Crypto interoperability evolves: From blockchain bridges to DeFi transfers

Today, paying for purchases in cryptocurrencies no longer seems like something out of the ordinary. Many online stores accept Bitcoin (BTC) and other coins along with traditional currencies, while in some cafes, cryptocurrency holders can even pay using point-of-sale terminals.

However, there is one thing that distinguishes traditional financial systems from cryptocurrencies: advanced interoperability. Thanks to interoperability, cardholders can make payments anywhere in the world without worrying about device compatibility and currency conversion.

Crypto interoperability

An owner of a crypto wallet can only dream of this, but a sign hanging on the door of a restaurant that says “Cryptocurrency accepted here” does not guarantee that patrons will be able to pay for their dessert with Ether (ETH). Instead, a server with a surprised look on their face will say that the restaurant’s terminals work only with Bitcoin.

However, if the visitor’s blockchain wallet and the restaurant terminal were compatible, the client would not have to remember what crypto they have on balance. The only thing that would be needed is to simply scan a QR code, and the system would convert the currency into the one accepted.

In order for users to pay with ETH in stores that accept BTC, their blockchain systems must be cross-chain interoperable. The question remains: Why, even 11 years after the first decentralized systems appeared, is this still a problem? The fact is that until recently, each type of blockchain was built as a separate independent ecosystem, and the developers seemed to be preoccupied more with competing with each other rather than working on things like compatibility.

However, with the growing popularity of decentralized finance in 2020, the issue of cryptocurrency compatibility is getting more relevant than ever. The thing is that the DeFi industry itself was conceived as a single financial ecosystem, the products of which could be compatible with each other. Jonathan Schemoul, the founder of decentralized application network Aleph.im, told Cointelegraph: “By nature, smart contracts are composable, small building blocks that can be combined to abstract away complexity and deliver a smoother experience to the customer.”

Today, DeFi is a market with a volume of locked funds of over $10 billion, which is becoming an alternative to banking services for thousands of users due to attractive rates for loans and deposits offered by DeFi products. An important factor contributing to this sector’s popularity is the successful attempt of DeFi developers to partially solve the compatibility problem. As a result, users can seamlessly exchange different tokens or refinance a loan from one asset to another.

However, despite such grand ambitions, the DeFi sector still lacks bank card compatibility. While fiat currencies can be exchanged anywhere, it’s still harder to bridge crypto to fiat and even harder to bridge crypto to crypto. To evaluate the progress being made by industry players in this direction, it’s important to understand how the concept of interoperability has evolved from the first attempts to bridge the gap between two blockchains to today’s cross-chain DeFi transfers.

2012 to present time

Few people know, but the first attempt to make cryptocurrencies interoperable was made back in 2012 by Joseph Chow. The developer created the BTC-Relay system with the purpose of obtaining information from the Bitcoin chain and using it in Ethereum smart contracts. Funds sent in BTC to an ETH address through a special smart contract that received information on the Bitcoin blockchain would then be transferred to Ethereum as soon as the transaction was confirmed.

In 2017, the first-ever atomic swap took place between the Decred, Litecoin and Bitcoin networks. In the same year, blockchain company Lightning Labs successfully completed an atomic swap between the Bitcoin and Litecoin test networks without registering a transaction on both blockchains. Atomic swaps allow the exchange of cryptocurrencies from different blockchains without involving third parties and underlie peer-to-peer trading on today’s decentralized exchanges. However, not every network can work with this solution. For cross-platform payments, the network must support the Lightning Network and Segregated Witness.

The next big step toward the interoperability of crypto was taken by Bancor in 2018 with the BancorX solution, which allows conversions between any Ethereum-based asset and EOS without the need to deposit funds to the exchange and the need to reconcile orders between buyers and sellers. Any Ethereum-based token can be converted to other EOS-based tokens in one click without conversion fees.

More recently, Javascript creator Brendan Eich has combined several intermediate tokens that can correlate with BTC, Litecoin (LTC), ETH and any other asset in a single Universal Protocol platform. Notably, these tokens are not native to a particular blockchain and can be created on any distributed ledger protocol.

In 2020, technology companies repeatedly noted the importance of combining the efforts of large blockchain platforms, which, until recently, were created autonomously from one another. This year, NEO, Ontology and Switcheo have launched a joint project called Poly Network — a heterogeneous interoperability protocol alliance aimed at seamlessly integrating the Ethereum, Cosmos and NEO blockchains into the larger cross-chain ecosystem.

Is DeFi a breakthrough in cross-chain interaction?

Now getting back to that cafe where a customer wanted to pay with crypto. It doesn’t matter what tokens the customer holds since the establishment of supports systems, such as Wanchain, provides “cross-chain asset transfers,” allows to connect to all the major blockchain platforms like Bitcoin, Ethereum and EOS, and provides asset conversion without the need to change any of the original properties or by a bridging chain.

The emergence of decentralized finance can significantly narrow the gap between crypto and the traditional financial system. Moreover, according to experts, DeFi solutions are able to solve the issue of integrating cryptocurrency into the financial world even faster than the payment industry leaders such as PayPal or Coinbase.

