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What is DeFi Interoperability?

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Bitcoin and Defi: Decentralized Finance in the Layers depicted 3D
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As decentralized blockchain technologies have grown in size and scale, they’ve unlocked countless use cases both within the realm of cryptocurrencies and Web3. Networks like Bitcoin and Ethereum have been the driving force behind most major developments in recent years, but not all of the features that make each network so vital to the blockchain ecosystem overlap. 

Therefore, interoperability has become one of the latest frontiers that blockchain builders are focusing their efforts on to bring even broader use cases to the forefront across multiple blockchain applications, including on DeFi protocols.

What is Interoperability and Why is it Important in DeFi?

Interoperability refers to bridging the gap between different research and development projects that has sprung up across various blockchain technologies and their developer bases by creating ways to boost a blockchain’s capacity to interact and exchange data freely with other chains. A high degree of interoperability would therefore imply that any asset or transaction documented on one blockchain can be represented and interacted with on another. 

This is an especially important concept in DeFi, where decentralized exchanges (DEXs) offering cross-chain swaps represent some of the earliest developments in the realm of interoperability across different blockchains. That is, however, just the beginning of what builders are hoping to make possible through broader interoperability, particularly in terms of increasing accessibility for both developers and end-users. 

Simply put, high interoperability between chains would allow users to access and exercise DeFi protocols seamlessly across different blockchain networks, which would allow their interactions with the DeFi ecosystem to be enhanced, thereby attracting more users to the space. This would, in turn, introduce increased liquidity into the system, which would allow for more sophisticated liquidity tools to be developed with increased scalability. The thesis here, broadly, is that this would enable larger-scale DeFi operations as well as greatly increased freedom for every individual user on how and where they manage their assets. 

Where Have We Seen Cross-Chain DeFi Interoperability with Bitcoin?

Currently, even some of the largest and most widely adopted dApps don’t allow for transactions to take place across multiple blockchains. Reasons for this vary by case, but the siloing is largely due to the lack of pre-existing bridges available for builders to integrate into their products. To build quality products in the current environment, it is simply more efficient for developers to focusing on building within their network of choice, rather than attempt a one-size-fits all solution.

The main drawback for users is that this reality leaves them on their own if they wish to transfer any assets between chains, having to move those assets through a third-party centralized exchange to get from one chain to the other. This limits a developer’s ability to scale any given project, a consequence that severely limits the prospects for mass adoption. 

Luckily, where there are obstacles, there are those working to overcome them. Several major interoperability technologies exist and are being improved upon to mitigate these problems and build bridges between the most widely used blockchain technologies. 

Cross-Chain Bridges: An Overview

To understand cross-chain interoperability in DeFi, it is important for users to understand what cross-chain bridges are and how they work. Cross-chain bridges have become one of the biggest components of the DeFi industry as they encompass a number of technologies that have led to the wider adoption of DeFi in recent years.

Cross-chain bridges in DeFi are essential infrastructure components that facilitate the interoperability of different blockchain networks. They enable the seamless transfer of digital assets and data between separate blockchain ecosystems. These bridges are designed to bridge the gap between various blockchains, allowing users to leverage assets and services from one blockchain on another.

One of the primary benefits of cross-chain bridges is increased liquidity and accessibility. They unlock the value of assets on one blockchain for use in DeFi applications on another. For example, users can bring assets like Bitcoin or Ethereum onto the Ethereum network through wrapped tokens (e.g., WBTC, which we will expand on, or wETH) using cross-chain bridges, thus participating in lending, trading, and other DeFi activities. This enhances market efficiency and expands the range of financial products and services available in the DeFi space.

However, there are risks associated with cross-chain bridges. One significant concern is security, as these bridges can be vulnerable to attacks. If a bridge is not properly audited or lacks robust security measures, it may become a target for hackers, potentially leading to the loss of users' assets. Additionally, centralization is a concern since many cross-chain bridges rely on trusted custodians or validators to facilitate asset transfers between chains. This centralization can go against the principles of decentralization that underpin blockchain technology. Moreover, the technical complexity involved in creating and maintaining cross-chain bridges can lead to challenges and potential smart contract bugs, which could result in financial losses for users.

In summary, cross-chain bridges play a crucial role in the DeFi ecosystem by enabling the movement of assets across different blockchain networks. Their benefits include increased liquidity and accessibility to a wide range of assets, but they also come with risks related to security, centralization, and technical complexity. To mitigate these risks, careful auditing, robust security measures, and transparency in bridge operations are essential for ensuring the safe and efficient functioning of cross-chain bridges in DeFi.

