DeFi Interoperability: A beginners Guide
An extremely crucial yet overlooked element of the DeFi ecosystem is interoperability. This is your comprehensive beginners guide to DeFi interoperability. Hope you enjoy!
If you’ve been reading about or keeping up with the DeFi space, chances are that you’ve heard the word ‘interoperability’ thrown around. That’s for good reason. Interoperability is one of the most important hurdles that the DeFi space is yet to cross. If you know about blockchains then you know that every blockchain is faced with a trilemma between Security, decentralization, and scalability. Hence, every blockchain is likely to have some drawbacks. This is where the importance of interoperability comes in. A way to harness all the benefits while trying to avoid the drawbacks. But before we get into what interoperability looks like in DeFi, let’s understand what it means in a traditional sense.
When we use fiat currency to make any purchase, we just tap our cards or use our mobile wallets and make the payment and that’s it. We don’t know what goes on behind the scenes as long as our experience is seamless. Regardless of location, bank, or type of currency our transactions go through with extreme ease. This is in essence what interoperability is about. It is the systems setup in the backend which allows different institutions to interact with one another and different currencies to be transferred amongst one another completely seamlessly. Say you have a Canadian bank card and have just landed in India and haven’t withdrawn any Indian rupees and you really want to buy a bottle of water. You can simply swipe your card and the transaction will go through instantly although you will have to pay a fee for it. This is the seamless interoperability that the DeFi space is missing. If you want to transfer assets from one chain to another you will have to go through rather tedious processes of first wrapping the asset, then bridging it to another chain, then unwrapping it or using that wrapped asset for other things. For a casual user anything other than one quick transaction is tedious. As it should be.
Interoperability in the context of DeFi refers to when multiple blockchain systems can ‘cross-communicate’ or interact with each other and exchange value completely seamlessly. If you have read any of my previous articles, then you may already know how beneficial the technology presented by the DeFi ecosystem can be for the world. However, achieving meaningful interoperability can completely change the game. The reason why I’m giving so much importance to the achievement of interoperability is because it will simply improve the user experience. When it comes to an issue as important as personal finances it is no secret that having an easy and simple experience is what will attract the most users. Nobody wants to sit and read 25 different whitepapers about the benefits and drawbacks of every chain just to be able to use DeFi. Hence, if we want to see meaningful growth in the space the next step has to be interoperability.
Below I will go through a list of different protocols that are working on interoperability and their unique solutions to the problem. The explanations below will be simplified, so if you are looking for a high-level and very technical analysis then I apologize.
Current solutions:
There are two general types of interoperability we see today. One is the development of a chain dedicated to interoperability and the second is focused on making it easier to move certain assets across chain. To being with, I will go over the second method.
Atomic Swaps
Atomic swaps can be looked at as decentralized version of escrow accounts. It allows the exchange of value across different chains in a peer-to-peer environment without the need for a centralized third party. Much like an escrow account, two parties create a contract with the conditions pre-define by the two parties and there is a time constraint attached to it. The two parties can then deposit the tokens into this contract and only when all the conditions of the contract are met will the transaction take place.
But, how does it work? You may ask. A key technical feature of atomic swaps is something known as the Hashed Time lock Contract (HTLC). The HTLC contract uses an encryption mechanism known as a has function in addition to having a time constraint feature. This combination makes the contract such that if any side of the bargain isn’t met then the funds are returned to the party’s involved. The two main components of a HTLC is the hashlock key and the timelock key. The hashlock key ensures that the transaction goes through only when both Party’s provide cryptographic proof while the timelock feature ensures that a deadline can be set and adhered to for the transaction to go through.
Wrapped Assets
Wrapped assets are a 1:1 representation of the price of a certain asset which is hosted on the Ethereum blockchain as ERC-20 token. Let’s look at an example of the most popular wrapped asset. Say you own a certain amount of Bitcoin (BTC) but since it’s only on the Bitcoin Blockchain you can’t do much with it, you want to put it to use either to trade for other alts or earn yield on it. This is where wrapped assets step in. You can convert your BTC to Wrapped BTC (WBTC) and now you have BTC as an ERC-20 token which can be used across the network for different purposes. Similarly, if you have assets in any other chain and want to avoid the costs and lengthy transaction times of bridging across chain you can simply get the Wrapped asset and then use that on Ethereum. pTokens are also similar to wrapped assets in terms of functionality. The key difference is that you can convert any token to be used on any blockchain which increases the usability.
Over the next part of this article I will go over the different blockchains that have been specifically developed to tackle the issue of interoperability.
Avalanche (AVAX)
Avalanche has been one of the hottest topics in the crypto space primarily due to its thermonuclear price rise over the last two months. However, its groundbreaking technology for helping solve the interoperability issues in DeFi is just as impressive.
Avalanche aims to be the so called “platform of platforms” in essence being the one blockchain to solve interoperability. To get a more in depth description of the technicalities of the consensus mechanisms I recommend reading the whitepaper. Avalanche uses a new consensus protocol called gossip which essentially uses elements of the Nakamoto Consensus (Proof-of-work) and Classical consensus (Proof-of-stake) to create its own novel consensus which allows 5,000+ real transactions per second with less than 2 second finality (finality is used to measure the amount of time one has to wait to ensure that their transaction has gone through and cannot be reversed). The real interoperability element is seen through its subnet model (also explained at a high level in the whitepaper) where a dynamic set of validators are put into different subnet groups to achieve consensus and hence each group has its own incentive mechanism which means that different blockchains can be built on top of avalanche with each one being use-case specific. It also allows existing blockchains to port onto the avalanche system. Therefore, creating an almost one-stop-shop interoperability layer for all of DeFi. Lastly, yet most importantly, the fees are extremely low, I’m talking like an average of $0.01-$0.02 which means its accessible to everyone.
