The Interoperability Arbitrage: Cross-Chain Infrastructure as Asymmetric Upside

By Arhat | Decrypting Crypto | 18 Aug 2023

A few days ago, I wrote an introduction piece on Chainlink's CCIP. I want to dive deep into the multichain infrastructure of what web3 represents and how we, as users, can build and benefit from this infrastructure. 

Cross-chain infrastructure represents an arbitrage opportunity to capture asymmetric upside as interoperability unlocks new network value.

Blockchain and cryptocurrencies have come a long way since the inception of Bitcoin in 2009. What started as a novel peer-to-peer electronic cash system has evolved into an entire ecosystem of decentralized applications, financial services, decentralized organizations, and more. However, one limitation that has persisted is that most blockchains operate as isolated islands, unable to communicate with each other. This results in the fragmentation of liquidity, assets, communities, and development efforts.

The future of blockchain is undoubtedly multichain-- where various Layer 1 and Layer 2 networks seamlessly interoperate. Just as traditional finance evolved from fragmented local and national systems to a highly interconnected global financial network, the same will happen with digital assets and blockchain-based services. multichain interoperability unlocks tremendous value and paves the way for mainstream adoption of Web3.

Some key drivers of the multichain future are:

  • Scaling limitations of single chains - No one blockchain can meet all demands for speed, cost, and functionality. Multichain architecture allows splitting workloads optimally.
  • Specialization of chains - Dedicated chains customized for payments, smart contracts, DeFi, NFTs, etc., can co-exist and communicate.
  • Avoiding platform risk - multichain provides redundancy against issues with any single chain.
  • Bridging networks and liquidity - Assets and apps on one chain can leverage services on another expanding reach.
  • Optionality for users and developers - Projects can choose different chains for specific needs, and users can optimize across chains.
  • Cross-pollination of ideas - Innovation on one chain can be adopted on others.
  • Interoperability with legacy systems - Links to off-chain data, APIs, banks, etc.

The Cross-Chain Bridging Solution

A critical technology needed to enable the multichain future is cross-chain bridges. Bridges allow the transfer of assets and data between independent blockchains, serving as the conduits that connect the chains into an interoperable network. Well-designed bridges can seamlessly move assets between chains, access services across chains, and enable complex cross-chain applications.

  • Liquidity Transfer: Transfer asset liquidity between chains. For example, moving stablecoins between DeFi and NFT marketplace chains.
  • Yield Optimization: Farmers can chase the best yields by moving liquidity pools across chains.
  • Access Wider Services: Assets on non-EVM chains can use EVM-based DeFi apps via bridges.
  • Non-Custodial Wrapped Assets: Wrap assets like Bitcoin and Monero on EVM chains to access apps.
  • Atomic Swaps: Asset exchanges directly between chains without a custodian.
  • Cross-Chain Transactions: Apps that execute operations across chains via bridges.
  • Cross-Chain NFT Trading: NFTs can be sent cross-chain expanding their tradable marketplaces.
  • Cross-Chain Identity: Single sign-on across chains and link on-chain identities.
  • Cross-Chain Oracles: Reliable price feeds across networks.
  • Cross-Chain Computation: Distribute compute across specialized compute chains.

Bridging mechanisms can be broadly classified as custodial or non-custodial.

  • Custodial Bridges: Custodial bridges rely on a trusted third party to hold custody of assets when transferring between chains. The custodian locks assets on the origin chain and mints a wrapped version on the destination chain—for example, in shuttle-based bridges like Wormhole, where the custodian is a consortium of reputed entities. Though convenient, such solutions have trust trade-offs and a single point of failure risk.
  • Non-custodial Bridges: Non-custodial bridges use cryptographic proofs to transfer assets between chains without intermediaries. These atomically swap assets, identity, and data between chains in a decentralized manner. As they minimize trust assumptions, decentralized bridges will be critical for a robust multichain future.

Leading protocols like Connext, Celer, and Allbridge push non-custodial bridge technology forward. Math-based validation schemes like Optimistic Rollups and zk-SNARKs make these bridges efficient and secure. Modular components around messaging, liquidity provisioning, and identity are being standardized between protocols to enhance interoperability. Efforts are ongoing to make bridges resilient against attacks like chain congestion and data availability issues seen in the past.

