Zou Chuanwei: Economic Analysis of Cross-chain Technology

On December 28, the “2021 First Digital Finance Frontier Academic Conference” was successfully held online. The conference was hosted by Tsinghua SEM Digital Financial Assets Research Center and chaired by Professor Luo Mei, director of the center. Zou Chuanwei, chief economist of Wanxiang Blockchain and an invited researcher of the Digital Financial Assets Research Center, delivered a keynote speech entitled “Economic Analysis of Cross-chain Technology”. This article is organized according to the content of the speech.

Cross-chain is an important direction for the development of blockchain technology, and it also involves complex economic issues. This article is divided into four parts to analyze the economics of cross-chain technology: the first part discusses the connotation, significance and related experiments of cross-chain, the second part discusses Hash Time Lock Contract (HTLC, Hash Time Lock Contract), the third part discusses asset bridge and Corridor Networks, Part IV summarizes the full text and raises questions for further research.

The connotation, meaning and experiment of cross-chain

  • The connotation of cross-chain

There is no unified definition of cross-chain. I tend to understand cross-chain in a broad sense, referring to the mechanisms and techniques for spanning interoperable objects from a source blockchain system to a target blockchain system. The “source blockchain” and “target blockchain” here are not only for the public chain, but also for the alliance chain, including the main chain and side chain (or Layer 1 and Layer 2).

There are three main categories of “interoperable objects”. One is identity, which is reflected in the blockchain system as the address and the private key behind it, corresponding to various users of the blockchain system. The second is information, including information related to Token transactions and status in the blockchain system, as well as information unrelated to Token in the blockchain system. The third is assets, including assets represented by homogenized and non-homogenized tokens. Correspondingly, cross-chain has three main goals.

First, the identity in the source blockchain system has the same operating authority, ownership statement and reputation in the target blockchain system. Second, the information in the source blockchain system can also be used in the target blockchain system. Third, the assets in the source blockchain system still retain their value in the target blockchain system.

Different blockchain systems may use different cryptographic algorithms, consensus algorithms and smart contract standards, etc. In addition, the blockchain cannot be copied, forged, and cannot be tampered with, making it far from simply standardizing interfaces and clarifying data across chains. Formats and unified communications protocols, etc. will work.

  • The meaning of cross-chain

The significance of cross-chain is reflected in many aspects. First, the need for multi-chain ecological interconnection. The users and application scenarios of blockchain are constantly growing. Users manage their own assets in different blockchain systems, as well as the interaction requirements between users of different blockchain systems, which all require cross-chain. Cross-chain can promote the interconnection of identity, information and assets between different blockchain systems.

Second, the need for intensive development and use of infrastructure. Although the multi-chain ecosystem is developing, if different blockchain systems build their own infrastructure, it may cause problems such as low utilization of infrastructure or even waste. Cross-chain can promote the intensive development and use of infrastructure in the multi-chain ecosystem.

Third, the need for expansion of the blockchain system. The performance of different blockchain systems is different. If assets can be transferred across chains under safe conditions, the transaction pressure on the original chain can be relieved. This includes going from the main chain to the side chain (or from Layer 1 to Layer 2). Lightning Network, WBTC, and Ethereum Layer 2 scaling are all targeting these needs and are getting more and more attention.

Fourth, the need for ecological spillover of the core blockchain system. Several core blockchain systems have emerged in the multi-chain ecosystem. They have a large number of users and application scenarios, and objectively constitute the “traffic portal” in the blockchain field. Many other blockchain systems are compatible with the core blockchain system to undertake the ecological spillover of the core blockchain system. This trend also creates a need for cross-chain.

Fifth, the need for blockchain systems to connect to other systems. Some projects are exploring how to expand the users of the blockchain, allowing ordinary users to access blockchain application scenarios without digital wallets, thereby lowering the threshold for blockchain use. This is also an important aspect of cross-chain.

Sixth, the need for risk management. This is the core problem to be solved by blockchain in the field of asset trading, and it is also the cross-chain scenario discussed below.

Atomic Swap (Atomic Swap), Voucher Payment (DvP, Delivery vs Payment) and synchronous foreign exchange (PvP, Payment vs Payment) essentially reflect the same risk management goals in different application scenarios:

The meaning of atomic swap is that the exchange between two tokens in the blockchain system (not necessarily in the same blockchain) is carried out through smart contracts, so that the exchange is either completely completed or not completed, but all participants can Get your money back.

