Monthly Market Review - January 2022

In this note, we look at cross-chain bridges, the risks they introduce and how they may lead to a multi-chain instead of a cross-chain blockchain world.

As web3 developed through 2021, its usage increased, resulting in blockchain capacity becoming scarce. As users have searched for cheaper blockchain capacity, multiple 'layer one' blockchains have boomed, with each 'layer one' making a different trade-off between scalability, security, and decentralisation. The most prominent smart contract blockchain is Ethereum, broadly considered the most expensive but most secure smart contract blockchain. Binance Smart Chain (BSC), Cardano and Solana are close competitors but have made different trade-offs compared to Ethereum. However, as Ethereum Gas fees have increased (current average ~$30 per transaction), more retail investors have been priced out of using web3 products.

So, to reduce transaction costs, low-fee chains have emerged. For example, BSC has decreased its transaction fees by increasing its centralisation. The low fees have allowed BSC to grow in popularity quickly. These cheaper and quicker layer ones have boomed as users have preferred using products that are cheaper to use. Another solution that has proved popular is 'layer two' blockchains. These chains handle multiple transactions off 'layer ones' and settle back in a single transaction. The settlement process allows 'layer twos' to benefit from 'layer one' security while still having low fees. Most 'layer twos' are based on Ethereum, the most secure (and expensive) 'layer one'.

To transfer assets between chains, developers have invented cross-chain bridges. In these bridges, you lock up your assets on one chain and withdraw them on another. For example, if you wanted to trade Ethereum but use a product on BSC, you would transfer your ETH into a bridge. The bridge would store your ETH and send the equivalent WETH (Wrapped Ethereum) to your address on BSC. As different layers have grown, so has the value stored within bridges. However, bridges also introduce significant systematic risk into both chains. Continuing the above example, say the bridge was compromised, and all ETH was removed, the WETH would still exist on Solana but be backed by nothing. Thus, any unsuspecting user on Solana who holds WETH would suffer losses. Therefore, it's always safer to keep Solana native assets on Solana and Ethereum native assets on Ethereum, removing the bridge risk.

A recent hack on Wormhole bridge, one of the most famous bridges between Solana and Ethereum, brought this risk to the industry's attention. 120,000 ETH (roughly $320 million) was stolen during the hack, leaving WETH on Solana worthless. Luckily for the broader community, Jump Crypto, one of Wormhole's and Solana largest investors, decided to save the bridge with a 120,000 ETH bailout to ensure that WETH remained pegged at 1:1 on Solana. The bailout prevented broader losses but proves these risks aren't just theoretical.

As bridges grow, the systematic risk grows as there is more incentive for somebody to attack the bridge, so the bridge risk increases over time. The growth of bridge risk reduces the chances of a cross-chain world rather than a multichain world. In a cross-chain world, single apps are deployed to many chains and use bridges to transfer assets. Instead, users have more incentive to adopt a multichain world, where assets are stored independently of each other and without this risk.

As we head into this multichain world, projects, pools of capital, developers and communities will become more isolated over time as each chain specialises around a single purpose. Developers will have to choose which broader community to focus on, which will cause future fragmentation. This fragmentation should decrease capital efficiency in the medium term, providing attractive arbitrage opportunities for well-positioned funds.