  • Path to Mass Adoption: Cross-chain bridges are on track to unlock the network effects of an interconnected Web3 ecosystem. However, some challenges remain on the path to mass adoption:
  • Usability: Complex user flows due to asynchronous asset transfers, waiting for transaction confirmations across chains, and a general lack of abstraction for end users. Progress is being made with UIs that hide complexity, but more work remains.
  • Liquidity Fragmentation: Bridge pools must be deep, have low slippage, and be available across chain pairs. This is an emerging area being tackled by liquidity providers like Bancor.
  • Bridge Security: As bridges now hold billions in assets, they need to be made resilient to all attack vectors via cryptographic proofs, staking mechanisms, governance controls, and insurance.
  • Scalability: Bridges are pushing the throughput limits of chains on both ends. Solutions like batching, state channels, sidechains, and rollups are evolving to address scalability.
  • Interoperability: Common standards between bridges around assets, identities, APIs, UI/UX, plugins, and SDKs can enhance interoperability and composability.
  • Compliance: Integrating KYC, transaction monitoring, regulators, and other aspects to make bridges legal and audit-friendly as adoption increases.
  • Data Availability: Ensuring bridges have reliable access to necessary data across chains to verify transactions. Secure data availability solutions are an active area of R&D.

Despite these challenges, the pace of innovation makes it very likely that secure, usable, and scalable cross-chain infrastructure will emerge in the next few years.

My Thesis on Why I Believe in Cross-Chain Infrastructure.

The multichain future underpinned by standardized bridges represents the next evolution of Web3 toward an open, unified ecosystem. This future is almost inevitable, as it mirrors how the internet evolved from separate networks stitched together by standard protocols like TCP/IP. Based on this view, investing in protocols and teams building cross-chain bridge infrastructure is attractive for the following reasons:

  • Growth Potential: As more assets, users, and activities shift to a multichain world, transaction volumes over bridges will rapidly grow. The growth will likely be exponential rather than linear as bridges network effects kick in. Bridges can accrue value and fees proportional to overall ecosystem growth.
  • Sticky Infrastructure: Bridges act as an infrastructure layer augmenting L1s and L2s. Like the internet's TCP/IP, widely adopted tech and standards get embedded at the protocol level, making them highly stable long-term investments.
  • First Mover Advantage: We are still in the early innings of cross-chain infrastructure. Teams that gain adoption now can establish standards, network effects, and switching costs that provide a sustained competitive advantage.
  • Technical Moat: Advanced cryptographic techniques, deep protocol-level integrations, and system-level optimizations enable wide moats around bridge tech. Core protocols have the potential to act as 'picks and shovels' for the multichain gold rush.
  • Valuation Headroom: The multi-trillion potential of multichain still needs to be appreciated relative to current bridge valuations. As the space matures, bridge tokens can likely command higher valuations.

The potential value of a fully interconnected multichain ecosystem likely measures in the trillions of dollars over the coming years.

This is driven by:

  • The trillion-dollar (potential) scale of major L1s like Bitcoin and Ethereum.
  • The synergies unlocked by interconnecting these networks - more use cases, liquidity, cheaper transactions, etc.
  • The ability for traditional finance to port over assets and infrastructure to the blockchain.
  • New business models and industries enabled by seamless cross-chain applications.
  • Network effects as bridges aggregate more value, and the system becomes more useful.

However, bridges are still a nascent technology today. The total value locked in bridge applications is currently in the low single-digit billions. The vast potential is still to be realized.

As the space matures, bridges will likely capture a greater share of the value they enable within the multichain ecosystem. This can happen through:

  • Fees from growing bridge transaction volumes as adoption increases.
  • Network growth increasing the utility and staking value of bridge tokens.
  • Revenue from ancillary services like cross-chain data oracles and indexing.
  • Emergence of core bridge protocols as industry standards with deep competitive moats.
  • Integration of bridges into application layer solutions like DeFi, NFTs, and gaming.
  • Mainstream understanding of bridges as a critical piece of infrastructure.

The gets-better dynamics of networks apply squarely to bridges driving growth.

Cross-chain bridges become more valuable as more users, assets, and chains plug into them. This is a classic network effect - the value of the system grows as nodes join the network.

Some specific network dynamics that apply to bridges:

  • As more assets and liquidity get ported through bridges, it attracts more users and transactions. This liquidity aggregation creates a virtuous cycle.
  • Bridges enable new cross-chain applications like atomic swaps and meta-transactions. These expand use cases, drawing more traffic.
  • Interoperability standards between bridges create seamless user experiences and composability. This can massively expand reach.
  • As more data moves across bridges, security and reliability improves. Better performance attracts yet more users.
  • Integration and partnerships with wallets, DeFi platforms, and other services expand the bridge ecosystem.
  • Bridges that gain critical mass and standards have the potential to become ubiquitous infrastructure similar to how TCP/IP took over the internet. This leads to a 'winner take most' dynamic.

Cross-Chain Aggregation Theory

Cross-chain aggregation combines liquidity, data, identities, and other resources across multiple blockchain networks via bridges. This enables higher utility of the aggregated resources compared to using chains in isolation.

Cross-chain aggregation can exponentially increase returns for users and the overall value captured within the multichain ecosystem. It represents a compelling investment thesis as interoperability standards emerge.