The bond payment comes from the field of post-trade processing of securities, which means that after the securities transaction is concluded, on the settlement date designated by both parties, the securities and funds are simultaneously settled and mutually conditional.

Simultaneous foreign exchange settlement is a settlement arrangement for foreign exchange transactions, which requires the two currencies involved in the transaction to complete the delivery at the same time to eliminate the risk of principal delivery, prevent the risk of settlement time difference in different trading time zones, and improve the operation efficiency of the foreign exchange market. If the blockchain is used in securities transactions and foreign exchange transactions, then the bond payment and foreign exchange synchronous settlement are equivalent to atomic swaps.

  • Blockchain-based coupon payment and foreign exchange synchronous settlement experiment

From 2017 to 2020, the Jasper project of the Bank of Canada, the Stella project of the European Central Bank and the Bank of Japan, and the Ubin project of the Monetary Authority of Singapore have all carried out coupon-payment experiments on the use of wholesale central bank digital currency for tokenized securities transactions (Table 1 right). below). In addition, both Ubin-Jasper and Stella have conducted experiments with simultaneous foreign exchange settlement between two wholesale central bank digital currencies.

Table 1: Blockchain-based coupon payment and foreign exchange synchronous settlement experiments

Zou Chuanwei: Economic Analysis of Cross-chain Technology

These central banks have used different blockchain systems and found that both the blockchain-based bond-payment and synchronous foreign exchange settlement can be attributed to two scenarios.

First, single-ledger atomic swaps. They found that for many blockchain systems, regardless of whether the two tokens represent funds and securities, or two different currencies, as long as the two tokens come from the same blockchain system, smart contracts can effectively achieve atomic swaps. Figure 1 is illustrated with the example of Stella.

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 1: Single Ledger Atomic Swap (Stella)

Second, atomic swaps across ledgers. Ubin and Jasper’s joint test (Figure 2) and Stella’s test both show that cross-ledger atomic swaps are difficult, mainly because of the flaws in the mainstream cross-chain technology used by central banks – hash time lock. The principle and defects of hash time lock are the content to be discussed in the second part.

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 2: Cross-ledger atomic swap (Ubin-Jasper)

hash time lock

  • Introduction to Hash Timelocks

Hash time locks originate from the Lightning Network and consist of time locks and hash locks:

The meaning of the time lock is that the submission is valid within a certain period of time, and the commitment scheme is invalid (whether it is the proposer or the acceptor) if the timeout is exceeded. If the transaction fails for various reasons, the timelock allows the parties involved in the transaction to get their funds back and avoid losses due to fraud or transaction failure.

The meaning of hash lock is that, for a hash value H, if the preimage R is provided such that Hash(R) = H, the promise is valid, otherwise it is invalid. Hash locks take advantage of the irreversibility of hash functions.

In the hash time lock, the transmission of the preimage and the hash value can be completed off-chain, and only the relevant content is checked on the chain. But no matter what form hash timelocks take, there is one core feature: preimages (information) and funds flow in opposite directions, so preimages can be viewed as receipts.

  • Simplified example of hash time lock and sequential game analysis

Regardless of the complex form hash timelocks take in practical applications, the core can be expressed as the simplified example shown in Figure 3.

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 3: Simplified example of a hash timelock

In this simplified example, Alice wants to open a transaction with Bob with a transaction amount of 0.5 BTC, but Alice needs to go through Carol to establish a channel with Bob for the transaction. The operation steps of the hash time lock are:

Bob sets the preimage R and tells Alice the hash value H=Hash(R).

Alice makes a conditional payment to Carol through HTLC: Alice pays Carol 0.5 BTC if and only if Carol provides the preimage R corresponding to the hash value H before time T. Similarly, Carol makes a conditional payment to Bob via HTLC: Carol pays Bob 0.5 BTC if and only if Bob provides the preimage R corresponding to the hash value H before time t, where t < T.

If Bob provides R to Carol before time t, he gets 0.5 BTC, and Carol knows R at this time. Conversely, 0.5 BTC will be returned to Carol, and Carol will not suffer any losses.

If Carol provides R to Alice before time T, she gets 0.5 BTC. Conversely, 0.5 BTC will be returned to Alice, and Alice will not suffer any loss.

This simplified example can be formulated as a sequential game and solved by reverse induction (Figure 4). The triples in Figure 4 represent the returns of Bob, Carol, and Alice under different strategy combinations in turn.

