Interoperability is the foundation of a multi-chain future. With multiple chains carving out their own use case across crypto, interoperability will provide a way for chains to share data. Most importantly, interoperability permits users to move their capital across different chains to optimize capital allocation, use cases, gas fees, and transaction volume. Once Web3 matures, interoperability will be similar to TCP/IP in Web2: a standardized set of protocols to exchange information across chains.
Today, crypto is still in the early innings, and each chain is focused on scaling itself rather than cross-chain interoperability. However, the rise of competitive L1 chains shows glimpses of impending interoperability needs. Looking at solutions today, interoperability is solved in two ways: EVM-compatibility and bridges.
EVM-compatibility is the primary method chains have used to port over key DeFi primitives from Ethereum (AMM, lending / depositing, overcollaterization, liquidity mining, etc.). EVM-compatibility provides interoperability of applications; it’s similar to running Parallel in MacOS to use the Windows version of Microsoft Office (can’t live without the Excel keyboard shortcuts!).
Meanwhile, bridges are the primary way to bring users and capital from one chain to another. Bridges take the native token of one chain and bring the monetary value to another chain. For example, Wrapped Ethereum can be bridged from the Ethereum network to the Avalanche network. Bridges serve as a crypto-to-crypto on-ramp to encourage users from at-scale Layer 1 (L1) to emerging L1 chains and Layer 2 (L2) solutions. Today, there are numerous bridges across chains but most are focused on bridging in users and capital from Ethereum, given the chain’s dominance.
However, EVM-compatibility and bridges are only temporary solutions. They work for now because the number of competitive L1s is limited while DApp innovation is primarily Ethereum-led. As a result, interoperability issues are not yet a pressing problem. Looking to the future, both solutions are not purpose built for supporting a multi-chain future.
Let’s start with long-term EVM-compatibility issues. EVM-compatibility is the primary gift from Ethereum; it provides a quick way to build DeFi on a new chain. However, EVM-compatibility has three long-term problems: customer acquisition costs, liquidity fragmentation, and non-EVM chain innovation incompatibility.
First, users don’t try out new chains because they’re benevolent; they do so because they are incentivized. The answer is usually simply handing users money through a dedicated ecosystem fund to bootstrap liquidity on ported EVM-compatible DApps – Binance’s $1B fund, Harmony’s $300M fund, Avalanche’s $180M Rush program, and more. However, ecosystem funds are inherently unsustainable: they serve as a finite budget for acquiring users. Each incremental user will require even more money to acquire. It’s like trying to reach buyers on Instagram ads; once you convert the easily impressionable user, the next user needs even more incentives, depleting the budget even faster.
Second, EVM-compatibility introduces liquidity fragmentation. While each project can exist on multiple L1s and L2s, each version of the project is running essentially a branded fork on each chain. For example, Aave exists on four chains, SushiSwap is on 14 chains, and Curve is on seven chains. Typically projects create separate vaults for each chain. As a result, each pool has less liquidity that ultimately creates suboptimal pricing for the same or similar assets, producing inefficiency for users.
Third, non-EVM crypto innovation is inevitable. Solana and Terra, both top five chains, are not EVM-compatible but represent tremendous momentum – 7,599% and 3,239% TVL growth respectively since March 18, 2021. At some point in the near future, both chains will produce new DeFi primitives or DApps that cannot propagate across crypto broadly because neither chains are EVM. EVM-compatibility is like globalization: easy to copy innovation locally but not set up to innovate on the edge.
Finally, bridges are a stop gap solution for Ethereum dominance. A multi-chain future pre-supposes that Ethereum’s first-mover advantage is competed away while other L1s and L2s build durable moats. As other chains gain prominence and activity, the number of bridges will have to increase to support interoperability. Thus, the number of bridges needed increases exponentially with each successful L1 and L2 chain.
Abstracting to the user experience, the L1 and L2 sprawl will create further friction. While not quite apples-to-apples, onboarding onto the Ronin Sidechain to play Axie Infinity is a good example. Crypto is already hard to use for crypto natives and new users will continue to struggle to enter the crypto ecosystem. For crypto to become mainstream, innovation cannot outpace on-ramp usability for users.
Thus, I believe a multi-chain future will require centralization: a hub-and-spoke model that solves for interoperability. A primary chain serves as the intermediary hub for other chains to connect through. Specifically, users should be able to bridge into a common denominator chain and then bridge out into another L1 or L2.
A successful hub will need to be purpose built for scalability, flexibility, and modularity.
Scalability: the chain needs to be able to handle or accommodate increasing transactions per second demand while maintaining affordable gas fees. Examples include Solana (L1), Avalanche (L1), and Zk rollups (L2).
Flexibility: the chain supports cross-chain DApp compatibility and bridges without significant friction. Examples include EVM-compatibility and the Avalanche-Ethereum bridge.
Modularity: the architecture of the chain is able to on-ramp DApps, users, and capital from different chains while preserving usability and speed. Examples include zones / hubs on Cosmos and subnets on Avalanche.
There are many solutions focused on interoperability either through native compatibility with Ethereum or purpose-built Layer 1s. Given crypto’s significant runway, I believe there will be many successful models, but the main winners will focus on creating the most frictionless user experience. An index bet would be on a chain that is dedicated to supporting the success of multiple chains.
Note 1: March 18, 2021 is the earliest date Defi Llama started tracking Solana TVL.
Note 2: My last article was about exporting Ethereum via EVM compatibility to win. The purpose of the article was how to win now and in the near-future. Winning long-term will require capturing innovation and network effects from non-EVM chains (e.g. Solana and Terra). If you disagree with my conclusions in general, feel free to shoot me a Twitter DM @dicekay__ (two underscores after the y). I strive to be open minded so I look forward to differing views.
Disclaimer: I hold investments in Ethereum, Ethereum specific projects, Solana, Solana specific projects, Terra, Terra specific projects, Avalanche, and Avalanche specific projects. This is not investment advice.