Understanding Cross-Chain Bridges Under a Multi-Chain Background

Since the development of blockchain technology, the industry’s market structure has changed to center on Ethereum along with multiple coexisting chains. In terms of practical application, DeFi, NFT, GameFi, Web3, and other such ecosystems are developing very rapidly. Unfortunately, this growth has exposed Ethereum’s insufficient underlying performance problems. On top of that, high gas fees and network congestion continue to hinder the ecosystem’s expansion. As if this weren’t enough, some people seek to “rescue themselves” from Ethereum, focusing their attention on either Layer 2 or other public chain options.

In 2020, the development of DeFi was seriously lagging, and many emerging public chains boasted lower fees and shorter confirmation times. Good examples of this included BSC, Solana, Terra, Avalanche, Fantom, Polygon, Arbitrum, Optimism, and Harmony, to name a few. Despite this, Ethereum remained the top choice for most DeFi projects, mainly due to the network’s high liquidity and transaction volume. But in the current DeFi era, where "liquidity is king," major public chains are using their high APYs to attract users. Indeed, according to statistics from DeFi Llama, the total value locked in DeFi on Ethereum had exceeded $161.5 billion as of October 22, 2021. Other public chains, such as BSC, Solana, and Avalanche, had achieved values of around $78 billion, forming a scale that simply cannot be underestimated.

Essentially, the traffic that had initially accumulated on Ethereum was divided bit by bit until a fragmented “value island” had been formed. This phenomenon has only been further exacerbated by the increased number of Layer 2 projects that have cropped up over the past two years. In essence, the coexistence of multiple chains is the new market pattern. As more public chains appear, Layer 2 projects continue on, and respective ecosystems improve, the demand for cross-chain asset transfer will explode.

Understanding Cross-Chain Bridges

Put simply: a cross-chain bridge is a chain-to-chain connection that allows the transfer of tokens and assets from one chain to another. Since nearly all chains have their own protocols, rules, and governance models, they aren’t interoperable on their own. However, these bridges can facilitate communication and trade by making the two chains compatible with one another.

Most cross-chain bridge designs include the following components:

• Oracle or Validator – This is responsible for monitoring the status of the source chain.
• Relayer - Transmits the information from the source chain to the target chain once the monitoring role receives the event.
• Consensus mechanism - In some modes, a consensus needs to be reached among the participants monitoring the source chain before this information can be relayed to the target chain. The consensus mechanism is designed to accomplish this.
• Signature - Participants are required to sign the information sent to the target chain cryptographically. This can be accomplished individually or as part of a multi-signature.
  

In summary, most cross-chain bridges on the market are two-layer extended versions. Most of these - such as Arbitrum Bridges, Optimism Bridges, Polygon Bridges, etc. – are built on Ethereum. Since its DeFi ecosystem is relatively mature, other public chains see their primary goal as achieving cross-chain asset transfer with Ethereum. Of course, the current cross-chain bridge mainly serves the liquidity providers. This helps drain traffic for their own DeFi ecosystems, providing that there is enough APY to drive that traffic.

It’s important to note that the rapid development of EVM-compatible chains and Layer 2 over the past year has allowed the network based on the Ethereum virtual machine to become increasingly diversified. In turn, people are gradually starting to realize that cross-chain asset transfer has more demand than previously anticipated.

Market Performance of Cross-Chain Bridges

According to the data monitoring of Dune Analytics, as of March 28, 2022, the total value locked (TVL) of the 17 major cross-chain bridges included in the Ethereum overtime had reached approximately $25.2 billion. Of this, the current TVL of The Polygon was the highest ($5.8 billion). Next in line was Avalance Bridges, which boasted a TVL of $5.47 billion. The following bridges with top TVLs were Arbitrum Bridges, Ronin, and Fantom, which were still reported as a respectable $3 billion+.

At present, the Top 10 projects all had TVLs equivalent to more than $100 million. Of course, there are at least 100 cross-chain bridge projects on the market, all of them falling into one of four distinct categories.

• The first category includes official bridges like Wormhole, which is based on Solana, and the rainbow bridge, which is based on NEAR. These types of bridges offer nearly guaranteed levels of safety.

• The second category includes more professional and asset-based bridges, such as Ren Protocol, Keep Network, DeCus, and pNetwork. These tend to be alternative cross-chain bridges that focus on connecting Bitcoin to other networks. Unfortunately, they tend to be disadvantaged in their lack of capital efficiency.

• The third category includes third-party bridges with high versatility, such as Poly Network, Celer, Anyswap, Hop Protocol, and Synapse Protocol. Such third-party bridges have received widespread attention, putting them on the radar of many industry experts.

• The fourth category includes cross-chain bridge aggregators, which are still in the relatively early stages. The category’s central concept involves automatically matching and recommending the best cross-chain solution for every user. To do this, they plan to aggregate mainstream cross-chain bridges according to need.

  
  

Third-Party Cross-Chain Bridges

As Ethereum continues to expand, Layer 2 has come a long way. Currently, the ideal L2 solution involves the use of Rollups like Arbitrum, Optimism, StarkNet, and zkSynch. With Rollups, the goal is to package transactions that occur within a given period of time into a batch, then store the transaction data in the read-only area of the Rollup block. Once in place, that data can be published on the main chain (Ethereum) so that everyone can obtain L2 transaction data at any time. This will help monitor transactions by forming a consensus between the two layers.

Rollup utilizes a series of compression schemes in order to process the original data and upload only a portion. The Merkle tree and the trusted proof calculations are performed off-chain, but the root hash of the Merkle tree and part of the transaction data are stored on the chain. Because of this distinction, it is critical that all off-chain activities be verified.

