DeFi
Interoperability by design can help catalyze DeFi growth
Decentralized finance has enormous potential in terms of accelerating access to financial services, but for all its promise, it faces a major limitation in terms of interoperability. Today, most DeFi platforms are effectively “walled gardens,” limited to the blockchain network they were built on. For DeFi to reach its disruptive potential, seamless interoperability is necessary.
By removing the barriers between blockchains, we can exponentially increase the utility of DeFi, allowing the sector to grow from the fragmented and limited capital pools that characterize the current ecosystem. Interoperability between DeFi protocols will create a more fluid, connected, and global alternative financial system that benefits all users.
Why is interoperability critical for DeFi?
Cross-chain interoperability is essential for DeFi because it leads to compounded network effects, multiplying collective value across chains through synergies between specialized protocols. Users will have access to a more diverse range of digital assets and applications, while leveraging the unique performance characteristics of each blockchain, while benefiting from reduced costs.
Interoperability will also help reduce competition and platform duplication, as new projects will need to innovate more and work together rather than simply copying the functionality of protocols on other chains. Additionally, it will improve liquidity, as assets will be able to flow more freely across networks.
Finally, interoperability will help DeFi become more resilient to outages, as problems on one blockchain will not impact any other network.
If DeFi does not have interoperability, DeFi ecosystems will remain fragmented, limiting users’ access to liquidity and preventing them from interacting with a more diverse range of crypto assets and features.
Connecting Fragmented Ecosystems
Blockchain Bridges are the most common method of interoperability and can be constructed in several ways. For example, many bridges use atomic swaps, which can be thought of as a decentralized repository that allows value to flow between chains in a peer-to-peer manner, without the need for third parties. To move assets across the chain, parties create a smart contract with time constraints attached. Transaction parties can deposit their tokens into this smart contract, which is programmed to execute only when predetermined conditions are met. Atomic swaps rely on the Hashed Time Lock Contract (HTLC) technique, which guarantees that if the specified conditions of the contract are not met, the assets will be returned to those who deposited them.
Another way to bridge funds across chains is through wrapped assets, which are 1:1 representations of assets hosted on other chains. For example, wBTC is a wrapped Bitcoin that resides on the Ethereum blockchain. Since Bitcoin is not compatible with Ethereum, users cannot simply transfer BTC to an ETH wallet. Instead, they can deposit their BTC with a custodian who locks it in a smart contract, providing the user with wBTC at a 1:1 ratio to the amount of BTC deposited. wBTC assets are an ERC-20 token that resides on the Ethereum blockchain and provide a way to use BTC in various dApps built on that network.
Bridge Safety Compromise
Although cross-chain bridges have been adopted to some extent by DeFi protocols, their use is not without risks. On the one hand, many bridges introduce centralization by relying on third-party custodians, who hold funds locked in smart contracts on behalf of users.
Not all bridges are centralized and not all rely on deposits. For example, some bridges secure value transfers between chains using collateral from miners and stakers, but these models have shown that attracting sufficient liquidity is a challenge. Other blockchain bridges attempt to increase performance by relying on a more limited set of validators, but this increases the opportunity for malicious actors to compromise their protocols.
Other issues with blockchain bridges include vulnerabilities written into their underlying code and a relatively low level of maturity, with many being young products that have yet to demonstrate their robustness.
While blockchain bridges broaden the horizons of DeFi users, they also require rigorous testing and validation to ensure their security, and even then, many of the most trusted bridges still fall victim to hackers — the $325 million hack the Wormhole Bridge in 2022 is a great example.
Interoperability by design
The alternative to bridging assets across chains is to use specialized blockchain infrastructures designed with interoperability in mind. These blockchains introduce architectures that enable the creation of interoperable, yet independent chains with flexible sovereignty that operate in parallel to the main foundational chain.
One of the most famous examples is Cosmos, which is an ecosystem of autonomous blockchains that uses the Inter-blockchain communication protocol to facilitate cross-chain interactions across the network.
The IBC protocol allows compatible blockchains to send and receive messages with each other, similar to how the internet enables instant messaging via WhatsApp, Messenger, and other services. IBC is a blockchain-agnostic standard, meaning that no single entity controls it, and it relies on multiple consensus mechanisms, ensuring that each blockchain can maintain its diversity while communicating with others.
Welus provides a good example of how IBC works. Nolus is a DeFi protocol that aims to eliminate the oversizing requirements of traditional DeFi dApps via its concept of “DeFi Leases”, increasing capital efficiency while providing better terms for borrowers.
It uses IBC to operate various liquidity centers across the entire Cosmos ecosystem, avoiding the asset fragmentation that persists across chains. It can trade multiple assets from different Cosmos chains on the fly, using any DEX platform it supports.
Nolus aims to eliminate the over-collateralization requirements of traditional DeFi dApps through its concept of “DeFi Leases,” improving capital efficiency while offering better terms to borrowers.
With its unique level of interoperability, Nolus can source capital from multiple liquidity sources without causing asset fragmentation across different networks. It is able to lend and trade assets from any DEX integrated into its platform. This helps streamline the lending process for users by eliminating the need for multiple liquidity pools for different assets.
Interoperability will catalyze DeFi
DeFi’s interoperability will be a catalyst for greater adoption. In some ways, this can be compared to how individual countries gain strength by joining forces with other nations to collectively overcome challenges that would be insurmountable if attempted alone.
By uniting blockchains in the same way, DeFi will increase its resilience and be able to overcome larger obstacles than any single dApp could overcome alone. Interoperability provides a platform for greater cooperation and more innovation, fostering a more inclusive and fairer digital economy that harnesses the enormous potential of DeFi.
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