February 8, 2022

Bridging liquidity - Market-making Perspective

1. Stepping in the era of cross-chain bridges

One of the biggest challenges with blockchain technology is the ability for these networks to communicate with each other, often referred to as interoperability. While the three major hurdles all blockchains have to face are:

  1. Scalability: being able to grow constantly.
  2. Security: how secure a network is.
  3. Interoperability: the ability for cross-chain communication.

Blockchain interoperability is the process of operations between two or more blockchains, in layman's terms, the process that is required when information from one blockchain is sent or received by another blockchain or blockchains.

Interoperability is becoming one of the key themes in the crypto industry for 2022 as more and more networks are becoming compatible with EVM (Ethereum Virtual Machine). As a result of having various networks, all with their own pros and cons, combined with the continuous creation of more blockchains that aim to improve on their predecessor, there is no obvious blockchain that will dominate the market in the next 5, 10, or even 20 years. As a result there is an increasing demand for cross-chain bridges that allow users to move their assets between the various blockchains.

Therefore, as the blockchain industry continues to grow, the multi-chain and bridge era will follow in parallel. DefiLlama reports that there are currently 12 blockchains with more than $1 billion in TVL (total value locked), with an additional 22 blockchains having over $100 million in TVL. Undeniably, cross-chain bridges have become a vital infrastructure in the crypto world and demand for such solutions will only grow.

Each blockchain has its native token, ETH for Ethereum, BNB for Binance Smart Chain, etc., which are used for transaction fees on their respective network, while native tokens are not exclusively used for transactions. For example, suppose you wished to swap your ETH for another token, but due to low liquidity, you could only complete your swap with high slippage. In that case, it might be in your best interest to bridge your ETH to another network to be able to complete the trade on another exchange that has lower slippage.

These cross-chain bridges often connect the big names, such as Bitcoin and Ethereum, to faster networks such as Polygon and Lightning. While all are still blockchains, the layer 2 platforms speed up the process of completing transactions, often at a fraction of the price. Therefore, technically, any blockchain could be a layer 2 to any other chain but would only provide utility if it enhanced the user experience through faster and cheaper transactions.

2. What is a cross-chain bridge and how does it work?

So what exactly are cross-chain bridges, and how do they work? Simply put, it's a bridge from one blockchain to another. Commonly referred to as a 'bridge' or 'blockchain bridge" is a set of code that includes smart contracts that allow for the transfer of tokens, data, instructions, and smart contracts events from one chain to another despite different protocols and governance models of the respective blockchains. Thus, the bridge ensures that the blockchains interoperate in a secure manner.

To summarise, blockchain bridges allow for users to:

  • Transfer digital assets between blockchains in a secure way
  • Intuitive user interfaces to allow for straightforward transactions
  • Benefit from faster transactions and lower fees when coming from slower networks
  • Implementation of dApps across various blockchains

But how exactly does a cross-chain bridge work?

To simplify, let's assume you want to travel internationally, but you would like to drive your car on your holiday. Let's say you are in New York and want to travel to London. In this case, the cities would be the different blockchains while the car represents any asset you wish to move. Therefore, you would take your car to a dealership in New York and store it there. The dealership would then inform their London office to create an identical replica of your car, but adhering to all the rules and regulations of the UK. Then as soon as you plan to return from your trip, you bring the car back to the dealership in London, and when you return to New York, your original car is waiting for you.

While the principles don't change, the terminology and process are slightly different. You have the 'main chain' (where you initially hold your assets) and the 'side chain' (where you wish to send your assets). Contracts on each side of the bridge ensure that the transfer takes place securely. Additionally, on the side chain, another contract allows the minting of the asset on the new network (adhering to the protocols and governance models). By contrast, the smart contract on the main chain only locks up your asset. Therefore, when users want to use the bridge, their assets are first locked on the cross-chain bridge smart contract, which triggers a signal to the side chain to start minting the locked asset through the smart contract. It's important to note that when the bridge is used from the side chain to the main chain, the token is instead burnt, and the original token is released on the main chain side instead of the process repeating.

3. Are there any problems with the bridges? Vitalik Buterin criticism

While the use of blockchain technology continues to evolve, Ethereum co-founder Vitalik Buterin has stated that the ecosystem's future will be multi-chain rather than one blockchain standing above the rest. Therefore, one would assume that Buterin favors the cross-chain bridges. However, Buterin has publicly stated on Twitter and Reddit that the technology is not advanced enough and is highly subject to security flaws. Furthermore, he highlights the issues with the basic infrastructure of each blockchain being different and suggests that this will ultimately lead to the failure of cross-chain bridges.

While Buterin doesn't mention it in his recent posts, another criticism of bridges is the fees for using the bridge. And while you might save by using an exchange on another network, you need to consider the costs of bridging your assets. While these fees are often a set rate, some bridges also take a small percentage of the asset being bridged.

4. Market-making perspective

With the development of the DeFi industry, both centralized and decentralized exchanges (CEXs & DEXs) have an all time high demand for liquidity. A wave of multi-chain token launches triggered the need for bridging liquidity, hence the importance of the cross-chain bridge. Furthermore, it plays a significant role as it allows the users and the projects themselves to move liquidity from one chain to another. Cross-chain volume becomes an important growth indicator for the token to remain successful. Therefore, cross-chain market-making becomes essential for token projects to sustain liquidity on different chains and exchanges.

Liquidity platforms require cross-chain volume to aid in the platform's development; however, a high volume of transactions in one direction can dry up the liquidity on the opposite side resulting in a cross-chain arbitrage opportunity. Thus, one can benefit by simultaneously  buying and selling the same asset but in different markets, generating  profit from price differences in the asset's listed price. Market-makers can benefit from cross-chain arbitrage, while rebalancing liquidity across networks and allowing volumes to scale and maintaining cross-chain price equilibrium.

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