Interoperable DeFi: How Layer 2 Solutions Are Creating Fast, Low Fee Cross-Chain Yield Opportunities
The rising congestion and fees in the Ethereum network is creating more and more DeFi liquidity pools that only big whales can afford to swim in. Over the last year (to May 2021), the number of smart contract calls on Ethereum has more than doubled from 50 million to 109.6 million pushing gas prices into the $15–$28 range for the most popular swap services. Since swaps are more computationally expensive, the fees are higher than those for a basic payment transaction.
To remain competitive, the race is in full swing for crypto decentralised exchanges (DEXes) to provide the lowest fees. Ethereum 2.0 recently started its two-year migration from PoW to the more efficient PoS consensus mechanism, with the end goal to implement shard chains to expand Ethereum’s capacity to process transactions and store data. However, the Layer 1 scalability solution will not arrive soon enough, so DeFi dApps are turning to Layer 2 fixes to improve performance.
Layer 2 is not one solution but an approach to running blockchain operations independent of the main chain to produce various improvements. Sidechains, state channels, bridges, and rollups are improving transaction speed, scalability, interoperability, and privacy preservation for DeFi protocols. What all these solutions have in common is they take the bulk of the work such as processing or computation off-chain while maintaining security on the permissionless mainnet.
Which Layer Can Do the Job?
No one perfect solution is emerging but instead, protocols are cobbling together different approaches to create higher performance DeFi services.
The Layer 1 Ethereum Contender
The leading alternative is a Layer 1 solution, the Binance Smart Chain (BSC) — an Ethereum Virtual Machine (EVM)-compatible chain running in parallel to the Binance Chain using a proof-of-staked-authority (PoSA) consensus mechanism. Swap protocols like PancakeSwap and BakerySwap and lenders Venus and Cream Finance are vying to overtake incumbents like Uniswap and Compound by delivering higher throughput and lower fees on the ultra-fast BSC. The average block time is ~3 seconds versus ~13 seconds for Ethereum. BSC, however, is a largely centralized system and thus is more vulnerable to system failures, and data privacy issues. Separately, BSC has been the victim of a recent rise in DeFi hacks.
Layer 2 Off-ramps
Decentralized Layer 2 solutions that run in parallel to the Ethereum chain but depend on the main chain for security have become a popular alternative.
Polygon’s solution is to build a zero gas base layer to unite them all. The protocol connects Ethereum-compatible blockchains networks into an interoperable Ethereum multi-chain ecosystem. By avoiding fragmentation, the platform retains the network effects, innovation such as advances in cross-chain DeFi on the established tech stack, and high security of the Ethereum ecosystem.
Over 400 dApps have already scaled their performance on Polygon through one-click deployment. The ability to interoperate across blockchain networks through Adaptor modules and benefit from zero-gas transactions has attracted high volume DeFi dApps including the likes of Aave, Curve Finance, and SushiSwap. With the recent launch of a $10.5 million DeFi developers fund with DEX protocol 0x, Polygon aims to entice more DeFi dApps onto its network.
Other solutions include sidechains (Plasma, xDAI) to scale payments, bridges (Binance Bridge, Polygon (MATIC) Bridge) for cross-chain assets, and rollups (Starkware, Optimistic, Findora) to run smart contracts at scale.
Rolling With Rollups
Ethereum co-founder Vitalik Buterin views rollups as the interim scalability solution while awaiting Ethereum 2.0. Rollups aggregate many transactions into one Ethereum contract off-chain to improve transaction speed and lower costs. Computation and transaction processing are performed off-chain while the final result is stored on-chain. Since less data is being transferred on-chain, the gas costs are significantly lower.
Zk-rollups and Optimistic rollups are the two most popular forms. Optimistic rollups depend on others to produce fraud proofs of an incorrect computation whereas Zk-rollups provide cryptographic proof called Zk-SNARKs. Zk-rollups are a type of zero knowledge proof (ZKP), a clever privacy preserving algorithm that confirms a fact (e.g., transaction data) is true without revealing its content.
Based on innovative new use cases in DeFi, gaming, and other sectors, many believe rollups have a very bright future ahead. Several DeFi platforms, including Synthetix and Uniswap, have recently integrated Optimistic rollups to slash the gas fees on swaps. China’s large blockchain ecosystem BSN (Blockchain-based Service Network) has integrated the Findora blockchain to protect data privacy in decentralized financial services transactions.
Layer 2 Solution Shortcomings
Composability
Layer 2 does come with trade offs owing to the fragmentation of off-chain transaction processing. One big drawback of Layer 2 solutions is lack of composability. Nextgen blockchains are focused on interoperability to exchange smart contract functionality, assets, and data. This ability of money legos to communicate across chains is at the nexus of future product innovation for DeFi protocols.
The world state for DeFi is no longer one Ethereum blockchain but a continually expanding network of EVM compatible blockchains whose money legos can interoperate with one another. Many protocols are working towards this universal DeFi view in which atomic swaps, cross-collateralized lending, and cross-margin trading can be frictionlessly executed across multiple protocols from one interface. This means you can transfer USDT from DEX A and ETH from DEX B to cross-collateralize a loan on Lending Protocol X to invest in a liquidity pool in Swap Pool Z.
High Gas Fees
While technically possible, high gas fees would currently make this multi-pronged strategy financially prohibitive. That’s where Layer 2 solutions like sidechains and rollups come in, taking the heavy work load off-chain to lower gas fees on the main chain. We are already starting to see DeFi dApps pass on low or no gas fees to users.
Moreover, you could also simultaneously offset risk in this mega transaction through a derivatives market like dYdX or Synthetix, both derivatives exchanges are using Zk-rollups and Optimistics, respectively, to lower gas fees, trading costs, and transaction size.
Liquidity
Another concern is that Layer 2 solutions could lower market liquidity. Owing to a lack of fluid capital flows, liquidity remains trapped in many different DeFi markets. Interoperable dApps and chains, on the other hand, allow capital to fluidly flow across mining, lending, insurance and other pools across protocols.
The Arrival of Layer 0 Solutions
Although many proposals pitch Layer 1 and Layer 2 solutions against one another, they ultimately need to work in synchrony. In fact, the most complete solution proposed to high Ethereum congestion and fees is an EVM compatible Layer 0 that can interoperate with Layer 1 and 2 solutions. The Polkadot multi-chain is a good example. On the Polkadot relay chain, built on the scalable and interoperable Substrate framework, parachains and Layer 2 bridges run in parallel with the relay chain. Or consider Polygon’s multi-chain, currently using an interoperability protocol that supports tokens, contract calls and bridges — as well as side chains and rollups — across systems.
Now imagine backing this world of interoperable money legos with the surety of the existing financial regulatory system. Centaur is doing exactly that by creating a dynamic ecosystem of swap pools that can interoperate cross-chain on the native Centaur Chain, with the benefit of Centaur’s semi-decentralized approach to bridging the regulatory control of traditional finance with DeFi.
These cross-chain composability possibilities are why investors continue to put their faith in DeFi while awaiting speed, scalability and interoperability improvements. The ability to instantly and opportunistically move money across any staking, mining, lending, or derivatives exchange as yields or fees change is worth a 3-second transaction wait, but DeFi users do not have to wait for much longer. Faster, scalable Layer 0 protocols like Centaur and Polkadot are rolling out this year.