Based on the difference in the proof method, there are two main schemes: ZK Rollup and Optimistic Rollup. ZK Rollup uses ZK SNARK cryptographic proofs, while Optimistic Rollup uses a fraud-proof/challenge mechanism. The latter requires a reasonable economic model in order to incentivize verifiers to participate in the process. At the same time, they need to disincentivize potential bad actors. Arbitrum Rollup's verification method also relies on fraud proofs, but with an improved challenge process.

For fraud-proof/challenge mechanisms, some L2 solutions have security models that, in the interest of speed, aggregate transactions into batches before submitting them to the L1 Ethereum via a single transaction ( a process known as “assertion). These transactions are assumed to be valid by default but can be challenged down the line if fraud is suspected. Such a challenge will have a time window during which disputes can occur.

That said, if a challenge is issued and upheld, the transaction behind the incorrect block will be deleted and “rolled” back. Because of this mechanism, users withdrawing assets from L2 to L1 will, in some instances, need to wait for an additional 7-days. Such challenge periods are currently in place on Optimism, Arbitrum, and several others.

Therefore, without using third-party cross-chain bridges, users that wanted to transfer the ETH on Arbitrum to Optimism would need to return the ETH (Arbitrum Ethereum) on Arbitrum (L2) to ETH (L1) first. After that, they would need to wait 7 days before transferring the received ETH to the Optimism bridge. This is both a costly and time-consuming withdrawal period. In fact, this specific scenario is why a group of bridges is being implemented to provide cross-chain services between L1 and L2.

On the whole, third-party cross-chain bridges are faster than official bridges, and there is no 7-day waiting period to withdraw assets from L2 to L1. That said, users need to pay extra to the market makers or protocols that provide cross-chain asset liquidity. This helps discount the time value of assets, reducing the potential loss caused by the 7-day vacancy.

The Business Logic of Third-Party Cross-Chain Bridges

To better explain this concept, let’s take a look at Hop Protocol, an early project of the third-party cross-chain bridges. Hop Protocol was created in January 2021 and functions as a Rollup-to-Rollup asset cross-chain bridge. When using Hop's solution, however, assets need to be transferred to the Layer 2 network through Hop itself. For example, ETH that enters the second layer through Hop's cross-chain bridges would become Hop ETH (or hETH).

hETH and ETH are completely equivalent – that is, they can be exchanged through Hop. In terms of its specific implementation, Hop is mainly completed by the automatic market maker (AMM) and the Bonder. Basically, the Hop Protocol converts the user's Token into hToken, and then uses the Hop Bridge to transfer the hToken from Rollup 1 to Rollup 2. As of this writing, the Bonder has provided early liquidity for hToken in Rollup 2. This means Hop's AMM can automatically help users convert hToken into Token of the target chain, thus eliminating the 7-day withdrawal period.

Key Users of the Third-Party Cross-Chain Bridges

Hop Protocol requires two types of key users.

The first is the arbitrageur. This is a user who buys tokens on one exchange and sells them for profit on another when there is slippage in the token’s price. Using Hop as an example, these users arbitrage on the spread between "hToken" and canonical tokens (such as hETH and Arbitrum ETH) on the Hop Rollup AMM and different Rollups. Eventually, as liquidity rebalances across AMMs, the price stabilizes.

The second type of user is known as a liquidity provider. Similar to other AMMs like Uniswap, anyone can become an LP of the Hop pool, thus earning transaction fees. And since the liquidity of Hop AMM is provided via the same underlying assets (hETH, Arbitrum ETH, etc.), these can basically be redeemed for an equivalent amount from the mainnet. This ultimately has the effect of drastically reducing the risk of impermanent losses to LPs.

Hop Protocol is an early project of the cross-chain bridge track, and one of the few to actually be delivered. The operation experience is very smooth, but it also has “first-mover” advantage. The initial operation of Hop began in early 2021, and business volume has grown rapidly since June of that year. In fact, the TVL has grown from less than $100,000 to $129 million, with liquidity mainly concentrated on Ethereum. At present, the growth rate has slowed down slightly, but the overall situation remains promising.

According to the team's data at the end of 2021 , more than 60% of TVL was staked in the AMM liquidity pool, allowing seamless exchange between hToken and canonical token. The rest was staked by Bonders (market makers), who provided early liquidity to users of the target chain. The cumulative number of users of Hop Protocol had also grown to more than 50,000, and the business development data remains quite impressive.

Looking out across the market, we can see many products in the cross-chain bridge track, with fierce competition all around. Indeed, the recent TVL of the track leader Multichain is as high as $7.67 billion. What does this mean for the future? Well, it means that when cross-chain bridges are fully developed, they will need to allow seamless cross-chain assets transfer on each chain. To complete this seamless process, the cross-chain bridges need to:

• Be able to support both EVM and non-EVM compatible public chains.
• Solve the “impossible triangle” of interoperability protocols (no need for trust, scalability, information universality). And while the problem may actually be very difficult, it can be continuously improved upon via the corresponding short board.
• Have sufficient security, preferably to the point where there will be no need for trust.

On the whole, the cross-chain bridge track already has a solid business foundation underneath it. Moreover, users demand for cross-chain bridges will always exist, so it will always be worthy of attention.

Disclaimer

Views expressed below are the analytical views of the LD Capital. They should not form the basis for making investment decisions nor be construed as a recommendation or advice to engage in investment transactions. All information in this report comes from publicly disclosed sources. The viewpoints and forecasts only represent analysis and judgment as of the release date, and does not stay valid permanently.

LD Capital is a leading crypto fund that is active in primary and secondary markets, whose sub-funds include dedicated eco fund, FoF, hedge fund and Meta Fund.