Wrapped Bitcoin (WBTC)

Generally when people give examples of how Bitcoin has been incorporated into the DeFi market, they often mention Wrapped Bitcoin (WBTC). WBTC is aimed at vastly improving Bitcoin’s practicality for use in the DeFi ecosystem. Despite being the most widely used and recognizable applications of blockchain technology, Bitcoin does not currently natively support smart contracts on its L1 (it can, however, through Bitcoin layers like Stacks). At its core, WBTC is an ERC-20 token that is pegged to Bitcoin. Launched in 2019, it aims to circumvent the trust issue inherent in having to complete financial transactions using bitcoin by going through a centralized exchange. 

Generally, the process of minting WBTC is such:

  • User Initiation: A user who owns Bitcoin (BTC) and wants to convert it into Wrapped Bitcoin (WBTC) initiates the process. This user is typically referred to as the "minting" party.
  • Custodian Approval: The user must choose a custodian that participates in the WBTC ecosystem. Custodians are institutions responsible for holding the Bitcoin that backs WBTC and minting the equivalent WBTC tokens. These custodians are typically regulated financial institutions. The user transfers their BTC to the custodian's address.
  • KYC/AML Compliance: The custodian performs Know Your Customer (KYC) and Anti-Money Laundering (AML) checks on the user to comply with regulatory requirements.
  • Bitcoin Custody: Once approved, the custodian takes custody of the user's BTC. The BTC is stored securely and may be kept in cold storage for added security.
  • WBTC Minting: After the BTC is in custody, the custodian creates an equivalent amount of Wrapped Bitcoin (WBTC) tokens on the Ethereum blockchain. These WBTC tokens are essentially representations of the BTC held by the custodian.
  • Smart Contract Interaction: A smart contract is used to facilitate the minting process. The custodian interacts with this smart contract, which locks the BTC and mints the corresponding amount of WBTC tokens. These WBTC tokens are then sent to the user's Ethereum address.
  • Verification: To ensure transparency and accountability, the minting process is typically audited and publicly verifiable. Users can check the supply of WBTC tokens on the Ethereum blockchain to ensure it matches the amount of BTC held by custodians.
  • Redemption: WBTC holders can redeem their WBTC tokens for the equivalent amount of BTC at any time by going through the custodian and the associated smart contract. This process is often referred to as "burning" the WBTC tokens.

Interoperability protocols via layered solutions

Other cross-chain interoperability solutions like RSK involve creating direct bridges between networks using layers built on top of the the layer one levels of Bitcoin and Ethereum.

RSK’s RSK-ETH bridge, for example, is an entire network that is pegged to Bitcoin, allowing users to complete ethereum-to-bitcoin (and vice versa) swaps via RSK’s rBTC protocol, and without an intermediary party. 

Atomic swaps 

Atomic swaps are a way for two parties to trade tokenized assets across blockchain networks without an intermediary, and are an area of major excitement in the DeFi ecosystem. Atomic swaps are peer-to-peer exchanges that work by each party depositing an equivalent amount of each cryptocurrency, i.e. bitcoin and ethereum, into a contract. The transaction works on an all-or-nothing basis, meaning that unless the two deposit amounts are equivalent, the contract will not execute. This methodology serves to protect each party’s assets, and also to ensure full transactional parity. 

This is accomplished via hashed timelock contracts (HTLCs), which only execute upon delivery of a pre-agreed upon amount of digital assets, which the two parties must acknowledge receipt of within a given time interval. 

Benefits of atomic swaps include decreased counterparty risk due to the lack of a third party necessary to complete a given transaction, deeper liquidity due to cross-chain exchange and less slippage.

Atomic swaps, however, are an imperfect cross-chain solution in their current state. Like WBTC, atomic swaps are somewhat cumbersome to use, and given their native peer-to-peer exchange method, they require multiple blocks to complete, which could theoretically introduce security risks from malicious actors who could potentially identify and target individual participants in a given transaction. 

Interoperability Protocols and the Future of Cryptocurrency DeFi

Blockchain interoperability solutions are the new frontier of DeFi. Their promise offers the potential to unlock new features and use cases for developers and end-users alike, and is yet another step on the ladder of mass adoption.

Many solutions are currently in their infancy, and new methods and approaches are likely to spring up as builders turn their attention toward overcoming what is a fundamental obstacle in the DeFi ecosystem.