Cross Chain Liquidity between Blockchain Networks
Blockchain is one of the most highly adopted technology in the recent years. Apart from its business use cases among various industries, it is the core technology underlies cryptocurrency and Decentralized Finance (DeFi), which continues to be stipulated as a large part of future of global finance.
As the ecosystem of cryptocurrency and DeFi continues to grow both in number and value, many blockchain technologies have been developed alongside faster and more efficient protocols. This has naturally led to a boom of user applications built on top of them through aspiring startups in the blockchain space. Though it helps increase the speed of the development and innovation in blockchain space, the diversity of protocols and systems continue to be one of the major obstacles for interoperability and integration between the blockchains.
Let’s take the example of cryptocurrencies on multiple crypto exchanges. To regular users or traders, cryptocurrencies which are traded on exchanges like Binance or Uniswap are no different to them. It is similar to us owning U.S. Dollar banknotes, where we can take the banknotes to any bank around the world that accepting U.S. Dollar to exchange for other currencies.
However, things do not work that way on blockchain, because each blockchain network is isolated and siloed from each other. That means what are created or issued on one do not exist and cannot be used directly on the others. Therefore, in our cryptocurrencies example, if we were to receive rewards in BTC from the mining on the Bitcoin network, we cannot directly trade it with other cryptocurrencies on Binance or Uniswap as they are all reside on different blockchain networks and are based on different protocols.
The Cross-Chain Bridge
To enable the interoperability between the blockchains, a bridging mechanism of sorts is required. The cross-chain bridge basically acts as a connector between blockchains by monitoring the event on a (source) chain and triggers a corresponding action on the respective chain programmed in the bridge.
Cross-chain bridges also play a vital role in transferring the value of cryptocurrencies across blockchains, which enables cross-chain liquidity movement so that market making can continue to happen among the participants.
To facilitate the cross-chain liquidity, the concept of asset tokenization is applied to produce what is known as a wrapped token. Let’s examine a real-world use case to get more understanding on how the process works.
Referring to the earlier scenario where we were to take BTC from the Bitcoin network to trade on Binance. Assuming that we already have an account and wallet with Binance, the simplified process flow would be as follows:
1. Specify the Binance account or wallet address to be the recipient for receiving the wrapped BTC
2. On Bitcoin network, deposit or transfer an amount of BTC from user to the given Binance’s account or address
3. The amount of BTC, from 2., is locked in the Binance’s account on Bitcoin network
4. The cross-chain bridge receives the event and validates the transaction for BTC received in the address
5. The bridge triggers the smart contract on the Binance network to mint the tokenized asset or wrapped BTC with the amount equals to 1:1 peg to the amount of BTC locked in 3.
6. The wrapped BTC is transferred to the user-specified account from 1.
Asset Pools (a.k.a Liquidity Pools)
From the example of transferring BTC from the Bitcoin network to Binance, the process looks simple and straight forward. It is because Binance has the full authority over its own network. Also, it is the one that provides the cross-chain bridging service on its own. Therefore, it has right to mint or issue the standard wrapped BTC, which is known as BTCB on the Binance network. We can visualize, in this scenario, that Binance has the same authority as a national central bank that holds the sole right to print money.
However, in the scenario that other providers would like to offer a similar bridging service between Bitcoin and Binance networks, most lack of right to issue the same kind of BTCB token as Binance. Hence, the provider must maintain an asset pool containing BTCB to serve the liquidity needs when there are demands to transfer the BTC from Bitcoin network.
An asset pool, or a liquidity pool as it is more commonly referred to, is basically an account or a crypto wallet that collects and pools assets together to fulfill activities such as asset lending or token swapping.
Therefore, in the scenario of other bridging providers, instead of minting wrapped tokens on the network, the bridge executes the smart contract to transfer the tokens from their asset pool to the recipient account.
This is more akin to when we go to a bank to exchange the U.S. Dollars with a local currency. The bank must have enough value of the local currency in the pool to exchange with our U.S. Dollars.
Normally, a bank enables currency exchange for multiple currency pairs, which means that the bank must preserve more than one currency in its pool to fulfill liquidity demands. The same goes for the maintenance of asset pools on any given blockchain that provide multiple cryptocurrency pairs for users to interact with.
In order to preserve enough liquidity on any given blockchain requires a large amount of initial capital. What if a provider would like to provide the cross-chain liquidity service between more than 2 networks? Maintaining the assets pool on every network would be cumbersome and require even larger capital to operate. This is where cross-chain liquidity aggregation comes into play.
Cross-Chain Liquidity Aggregation
To improve cross-chain interoperability with regards to liquidity, several cross-chain liquidity aggregation protocols have been developed, such as Polkaswap, Harmony, O3swap, or 0x_nodes to name a few.
In addition to the basic functionality of acting as the bridge to facilitate the cross-chain liquidity between a pair of blockchain networks, the protocols also perform an aggregation of liquidity pools to fulfill the swap request.
For example, if there is a request to exchange or swap a large amount of BTC for USDT on the Ethereum network, but a single pool does not have sufficient USDT, the cross-chain aggregator will combine the pegged USDT from other pools to fulfill the request.
The aggregator is not only capable of aggregating the assets pool to fulfill the transaction, but it also provides other benefits such as finding the best exchange rate among the aggregated pools for swapping, lowering user transaction fees and reduce token price slippage so that buy/sell prices can be optimized. It simplifies cross-chain swapping for both the user and developers building on top of these protocols.
Existing Gaps and Future Development Areas
All in all, cross-chain liquidity aggregation looks very promising for interconnecting the vast blockchain landscape that keeps growing at an unprecedented pace, although no single solution that can function on all the blockchain stacks yet. Regardless, we continue progressing towards the direction of supporting the most widely used or larger public blockchain networks.
On the flip side however, this could widen the gap between public blockchains and permissioned or private blockchains. The gap between these types of blockchain should be taken into consideration, especially when national initiatives such as CBDC (Central Bank Digital Currency) are being researched, piloted and introduced into the larger financial system.
There is a good chance that blockchains backing CBDCs will not be implemented on the public blockchain to protect the monetary sovereignty of the country. To increase the adoption of digital currencies as a whole (CBDCs, cryptocurrencies, stablecoins), both interoperability and cross-chain liquidity play a crucial role in ushering in a new era of money.
Therefore, the need for deeper integration between new CBDC networks among different countries and public blockchains should be expected as a new area for blockchain innovation and adoption.
The possibilities are far and wide for the products and services which could be offered by the solution providers as we look towards more disruption in one of the oldest industries of our time.