Cosmos
The Cosmos ecosystem aims to be the so called “Internet of Blockchains” which as the name suggests it aims to allow seamless communication across different blockchains which is basically interoperability. The primary mechanism to achieve this interoperability is through something known as the Inter Blockchain Communication (IBC) Protocol.
In simple terms, the IBC protocol allows Blockchains to send and receive messages to & from one another much like the internet allows with computers. It is blockchain agnostic which means it is not controlled by one entity nor does it need to be controlled by one entity, it uses a host of different consensus mechanisms to ensure that each chain can maintain its diversity while seamlessly interacting with one another.
Wanchain
Wanchain is a blockchain focused specifically on interoperability. Its key feature that allows DeFi interoperability is the focus on cross-chain asset transfers. It does not deal with data sharing, only trading, investing, lending, borrowing, and exchanges. Wanchain uses a consensus mechanism called storeman nodes which is basically groups of nodes that validate cross-chain transaction. Through this all the major blockchain platforms whether private or public can connect to Wanchain and transfer assets across chains without the need for bridging or changing any of the original properties of the asset. Assets can also be transferred back to the original blockchain without any issues.
Recently, Wanchain and Avalanche have announced a partnership where cross chain transfer mechanisms have been brought onto the Avalanche ecosystem with the aim to allow the development of new Dapps that can harness the power of rapid, non-custodial, and trustless interoperability to create new demand for products in the DeFi space, all while maintaining low fees.
Polkadot
Polkadot was the first project to introduce the concepts of parachains/side chains lead by the prominent tech figure Gavin Woods. After noticing the high gas fees and overload of usage on the ethereum chain, the Polkadot team came up with the idea to have one main chain with multiple use-case specific chains running by its side and these chains can be used to process transactions and validate transactions which reduces the stress on the ethereum chain or any other chain which in turn will reduce transaction costs and times making the DeFi system more efficient all around.
The Polkadot system works a little like this, the relay chain is the main polkadot chain which is primarily responsible for the security and consensus of the chain. Attached to the relay chain is the parachain (parallelized chains) which is a bunch of sovereign blockchains that run by the side of the relay chain and can be optimized for specific use cases. Then there is the bridge chain which allows the parachains to connect to external blockchains like Bitcoin, Ethereum etc. So, at every step of the way Polkadot aims to achieve interoperability while trying to relieve the computational stress on the system.
Compound Chain
Seeing Compound here may come as a shock to some of you giving that it’s an industry leader as an autonomous and algorithmic interest rate protocol. However, they released a whitepaper for the compound chain which proposed a next-gen interoperability solution called “Gateway”. Gateway is a stand-alone blockchain whose entire architecture is built around interoperability so developers can use all base layers and not just ethereum. It offers the ability to borrow and lend any asset from any blockchain where interest is paid and earned in gateways native stablecoin $CASH.
It works a little similar to the Polkadot ecosystem in the sense that Gateway is the main chain which has a bunch of “peer” chains running by its side. The difference here is the use of its novel contract technology known as “starport” which connects the peer chains to the gateway chain and allows the locking and unlocking of any asset from any blockchain. The testnet has been live since March 1st 2021 with the launch of the mainnet being imminent.
REN
Ren is a protocol that’s been in the game for a long time and have a unique approach to the interoperability issue. They have the RenVM (Ren Virtual Machine) which uses something called the “token Representation model” where the custodian is responsible minting a 1:1 ratio backed token on another chain in a completely decentralized manner.
0x_nodes
0x_nodes approaches interoperability with a focus on synthetic assets and improving yield strategies. 0x_nodes is essentially a cross chain network that allows the movement of synthetic assets between blockchains. Synthetic assets are basically a tokenized representation of an underlying asset (examples include mirror protocol, synthetix). By enabling the seamless movement of value across blockchains in the form of synthetic assets the potentials for creating new yield aggregating strategies become endless.
0x_nodes does this by using the EVM (Ethereum Virtual Machine) ecosystem to deploy nodes and eventually use that network of nodes to then allow bridging to other chains which then allows the seamless transfer of assets.
Concluding remarks:
As you’ve seen above we have a bunch of very interesting and innovative solutions but we are still yet to see the protocol with the IT factor. This is mainly because all of the projects listed above are still in the experimenting and testing phase to see what works best for interoperability. Recently, Avalanche and Wanchain have been stand outs in terms of attracting users to their platform but I don’t believe that the protocols are ready for mainstream adoption yet. Over the next few years, the systems and solutions will only continue to improve and given the speed at which the DeFi space moves it’s possible that this time next year we will have a ton of new and improved solutions as well.
The product with the “IT” factor is the one that has a superior user interface and user experience such that in just a few clicks a user can make their desired transactions while the blockchain itself maintains the key elements of decentralization, scalability, and security. This sounds easy in theory but is incredibly difficult in practice. However, the developers in the DeFi space are the best in the world at what they do and I have no doubt that sooner or later we will find that interoperability solution that we need
All in all, this guide was to help you the reader understand a little bit about interoperability and its extreme importance in really bolstering DeFi to the next level. With billions of dollars in value already locked into the ecosystem despite interoperability being a major issue, one can only imagine where the DeFi space can reach when true interoperability is achieved.
Thank you for reading,
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