Working Example

Consider a hypothetical scenario with:

  • Chain A - Ethereum-based decentralized exchange and lending protocol
  • Chain B - Solana-based NFT marketplace
  • Bridge X - Non-custodial bridge connecting A and B

Without the bridge, chains A and B remain isolated with siloed liquidity. Once the bridge is established, new use cases become possible:

  • Users can supply liquidity pools on A using assets bridged from B. This gives liquidity providers access to higher yield opportunities.
  • NFT traders on B can instantly borrow funds using A's lending protocol to make purchases rapidly without having to cash out of their positions.
  • Stablecoins can move freely between A and B enabling frictionless payments as users interact with both ecosystems.
  • NFTs minted on B can be sent over the bridge and sold on A's larger marketplace, greatly expanding their reach.

In each case, cross-chain connectivity unlocks significant new utility for users on both chains - asset yields improve, liquidity increases, convenience improves, and markets expand.

Value accrues both at the application layer on each chain and the bridging protocol connecting them. Given the network effects, the benefits grow exponentially as more chains get bridged.

Case Study: WBTC

A real example of cross-chain aggregation creating value is WBTC - a Bitcoin-backed ERC20 token minted via the WBTC bridge. This gave Bitcoin access to the DeFi, NFT, and application ecosystem on Ethereum.

Key benefits that accrued:

  • Bitcoin could be supplied to DeFi protocols earning yield for BTC holders. Over $1.3 billion of WBTC is currently supplying liquidity pools on Ethereum.
  • WBTC expanded the on-chain BTC lending market, enabling borrowing against Bitcoin collateral.
  • WBTC can directly participate in DEX trading and atomic swaps on Ethereum - reducing reliance on centralized exchanges.
  • Wallet integration of WBTC made Bitcoin available alongside other Ethereum assets improving usability.
  • Trust minimized wrapping of Bitcoin expanded use cases while retaining custody.

WBTC demonstrates how high-value aggregation can occur by making assets cross-chain compatible even when the native chains are not interoperable. This proven model is beginning to be replicated across other asset bridges.

Cross-chain aggregation via bridges is poised to create tremendous value as it expands the total utility of the multichain ecosystem. It improves returns for users at both the application layer as well as the infrastructure layer.

It represents an attractive thesis today based on analogous examples like WBTC. However, common interoperability standards are needed for full network effects to kick in. Teams focusing on standards and building bridges that provide the most seamless and secure aggregation functionality will likely see exponential growth.

Exposure to carefully evaluated bridge protocols and liquidity pairs that bring unique value together through aggregation provides upside. As adoption grows, network effects can potentially lead to a 'power law' effect where a few solutions capture most of the value. This makes cross-chain aggregation a promising investment framework for the emerging multichain future.

In Conclusion

Cross-chain bridges represent an asymmetric investment opportunity today. Though early stage, the technology risk is mitigated given steady technical progress by multiple credible teams. Adoption incentives are aligned as the multichain future is a necessity for the Web3 ecosystem. The gets-better dynamics of networks apply squarely to bridges driving growth. And bridges form a foundational layer for the trillion-scale disruption of Web3. Therefore, exposure to this critical category and prudent risk management seems like an attractive bet for forward-looking crypto investment portfolios.

When evaluating opportunities in cross-chain bridges, the highest upside is likely to come from protocols and liquidity pairs that exhibit the following characteristics:

  • Unique Value Aggregation: Bridges that interconnect chains and assets in innovative ways to generate new utility and value. For example, bridges between non-fungible chains like Bitcoin and data chains like Arweave for novel applications.
  • Early in Adoption Cycle: Getting exposure early before the network effects kick in can magnify the upside. However, technology risk needs to be assessed.
  • Standards Compliance: Protocols that embrace interoperability standards are likely to gain network effects faster as more bridges adopt compatible interfaces.
  • Deep Liquidity: Large liquidity pools that minimize slippage and ensure stable swaps. Projects that incentivize external liquidity provisioning through mining/farming rewards help bootstrap liquid markets.
  • Valuable External Services: Bridges that provide additional services like cross-chain oracles, indexing, and analytics have additional monetization avenues.
  • Integrations and Partnerships: Bridges embedded into wallets, DEXs, dApps, and other services gain distribution and stickiness. Partnerships validate network effects.
  • Strong Technical Team and Community: A bridge is only as strong as the team building it and the community supporting it. Evaluating core contributor and backer quality is essential.
  • Robust Security Design: Given the risks, battle-testing the crypto economics, staking mechanisms, governance processes, and securing audits raise confidence.
  • Sustainable Tokenomics: Analyze if the bridge token has compelling utility and long-term value accrual to justify holding.

Identifying bridges and liquidity pairs that score highly on these parameters can yield asymmetric upside. The analysis requires assessing individual bridge merits and interoperability with the broader ecosystem.

While still early, thoughtful exposure now could generate strong growth as cross-chain bridges fulfill their potential.

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Founder 3z3 Labs. Ordinary thinker. I write about web3 use cases, hacks and deep dives.

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