Leaky Thoughts with S. ArchΞr: Ethereum Layer-2 Fragmentation, Interoperability Bridges, and Tokemak

Tokemak
Tokemak

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by Community Contributor @Archer_MD_

Archer MD in the Leaky Reactor (Tokemak’s Discord-based cantina), probably.

The following post was authored by Tokemak community contributor https://twitter.com/Archer_MD_ We felt it relevant given discussions around L2 and the future of Tokemak outside of Ethereum L1. While we like what Hop Protocol is doing, they’re just used here as a possible example from a list of general composability options for Tokemak to bridge liquidity to L2's.

Background

Evolution through disruption. Ethereum’s forward-facing culture enabled the transition from the “internet of data” into the “internet of value”. This metamorphosis created an open and permissionless Decentralized Finance (DeFi) ecosystem that provides unprecedented access to financial services to anyone with an internet connection. The dawn of the fourth industrial revolution is here, however, it is still unfeasible to scale Ethereum for mass adoption. In order to overcome the usability hurdles that are imposed by
exorbitant gas fees, Ethereum’s roadmap relies on Layer-2 solutions as a crucial component to its scalability.

Rollups represent a type of Layer-2 solution that can be segmented into two different parts, optimistic rollups, and zk-rollups. Due to the different verification methods that are used by both rollups while interacting with the Layer-1 chain (i.e. fraud and validity proofs), there are different tradeoffs that are intrinsic to each rollup.

The aforementioned verification methods have two main constraints, long exit times and high costs. As a result, the interaction between rollups and the respective Layer-1 chain is slow and expensive. These limitations introduce new challenges to the Ethereum Layer-2 ecosystem, such as fragmented liquidity and limited composability between different rollups. DeFi’s composable nature is the catalyst that led the entire ecosystem to its current state, limiting this idiosyncratic trait would not only hinder DeFi’s usability on Ethereum Layer-2, but it would also lead to a decline in future innovation. Due to this, it is essential to create bridges that enable fast and cost-effective transfers of assets between different rollups in order to preserve composability and frictionless liquidity.

Interoperability bridges such as Hop protocol seek to capture this value proposition by acting as liquidity networks that connect the siloed components that constitute Ethereum’s rollup ecosystem. This type of infrastructure enables cross-rollup transfers of assets that overcome the limitations that are imposed by the high exit times and costs that are associated with Layer-1 interactions. Regardless, the lack of liquidity that exists within these bridges remains as a major obstacle for adoption.

This article explores how Tokemak can create a symbiotic relationship with interoperability protocols by providing sustainable and frictionless liquidity that will ultimately help Ethereum to scale and preserve its composability at a Layer-2 level. While there are several bridging solutions, we’ll focus on Hop Protocol as an illustrative example.

Interoperability Bridges — Hop Protocol Overview

Hop Protocol is a rollup-to-rollup general token bridge that enables fast and cost-effective transactions of assets between different rollups and the Ethereum mainnet. Structurally, the protocol can be divided into two main components: cross-network bridge tokens, and Hop’s Automatic Market Maker (AMM).

The cross-network bridge token is used to transfer assets between different rollups (or to claim the underlying asset on the Ethereum mainnet), while the AMM is used to swap between bridge tokens and the rollup token representation. Furthermore, Hop’s AMM enables a dynamic pricing of liquidity and its respective rebalancing across the network.

hAssets

Hop bridge tokens (i.e. hAssets), are intermediary assets that exist within Hop Protocol to facilitate cross-rollup transactions. In order to mint hAssets, it is necessary to deposit the corresponding asset into the Layer-1 Hop bridge contract (e.g. 1000 USDC deposit on Layer-1 can mint 1000 hUSDC on a Layer-2 Hop bridge contract). As a result, hAssets have a 1:1 collateralization. While redeeming hAssets the same logic is applied. The Hop bridge token is burnt on Layer-2 and the underlying asset is unlocked on Layer-1.

Cross-Rollup Transfers

While exchanging Hop bridge tokens between different rollups, Hop Protocol mints a hAsset on the destination rollup and burns it on the origin rollup. In order to execute a quick cross-rollup transfer of assets, the protocol relies on a third-party called “Bonder” that provides upfront liquidity on the destination rollup in exchange for a fee. Once the transfer is propagated through Layer-1, the Bonder’s liquidity is returned.

To illustrate how cross-rollup transfers work on Hop protocol consider the following example:

1. USDC is swapped for hUSDC through Hop’s AMM on Rollup 1.
2. Using the Hop Bridge, the protocol sends hUSDC from Rollup 1 to Rollup 2.
3. The Bonder provides upfront liquidity for hUSDC on Rollup 2.
4. hUSDC is swapped for USDC through Hop’s AMM on Rollup 2.

