How Cross-Chain Composability Is the Future of Decentralized Finance

Decentralized finance faces a liquidity issue, but there are multiple solutions in the works that hope to tap into Bitcoin’s massive market cap.

Decentralized Finance, or DeFi, has been making strides in providing tools for users to take control of their own money and truly be their own bank. However, the assets that power this revolution exist primarily on blockchains, and historically these networks don’t easily communicate with each other. This creates real roadblocks and liquidity issues for many of the applications that are trying to revolutionize finance. New solutions could pave the way for greater “cross-chain composability,” which would mean users with almost any decentralized holdings could easily use it as collateral to get involved with Decentralized Applications, or DApps, across all networks. One of the first assets that many are setting their sights on is Bitcoin, which still reigns as king — the most commonly held cryptocurrency.

The Current Issue of Cross-Chain Composability

While there are many unique DeFi applications already released or in development, virtually all of them work on one specific blockchain. Ethereum and EOS are popular choices, for example, but there are several others. For now, Ethereum DApps need to transact using Ether or Ethereum Tokens, EOS DApps must stick with EOS and so on, as these are the only assets the network is designed for. While there has still been notable success in the early iterations of these services, it is obvious that everything would become much smoother, especially for the end user, if any asset could be seamlessly moved wherever it is needed regardless of native blockchain. This matter is also known as “interoperability,” and many see the future as a place where all chains and DApps can easily transfer value between each other. For now, most protocols are effectively isolated, but with the right implementations, the value across all of these networks could become “unchained.”

Generally, the solution to this issue is to create a protocol that can accurately and quickly transfer value between different blockchains. This is easier said than done, but there has been a lot of research put into coming up with a trustworthy way to do it. A few different approaches that have been explored include “Atomic Swaps,” “Wrapped Bitcoin,” and “pTokens.” While the overall goal is to get virtually any chain to be able to interact with any other, keep in mind that many are hoping to see Bitcoin specifically become frictionless and able to move onto other networks. The sheer size of Bitcoin’s market cap could do wonders for the DeFi ecosystem if there were no walls blocking its use from the most popular DApps. The solutions just mentioned all take different approaches to this, and we will walk through each of them now.

One problem, many solutions

We’ll start with the aforementioned “Atomic Swaps.” What this process involves is using a specific type of smart contract, called a hashed timelock contract, or HTLC, to move value across networks. In this system, two parties (one from each blockchain) effectively agree to a predetermined transfer across both networks, and the contract ensures that the transaction is not executed until both sides have fulfilled their conditions. The “timelock” element means that the contract expires if not completed by a specific time. This whole protocol ensures that the exact amount of value that is removed from one blockchain is created on the second, therefore “transforming” one asset into another.

There are currently some limitations on atomic swaps, however. One is that the process is still fairly technical and would not be readily accessible to the majority of users. However, what is probably the biggest issue is that both blockchains must have the same hashing algorithm and support HTLCs. While many popular coins do share algorithms, such as Bitcoin’s SHA-256, it is still not universal. Considering the goal is to integrate Bitcoin into DeFi solutions, this creates a problem. Neither Ethereum nor EOS — the most popular platforms for finance DApps — share this algorithm, and hence won’t allow for this functionality.

Another solution which works around this limitation is something called Wrapped Bitcoin (WBTC). WBTC is a token that gets pegged to Bitcoin but exists on another network. In order to create the new asset, a specific amount of coin is sent to a custodian, and through a smart contract that custodian then mints an equal value of tokens to be used on the other network. To reverse the process and redeem the Bitcoin, the user must then enter into a “burn” contract, which basically is the reverse of minting, where the tokens are returned to the custodian and the Bitcoin is sent back to the original user. 

The downside here is that, currently, Ethereum-based WBTC is the only major offering available. A Tezos version has been launched as well, and theoretically other blockchains could implement the same model, but it could take time to see those types of developments emerge. It is true that Ethereum offers a wide variety of DApps, and hence this is a step in the right direction. This at least allows for Bitcoin holders to take part in DeFi without having to directly sell into a new network, but there still isn’t enough universality here to make this a “one size fits all” answer. On top of this, the WBTC system is centralized, and many feel that trusting a third-party custodian runs a bit against the philosophies of DeFi, and hence would like to see a more trustless solution.

Unlocking every blockchain

One project attempting to find a road to frictionless liquidity is known as pTokens. pTokens were originally developed by the company Provable Things, and look to go further by making every blockchain compatible with every other. What makes this possible is something known as a “Trusted Execution Environment,” or TEE, which is basically a server that interacts with the two blockchains you are looking to transfer between. The TEE is effectively the custodian from the WBTC system, and can be set up so that it can transact the swaps between any two chains in a way that is fully auditable. From the pToken white paper:

In general, a TEE runs a small-footprint operating system which exposes a minimal interface to the main operating system running on the device. This smaller footprint reduces the potential attack surface of the TEE. Because of this, TEEs can run applications with high security requirements, such as cryptographic key management, biometric authentication, secure payment processing and DRM.

So far pBTC tokens are the only ones that have been implemented, but plans are already in motion for pLTC, pUSDT, pDAI, pTRON and many more. Generally, these tokens are all being designed for Ethereum and EOS, as those are where they are needed most, but in time, this same technology could be applied across virtually any blockchain. 

One project that seeks to leverage pTokens to make DeFi easier is known as Equilibrium. The system allows for users to put up crypto collateral in order to mint EOSDT, a decentralized stabletoken that can be used to interact with any DApp the platform offers. In its first iteration, only EOS was supported for collateralization, but more recently, Bitcoin has been integrated into the system as well. This means that anyone holding Bitcoin can easily transfer its value into EOSDT, take part in any DApps they choose, and even turn it back into Bitcoin at any time. This is the closest we have seen to the type of frictionless liquidity that many claim is essential to bringing about a wider DeFi adoption. Equilibrium has announced that by tapping into Bitcoin, they have been able to raise the circulation cap on EOSDT by $100,000,000. Considering how many other projects exist out there to be collateralized, this could be just the beginning of a much larger liquidity pool.

With the functionality of pTokens, the sky is theoretically the limit. With more and more assets supported, users will find it easier to begin getting involved in DeFi applications. Hopefully, this will encourage even more interoperability, as any project not supported cross-chain will start to feel archaic. This should also enhance ongoing user experience, as more of the techniques described here will be happening behind the scenes, and from an outsider’s perspective, should just work.

While there is still much to do, major strides have already been made. Being able to leverage Bitcoin itself, still by far the most popular asset in the whole DeFi space, is almost certainly essential for a broader adoption to ensue. If these projects can keep pushing and go further to where virtually any asset can seamlessly move across chains, then one of the biggest hurdles to making this space user-friendly will be eliminated. Based on the way things are going, the future is looking very optimistic.