Speaking at Ethereal Summit, Antonio Juliano, the founder of margin lending platform dYdX and, previously, a software engineer at Coinbase, shared his observations on how much effort Coinbase made on traditional financial integrations versus decentralized alternatives: “About 75% of the company’s effort goes to dealing with the traditional payment side. And a very small proportion of that […] is actually integrating directly with the crypto side.” Juliano also added that it would be much easier to build these new financial products in DeFi.

Reflecting on whether cryptocurrencies can achieve the same level of fungibility and user experience as traditional payment systems, Peter Mauric, the head of public affairs at blockchain infrastructure firm Parity Technologies, told Cointelegraph that while the decentralized fintech sector is gaining popularity, digital payment applications are simple to implement on scalable, interoperable, crypto-economic networks: “As distrust between users and the traditional financial systems grows, I predict we will start to see blockchain-based payment, lending, saving and banking apps gain in popularity.”

Some cases show that DeFi solutions are already winning this competition. For example, Curve provides efficient interoperability among stablecoins that exceeds what is currently offered by centralized finance.

In less than a year, DeFi projects have reached the level of some banking services, and to some extent, they’ve managed to do what banks have not been able to do so far — to launch cryptocurrency lending and deposit services. Many of these platforms have made significant strides in internal interoperability. For example, Instadapp has created a single point of access to several platforms at once, such as MakerDAO, Aave, Compound and Curve, for users to take loans or make deposits and made it possible to refinance debt from one chain to another.

Better scalability with fast latency blockchains is already making things look similar to credit cards in terms of transaction processing times and fees, according to Sandeep Nailwal, co-founder and chief operations officer at blockchain scalability platform Matic Network. The platform’s sidechains support two-second block times with extremely low transaction fees, making the payment experience look more like a bank card transaction.

But what’s more important is that DeFi solutions enable the transfers of all types of assets, and not only cryptocurrency. Polkadot, for instance, created one gateway to bridge any type of blockchain through so-called parallel chains.

However, the opposite side of the increased functionality such cross-chain solutions provide can be decreased network security when foreign tokens are transferred to proof-of-stake blockchains. This is especially applicable to staking, which is what Polkadot is based on. If the amount of tokens deposited is greater than the value of tokens at stake, then validators have incentives to misbehave.

One possible solution to this problem was proposed by KIRA Network, which made it possible for any deposited token to be staked so there are no limitations in terms of how much can be transferred cross-chain or used on the platform safely. The developers also brought the cross-chain interoperability to the next level, allowing for cross-chain transfers across almost any network, whether it’s proof-of-stake or proof-of-work, as long as they have finality or probabilistic finality.

Overall, it seems that DeFi developers have made great progress in making cross-chain transactions possible. However, there is still much work to be done to bring this interoperability to that next level. Some believe that insufficient scalability, high fees and regulation among the main hurdles for reaching the same level of interoperability.

External interoperability is still under question

While emerging DeFi systems offer easy and low-cost conversions across various cryptocurrencies, even those considered today to be inexpensive carry very high fees when used for typical purchase-sized conversions. This is because any merchant who works with crypto sooner or later will need to convert it into fiat. While this is where higher fees are hidden, according to Mike Toutonghi, the lead developer at Verus — a zero-knowledge technology and privacy-oriented project — the total combined value of these fees may exceed the cost of debit or credit card transaction processing. He told Cointelegraph:

“All these fees together inevitably make up the total fee overhead for both merchant and customer. While it may seem that the 0.3% fee offered by Uniswap liquidity pools is only a fourth of the best credit or debit card fees, one must consider Ethereum or other network fees, and unless the merchants start accepting native cryptocurrency more broadly, these fees and the delays associated with conversion are in addition to, rather than in lieu of the total fees paid by fiat users.”

Interoperability can still remain internal until cryptocurrencies solve the problem of limited scalability. This limitation is mainly due to Ethereum’s infrastructure, according to Danial Daychopan, founder of Plutus — a gateway that connects blockchain technology with the existing infrastructures. Speaking with Cointelegraph he suggested that this is, however, just a matter of time: “Smart contracts are still not reliable or scalable to millions of users but with concepts such as sharding, it could be possible to greatly increase the number of possible crypto transactions, making it a feasible alternative to bank card payments.”

Others stress that DeFi protocols need to implement controls for Anti-Money Laundering that will be acceptable for merchants and payment providers. Michael Shaulov, the CEO of Fireblocks, told Cointelegraph that some progress, however, is being made in this direction:

“We are not there yet, but it is on their [DeFi platforms] roadmap and technically feasible if we look at how they blocked funds from the KuCoin hack. At the end of the day, the market eventually finds its way when a more efficient alternative exists.”

Bridging fiat to crypto is the next step

Although, in theory, it’s possible to pay with Ether in every cafe where only Bitcoin is accepted, such practice is not common yet. However, the big steps that have recently been taken to unify the efforts of blockchain systems make it possible to believe that interoperability will soon cease to be a problem for cryptocurrencies.

This suggests that reaching the next level of interoperability — external this time — is just around the corner. And big steps are being made to create free space where digital money will be compatible with fiat. For instance, Ripple is working on the Interledger Protocol that allows for carrying out transactions between blockchain and non-blockchain platforms.