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 4: Sequential game and solution related to hash time lock

The analysis of the sequential game shows that under the premise of the rationality of the participants, the sequential game can obtain an ideal equilibrium result; but if there is an intermediate node that cannot conduct transactions for some reason, it must wait for the time lock to expire before refunding, and if sending Anyone who changes the path before the time lock expires will take great risks.

  • Central Bank Experiments with Hash Timelocks

The practical application of hash timelocks by central banks is much more complex than the simplified example above. Table 2 compares the five cross-chain technologies used by the European Central Bank and the Bank of Japan’s Stella project and their respective characteristics. The core of them is hash time lock. The Bank of Canada and the Monetary Authority of Singapore are also using hash timelocks in trials of blockchain-based bond-payment and simultaneous foreign exchange settlements.

Table 2: Cross-chain technologies used by the Stella project

Zou Chuanwei: Economic Analysis of Cross-chain Technology

The above-mentioned central bank’s experiments on hash time locks have reached a consistent conclusion: hash time locks may fail under certain conditions, resulting in unsatisfactory game equilibrium results, but this shortcoming has not been resolved so far.

Additionally, hash timelocks lack economies of scale in applications. Assuming that N institutions use hash time locks for securities transactions or foreign exchange transactions, it is necessary to establish a hash time lock transaction channel of the magnitude of N^2. This is obviously uneconomical as N increases.

  • Point Time Lock (PTLC)

Point time lock is an improvement that is still being discussed in the field of Lightning Network, mainly to improve the privacy and security of transactions. A simplified example of a point time lock is shown in Figure 5.

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 5: Simplified example of point time lock

The point time lock operates as follows:

The sender generates two random numbers x and y, the receiver generates z and settles Z=z*G (G is the base point on the elliptic curve);

The sender tells the receiver x and y, and the receiver tells the sender Z;

The sender tells the intermediate node y and (x+z+y)*G, and requires the intermediate node to send x+z within T time;

The intermediate node requires the receiver to send x+z+y within time t, where t<T.

The core of point time lock is to replace the hash function used for hash time lock with the point multiplication function on the elliptic curve. Like the hash function, the point multiplication function on the elliptic curve is also irreversible, but it has linear characteristics and supports the combination and distributive laws of multiplication, so it can support more complex information interaction. But aside from these differences, the point time lock is the same as the hash time lock in the core mechanism, and it can also be expressed as a sequential game similar to Figure 4. The reverse induction method is also applicable, and even the game equilibrium result is the same. Therefore, point time locks also suffer from the same drawbacks as hash time locks.

Asset Bridge and Corridor Networks

  • Example of Asset Bridge – WBTC

In the field of encrypted assets, WBTC is currently the most successful asset bridge project. Like the Lightning Network, WBTC also helps to solve the scaling problem of the Bitcoin blockchain system, but its scale is much higher than that of the Lightning Network, which shows the advantages of asset bridges over hash time locks.

The core design of the WBTC project is to use the centralized custody operation method to lock the Bitcoin of the Bitcoin network as a reserve, and issue the ERC20 token WBTC that can be exchanged 1:1 on Ethereum. The core participants of the WBTC project include:

Custodian: BitGo is responsible for keeping the private key of Bitcoin and minting WBTC;

Operators: Agents between users and custodians, apply to the custodians for the minting and destruction of WBTC in batches according to supply and demand, and distribute WBTC to users in their respective operating systems;

User: Holds WBTC and can transfer WBTC on the Ethereum network, and does not have the right to apply for issuance and redemption of WBTC;

WBTC DAO members: It consists of the private key holders of a multi-signature contract, which controls the modification of WBTC-related smart contracts, the increase or decrease of custodians and merchants.

  • Other Embodiments of the Asset Bridge Thought

In fact, the application of the asset bridge idea is not limited to cross-chain problems in the blockchain field. In the area of ​​money and payments, the closest thing to an asset bridge is e-money (Figure 6).

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 6: Operation mechanism of e-money 1 

According to the Bank for International Settlements (BIS) Committee on Payments and Settlement Systems (CPSS, now the Committee on Payments and Market Infrastructures CPMI) 2012 definition 2, e-money has 4 elements: 1. The monetary value expressed in terms of the right to claim the issuer 2. Deposited in an electronic device; 3. Issued based on prepaid value; 4. Accepted outside the issuer as a payment instrument. The core feature of e-money is that it can be redeemed at face value into its anchored currency, including Alipay and WeChat Pay in my country, Paytm in India, M-Pesa in Kenya, and U.S. dollar stablecoins such as Paxos and USDC. e-money represents the prepaid monetary value, which is circulated among different users, and has a special account system to ensure the efficiency and security of payment.

