Bridges & The Liquidity Conundrum

Prior to the advent of bridges, liquidity was fragmented amongst the various blockchains. Bridges were introduced as a means for allowing a more seamless movement of liquidity between different blockchains, making it easier for users to move and deploy funds where desired with as little friction as possible.

Fast forward to today, blockchain bridges and interoperability protocols are now the norm with increasing usage (prior to the current bearish period). This development in the infrastructure of blockchains was initially a welcomed one, but with over $2 billion exploited from bridges, confidence in bridging protocols has hit a low and for most part are eyed with caution.

This would be a possible explanation for the decline in bridge volumes, with the exception of event-driven spikes (ex. Arbitrum Odyssey), alongside the general decline in crypto transactions overall.

From Unifying Back To Fragmentation

With the recent bridge exploits, some blockchains have resorted to implementing bridge specific tokens, where assets are identified by the bridge used when bridging to a blockchain. For example, on Evmos there are three different versions of USDC which are ceUSDC (Celer’s cBridge), gUSDC (Gravity Bridge) and madUSDC (Nomad Bridge).

When the Nomad Bridge was exploited, the impact on Evmos was limited to tokens bridged through the Nomad Bridge. And while overall liquidity on Evmos was impacted, funds that were bridged through cBridge and Gravity Bridge were unaffected.

In the case of the Horizon Bridge exploit, the value of all assets on the Harmony blockchain were negatively impacted regardless of the bridge utilized with stablecoins on the chain also losing their peg.

While the idea of splitting tokens by bridge used is positive step towards minimizing the impact of bridge exploits on the impacted blockchain liquidity, it however adds another point of liquidity fragmentation. Liquidity needs to be added to DEX’s for each bridge token rather than a single pool in the case of USDC. A lack of liquidity normally leads to a user being unable to swap their bridged tokens to a token with better liquidity; this does not provide the best user experience and can often lead to dissatisfaction.

Cross-Chain Swaps

One innovation within the space was the introduction of cross-chain swap protocols. Often these are built on or aggregate other bridging protocols in their underlying layer. Cross-chain swap protocols combine bridging capability and liquidity of DEX’s on different chains allowing users to swap from one token to another on a different chain.

This eases the experience for users crossing between different blockchains without having to worry about available liquidity on the destination chain.

Taking into account that the majority of cross-chain swap protocols converts the original token to a stablecoin for bridging before swapping again to the desired token at the destination, this potentially exposes users to slippage from using multiple protocols in order to complete the desired swap.

While the solution works by all means and purposes, in order for blockchain bridges and the cross-chain swaps built on them to form the underlying infrastructure that allows users to move between chains seamlessly more innovation is needed.

Continued Innovation

Recently, more protocols have announced planned innovations for moving liquidity across chains. The majority of these revolve around the Just-In-Time (JIT) model for moving liquidity between different blockchains by working with Automated Market Makers (AMM).

These AMM’s run liquidity pools on the various connected blockchains and respond to Request-for-Quotation (RFQ) received through the protocol. The model does not require the AMM’s to lock their liquidity with the protocol thus enables the AMM’s to further maximize revenue from their available liquidity.

In practice, this is a much needed solution as the Total Value Locked (TVL) on bridges continues to decline with decreasing token values and greater Liquidity Provider (LP) withdrawals. This solution allows continued participation by AMM’s without requiring liquidity locking and increases the depth of available liquidity without having to rely solely on liquidity pools within the protocol.

From the screenshot above we can see that volume across all bridges remains significant even during the current down market. If current volumes remain at these levels, then it is entirely possible for volumes to increase to the highs seen in the chart during a more positive market cycle.

JIT Model And Its Benefits

The demand for liquidity to enable bridging during positive cycles would increase demand on protocols for locked liquidity based on current protocol architectures. By utilizing a JIT model, this reduces the existing over reliance on locked liquidity. It also has other nett positives for protocols:

  • Reduced incentive payouts – Protocols do not have to increasingly incentivize more LP’s to lock their liquidity. This provides a nett positive to the protocol’s treasury by allowing funds to be deployed for other purposes.
  • Reduce being a target of hacks – With the decreasing need to lock large sums of liquidity within protocols, this reduces the attractiveness of bridging and cross-chain protocols to hackers. Considering that the JIT model is reliant on AMMs on both source and destination chains, funds bridged are not locked on the bridge itself.
  • Allows for greater transaction liquidity – As AMMs have greater available liquidity, this allows bridges and cross-chain protocols to be able to facilitate bridging of larger transactions.

For users of these protocols, the JIT model also offers some interesting benefits.

  • Allows for native swaps – Users can trade a native token on Chain A for a completely different native token on Chain B.
  • Reduce slippage and fees – Users no longer need to use multiple protocols to complete their transaction and receive the desired token on the destination chain. This helps users reduce exposure to slippage and fees.
  • MEV Protection – Order matching done off-chain through cross-chain messaging provides protection against sandwich attacks and other MEV techniques.

While some of the benefits above may not be as relevant for users that move smaller amounts, its definitely a step in the right direction for the sector as a whole. There are a number of protocols currently building out similar solutions but for the benefit of this post, we’ll stick to those build on some of the primary cross chain infrastructure.

Name:0xSquidPeti ProtocoldeSwap Liquidity Network
Infra:Axelar ProtocolCeler NetworkdeBridge
Status:In DevelopmentLaunchedTarget Nov 2022

The JIT model however has its drawbacks. It’s dependence on AMMs can lead to situations where the rates provided by the AMM can be more expensive in comparison to a regular bridge transaction.

As with everything, there are tradeoffs and here it seems an acceptable one. While the solution has its benefits, it may not be the best solution for all scenarios. Regardless, this continued innovation in the bridging and cross-chain space is a welcomed one. There is still more to be done in the space before these solutions can become an underlying solution connecting blockchains.

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