx, outlines the turn of events in detail.

After nine months of rapid growth, we have now reached the point where the average DeFi investor also regularly uses cross-chain bridges. On the surface, this is good news for the recently launched cross-chain bridge project. However, with the reality of the current market downturn and its impact on transaction volumes, these projects are now competing for market share among a dwindling user base.

In this battle, the choice of bridging and verification methods will be the key to determining the competitive landscape of cross-chain bridges in a few years.

What are your assets?

As a basic definition, a cross-chain bridge facilitates the migration of assets from chain A to chain B. In this concept, users usually have only two types of assets after migration: “IOU (I owe you) assets” or natively issued assets. From a cross-chain bridge designer’s perspective, this amounts to one of two approaches: token wrapping or creating liquidity.

1. Token Packaging Bridge (Total TVL: $11.2 billion)

Alternatives to Layer 1 and their DeFi projects initially saw cross-chain bridges as a way to bring assets into their ecosystems. However, the creators of these assets themselves are not necessarily interested (for example, Avalanche will not issue AVAX coins on competing chains). So, in this case, the “wrapper” bridge is used on Layer 1. With a wrapper bridge, the asset is locked on chain A, while the “wrapped” version is minted on chain B. While it might be easier to think about from a transfer perspective, the asset doesn’t actually move. Therefore, it is important not to call it “wrapped”, as it is essentially an “IOU” across the chain bridge and has no intrinsic value on the new chain.

Competition between packaging bridges would result in multiple non-fungible versions of the token, which would confuse users and lead to liquidity fragmentation. For example, Solana has multiple versions of USD; Sabre lists 70 versions of the usd token.

2. Liquidity pool cross-chain bridge (total TVL : $ 600 million)

Some tokens are actually native to many cross-chain bridges. For example, the team behind USDC itself issues its tokens on multiple chains. The liquidity pool cross-chain bridge connects these tokens by collecting symmetric pools on the source and destination chains.

This is a highly capital-intensive bridging method that relies primarily on the incentives of bridging tokens to compensate liquidity providers for their opportunity cost. It is unclear whether transaction fees will be sufficient to cover liquidity costs in the long term. But it is a safe bridging experience for users as they receive tokens minted by the team. Also, liquidity pool cross-chain bridges are generally faster than token wrapping. Synapse and Celer are examples of cross-chain bridges that use this approach.

Verified by whom?

Within the scope of the existing cross-chain bridge, three verification methods have emerged, and different verification methods are used for asset transactions between different chains. Our take on these issues—including their pros and cons—is as follows:

1. Off -chain validators (total TVL : $ 10 billion)

In such a cross-chain bridge, a third-party validator observes the original blockchain for a signal that an asset is locked. They then transmit this message to the target blockchain (invoke a smart contract on the target blockchain). To avoid centralized control by one validator, either use a multi-signature wallet or some kind of consensus mechanism.

This approach can be risky as it involves trust in third parties who control the assets on the source chain. The three largest hacks on Rekt’s list all occurred on cross-chain bridges using validators (Ronin, PolyNetwork, Wormhole), with a total loss equal to the sum of losses from the subsequent 17 hacks.

However, the advantage of such a cross-chain bridge is that new chains can be connected relatively easily and can carry any kind of message (not just token transfers).

2. Local Validation Bridge (Total TVL : $ 700 million)

Instead of relying on third-party validators, these cross-chain bridges use the (“local”) validators of the underlying blockchain to validate transactions. Additionally, any third party who notices a fraudulent/incorrect transaction has a time window to submit a “fraud proof”. This second feature is similar to an optimistic shift to Layer 2 like Arbitrum and Optimism. Nomad is an example of a local validator bridge, and as its documentation explains, “this transaction enables Nomad to save 90% in gas costs compared to pessimistic relays, while still maintaining a high degree of security…”. Connext uses Nomad as its liquidity network. The downside of these cross-chain bridges is limited support for generic messaging.

3. Light clients (total TVL : $ 1.2 billion)

The third way is to create smart contracts on one chain as a light client validator for the other chain (technical explanations for Rainbow, OpticsBridge, IBC here). The main advantage is that there is no need to trust a third party; it is enough to trust the code. Furthermore, since the security of the source chain is borrowed, an attack to break such a cross-chain bridge would have to be a (very expensive) consensus-level attack.

In general, light clients are expensive (they write large amounts of data to the blockchain), not scalable (new smart contracts must be written for each newly added chain), and sometimes more expensive than other validator methods slow.

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Risk and Future Market Structure

With cross-chain bridges now an integral part of regular DeFi activity, the stakes (and risks) are higher.

First, it is indeed possible that a cross-chain bridge will dominate. With such a cross-chain bridge, the entire ecosystem may become dependent on it. As an example, imagine that around 20% of TVL in BSC and Fantom is externally migrated (mostly ETH from Ethereum). If this were migrated in via a cross-chain bridge, and then that bridge was hacked, 20% of the assets would disappear, which would have a significant negative impact on the respective ecosystems.

Also, as the bridged tokens are used in AMMs, lending protocols and beyond, a crash could affect the entire ecosystem.

Finally, in order to build ongoing user trust, cross-chain bridges must provide some kind of “service level agreement” that guarantees that they will remain operational for at least two or three years (which is hard to imagine).

In addition to these risks, it goes without saying that safety is paramount. Since much of the latter depends on who does the verification, we expect the following issues to be unraveled by market structure over the next two years. A few predictions:

The light client cross-chain bridge will become the bottom layer of the infrastructure bridge. They will play a key role in defining regulated assets and will be used for “institutional scale” transactions.

To offset issues of cost, poor scalability, and slowness, the liquidity pool cross-chain bridge will be used for high-frequency, low-volume “retail” transactions.

From a technical point of view, the liquidity pool cross-chain bridge will be implemented as a validator or a local validator bridge, depending on whether scalability or speed is required.

These market dynamics are just beginning to unfold and will certainly be influenced by how the entire multi-chain world evolves.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/in-depth-understanding-of-defi-cross-chain-bridge/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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