Interoperability Powered by Tokemak

The main obstacle for the mainstream adoption of Ethereum Layer-2 solutions lies in the long exit times and high costs that are inherent to rollups. As aforementioned, interoperability bridges offer a solution to this problem, however, one issue remains, liquidity. While transferring assets using Hop protocol, a large part of the transaction fees correspond to the price impact that is associated with the trade size. This happens due to the limited size of Hop’s current liquidity pools. As a result, it isn’t economically feasible to conduct large cross-rollup transactions.

The heuristic that is applied to this limitation is that more liquidity will provide cheaper transactions for end users and catalyze the development of Ethereum’s Layer-2 ecosystem through better trade executions, improved composability and unified liquidity. Interoperability bridges require liquidity, Tokemak provides liquidity. As a decentralized market maker, Tokemak is naturally composable with interoperability bridges. In Hop’s particular case there are two sources of demand for liquidity that can be provided by Tokemak: AMMs and Bonders.

Hop AMMs

Hop Protocol relies on AMMs that are essential to swap between hAssets and the native token representation of those assets. As of now, a 0.04% fee is applied to all swaps that are executed on Hop’s AMM.

In order to incentivize liquidity to its pools, Hop Protocol conducted a liquidity mining program with Polygon that distributed MATIC rewards to liquidity providers. As expected, once the liquidity mining program ended, the liquidity that was present in those pools suffered a sharp decline.

As new rollups are supported (e.g. Optimism and Arbitrum), there will likely be new liquidity mining incentives that will suffer the same fate. The solution for the long-term sustainability of interoperability bridges can be attained through the creation of “Bridge Reactors’’ within Tokemak.

Instead of spending liquidity mining rewards in pseudo “liquidity loans” that cease as soon as the incentives disappear, interoperability bridges and all interested parties could use those funds to direct liquidity to bridge pools through Tokemak.

Considering that Hop AMMs rely on same-pegged trading pairs (i.e. hAsset:Asset), the hypothetical “Bridge Reactors” would represent minimized impermanent loss risks due to the unlikely peg deviation between both assets.

Liquidity Bonders

Bonders are an essential component of Hop Protocol that provides upfront liquidity on the destination rollup in exchange for a 18bps fee. Providing liquidity to this role has technical challenges such as liquidity lockup requirements and verification nodes that must be kept online. Considering that Hop Protocol wishes to further decentralize this role, this could be achieved with Tokemak, regardless, this application needs to be subject to further research.

Conclusion

Layer-2 solutions are a critical component of Ethereum’s scaling roadmap. In order to preserve both composability and a seamless flow of liquidity at a Layer-2 level, it is crucial to develop highly liquid interoperability bridges that connect the currently siloed rollups. Incentivizing liquidity within these bridges through inflationary mechanisms or centralized market makers would render the Layer-2 ecosystem vulnerable to either highly fluctuating mercenary liquidity or a centralized dependency. None of these solutions is optimal for this ecosystem’s long-term horizon.

Tokemak provides a sustainable solution for the liquidity dilemma that currently represents a major obstacle for the adoption of Layer-2 solutions. Instead of borrowing temporary liquidity through liquidity mining incentives, all interested parties (e.g. interoperability protocols, scaling solutions, DeFi protocols, etc) could leverage those incentives to connect themselves to Tokemak’s liquidity infrastructure layer and direct long-term and sustainable liquidity to interoperability bridges.

This symbiotic relationship between Tokemak and interoperability bridges would not only enable a composable and frictionless flow of liquidity for the Layer-2 ecosystem through “Bridge Reactors”, but it would also represent a source of revenue for Tokemak with no added liabilities due to the minimized impermanent loss risks that are inherent to same-pegged asset pools.

Different bridge designs offer distinct tradeoffs in terms of security, speed and capital efficiency. Regardless, there is one common trait that is intrinsic to all designs, the liquidity requirement. Despite this article’s focus on Hop Protocol as a case study, this approach can be generalized to other interoperability protocols such as Connext.

As the demand for Layer-2 solutions and interoperability bridges grows, Tokemak will be able to establish itself as the liquidity layer that supports Ethereum’s Layer-2 connectivity. Furthermore, it is possible to extrapolate a similar hypothesis to a multichain paradigm at a Layer-1 level through cross-chain interoperability protocols such as Thorchain.

In summary, the “internet of value” has to be connected through interoperability bridges at a Layer-1 and Layer-2 level, as a decentralized market maker, Tokemak has the potential to become the liquidity layer that powers the bridges that unify all siloed components of this novel network of value. Leveraging this future application, Tokemak can simultaneously earn risk minimized revenue and unleash the full potential that this ecosystem has to offer by supporting its scalability, composability and frictionless flow of liquidity.

Special thanks to S. Archer — expect more Leaky Thoughts in the future.

☢️

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