Comparing with my country’s non-bank payment, the e-money mechanism can be well understood. After the user recharges the non-bank payment institution, the non-bank payment institution will increase the balance of the user’s payment account by the same amount while depositing the reserve fund in the People’s Bank of China. Transfers between users only affect their payment account balances, not the reserves in the People’s Bank of China. When a user withdraws cash, the non-bank payment institution deducts the balance of the payment account and transfers the corresponding amount from the reserve fund to the user’s bank deposit account. Compared with bank accounts, payment accounts can better access online payment scenarios such as e-commerce and social networking. Essentially, it is based on the idea of ​​asset bridge to open up the connection between payment systems and e-commerce and social systems.

In addition, the “wholesale-retail” two-tier operation structure composed of “custodian-operator-user” in the WBTC project also has many applications in the mainstream financial field. This is the case with the two-tier operating structure of the central bank’s digital currency. The same is true for the distinction between the primary market and the secondary market of exchange-traded funds (ETFs): in the primary market, authorized participants (AP) participate in the purchase and redemption of ETF shares; investors buy and sell ETF shares on the stock exchange, constitute the ETF secondary market.

  • Corridor Networks and Multilateral Central Bank Digital Currency Bridges

The concept of the Corridor Network originated from the simultaneous foreign exchange settlement experiment jointly carried out by the LionRock project of the Hong Kong Monetary Authority and the Inthanon project of the Central Bank of Thailand (Figure 7). The core mechanism of the corridor network is to “map” the two central bank digital currencies into the same blockchain system (that is, to issue depository receipts on the corridor network based on 100% of the central bank’s digital currency reserves), so that the same blockchain system supports A variety of central bank digital currencies. In this way, the synchronous settlement of foreign exchange occurs on a single ledger and does not involve cross-chain operations.

Zou Chuanwei: Economic Analysis of Cross-chain Technology

Figure 7: Corridor Network

Based on the corridor network, the Bank for International Settlements proposed the concept of a multilateral central bank digital currency bridge (Multi CBDC Bridge), which has four core characteristics. First, the cross-ledger problem is transformed into a single-ledger problem, which does not involve cross-chain operations, and is easy to implement atomic swaps through smart contracts. Second, it is compatible with different central bank digital currency systems and designs. Third, a multilateral central bank digital currency bridge can connect multiple central bank digital currencies, with good scalability and obvious network effects. Fourth, the impact of the central bank’s digital currency’s overseas circulation on the currency sovereignty of other countries has been alleviated.

On February 23, 2021, the Hong Kong Monetary Authority, the Bank of Thailand, the Central Bank of the United Arab Emirates and the Digital Currency Research Institute of the People’s Bank of China announced the joint launch of a multilateral central bank digital currency bridge research project. The project is supported by the Bank for International Settlements Hong Kong Innovation Centre. On September 2, 2021, the Australian Central Bank, the Bank Negara Malaysia, the Monetary Authority of Singapore and the South African Central Bank launched the Dunbar project with the support of the Bank for International Settlements Singapore Innovation Center, which is also to explore the application of multilateral central bank digital currency bridges. In general, new international financial infrastructure and governance mechanisms may emerge around the “wholesale central bank digital currency + multilateral central bank digital currency bridge”.

Summary and questions for further research

First, although there are many researches and experiments on cross-chain technology in the blockchain field, the only ones that are really widely used are hash time locks and asset bridges.

Second, hash time lock does not rely on centralized institutions or trust assumptions. Starting from the rationality of the participants, it relies on sequential games to obtain ideal equilibrium results, but the possibility of failure cannot be ruled out. Is there a better game theory design for this flaw?

Third, asset bridge has a certain centralization color, but whether it is in the field of central bank digital currency or in the field of encrypted assets, the current application situation is better than hash time lock. Which links in Asset Bridge can introduce distributed design? Does distributed design constitute a Pareto improvement in safety and efficiency?

Fourth, is cross-chain technology also subject to the “trilemma” (decentralization, security, and efficiency cannot have both)? From the comparison of hash time locks and asset bridges, I think the “triple paradox” is true.

Fifth, the relationship between cross-chain technology and interoperability in general.

[1] Source: Chiu, Jonathan, and Tsz-Nga Wong, 2014, “E-Money: Effciency, Stability and Optimal Policy”, Bank of Canada.

[2] CPSS, 2012, “Innovations in Retail Payments. Report of the Working Group on Innovations in Retail Payments”.

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