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Interoperability in DeFi

By Romeo F.
8 Apr 2023
8 min read

DeFi, is all about using blockchain technology to create a more open and transparent financial system. It's like traditional finance, but without the intermediaries and red tape. Instead, anyone with an internet connection can access financial services directly.

The DeFi world has exploded in recent years, with over $93 billion worth of assets locked in DeFi protocols as of September 2021. However, one of the biggest challenges facing DeFi is interoperability - or how different blockchains can communicate and work together.

Interoperability is a big deal for DeFi because it means assets and data can move between different blockchains more easily, which increases the liquidity and accessibility of financial instruments. It also leads to more innovation and collaboration within the DeFi space, and more exciting new financial products for all of us to use.

In this article, we'll dive into why interoperability is so important for DeFi, the challenges of making it happen, and the current solutions available in the DeFi ecosystem. So buckle up and get ready to learn!

Why do we need interoperability in DeFi?

Interoperability is crucial for the success of DeFi because it unlocks a whole new level of functionality and accessibility. Here are just a few reasons why:

Interoperability allows different blockchains to communicate with each other seamlessly. This means that assets and data can be moved between blockchains without any problems.

Why is it important? Because there are a lot of different blockchains, each with its own strengths and weaknesses. Being able to connect them all together means that users can take advantage of the unique features of each blockchain while still being able to access everything in one place.

Interoperability creates a larger pool of liquidity and access to diverse financial instruments. Meaning that users can access more liquidity from different markets, which can help them get better prices for their assets.

It also allows users to access a wider range of financial instruments, such as derivatives, options, and futures, which can help them manage risk and improve their overall investment strategy.

Interoperability enables easier access to global markets. With DeFi, users can access financial services from anywhere in the world, but different regions may use different blockchains or have different regulations. It also allows users to seamlessly access financial services across borders and between different blockchains, without having to worry about the complexities of different jurisdictions.
Interoperability promotes innovation and collaboration within the DeFi ecosystem. With more blockchains working together, developers can create new and innovative financial products and services that weren't possible before. This can lead to a more vibrant and dynamic DeFi ecosystem, with more opportunities for everyone involved.
Overall, interoperability is a key enabler of the DeFi revolution. By connecting different blockchains together, we can create a more accessible, innovative, and dynamic financial system that benefits everyone.

Challenges Associated with Interoperability in DeFi

While the benefits of interoperability in DeFi are clear, achieving it is not without its challenges.

No Standardized Protocols

Different blockchain protocols have their own unique features and incompatibilities. This makes it difficult to create a standardized protocol that can work across all blockchains. Each blockchain has its own programming language, consensus mechanism, and smart contract system. These differences create technical challenges when trying to achieve cross-chain communication and interoperability.

Security Concerns

Thirdly, security concerns and risk management are also major challenges. When different blockchains are connected together, the potential attack surface increases, which makes it harder to ensure the overall security of the system. This requires strong security measures and risk management practices to be in place to prevent malicious actors from exploiting vulnerabilities.

Lack of Governance Models

Finally, governance issues and decision-making processes are also a challenge. With multiple blockchains involved, it can be difficult to coordinate and make decisions about how to move forward with interoperability. Different blockchains may have different governance models, and decision-making processes can be slow and complicated.

Despite these challenges, there are solutions being developed to overcome them. For example, some projects are working on developing standardized protocols that can work across different blockchains, while others are focused on building specialized technology to enable cross-chain communication. As the DeFi ecosystem continues to evolve, we can expect more progress in overcoming these challenges and achieving interoperability.

We are advancing steadily towards interoperability solutions

As the DeFi ecosystem grows, so do the solutions for achieving interoperability. Here are some of the current solutions for interoperability in DeFi:

Blockchain Bridges

Bridges and gateways are being developed to connect different blockchain networks. These bridges act as a sort of middleware that enables communication between different blockchains. Bridges can be built between public blockchains, such as Ethereum and Bitcoin, or between private and public blockchains.

Wrapped Tokens

Wrapped Tokens and cross-chain swaps are becoming more popular. Wrapped tokens are tokens that are pegged to an asset on a different blockchain. For example, a wrapped Bitcoin on Ethereum is a token that represents Bitcoin on the Ethereum blockchain. Cross-chain swaps allow users to exchange wrapped tokens between different blockchains, enabling them to move assets between different ecosystems seamlessly.

Interoperability-focused Blockchain Protocols

There are interoperability-focused blockchain protocols such as Polkadot and Cosmos. These protocols are designed specifically to enable interoperability between different blockchains. They provide a standardized framework for cross-chain communication and facilitate the movement of assets and data between different ecosystems.

DEX Integration

Decentralized exchanges (DEXs) with multiple blockchain integrations are becoming more prevalent. These DEXs allow users to trade assets from different blockchains in a decentralized manner. They typically use wrapped tokens or cross-chain swaps to enable the movement of assets between different blockchains.

Are the current interoperability solutions 100% secure?

As much as we would like to say that we have got the answers to everything, we don’t. While interoperability solutions like bridges and gateways offer many benefits, they also present some unique security challenges.

In the past few years, several security exploits have taken place specifically targeting these solutions. Here are some of the main security concerns associated:

Centralization Risks: Many interoperability solutions rely on centralized bridges or gateways that act as intermediaries between different blockchain networks. This centralization can create a single point of failure and a target for malicious actors seeking to exploit vulnerabilities in the system.

Smart Contract Risks: Interoperability often requires the use of smart contracts to facilitate cross-chain communication. These smart contracts can be complex and may contain bugs or vulnerabilities that could be exploited by attackers. The risk is even higher in cases where smart contracts are deployed on multiple blockchains.

Token Standards Risks: Interoperability can require the use of token standards that are compatible across different blockchain networks. However, not all token standards are created equal, and some may have vulnerabilities that could be exploited by attackers. The use of non-standard tokens or custom token standards can also introduce additional risks.

Governance Risks: Interoperability requires a level of coordination and governance between different blockchain networks. This governance can be complex and may involve multiple parties with different interests, making it more difficult to reach consensus and make decisions.

EVM is advancing interoperability in DeFi

The Ethereum Virtual Machine (EVM) is a crucial component of the Ethereum blockchain that enables developers to create and execute smart contracts. In simple terms, the EVM is a virtual computer that runs on the Ethereum network, allowing developers to create decentralized applications (dApps) and automated financial instruments (smart contracts).

One of the key benefits of the EVM is that it provides a standardized environment for executing smart contracts. This means that developers can create smart contracts using a variety of programming languages and tools, but they will all run on the same EVM, ensuring that they are interoperable with each other.

Some of the most popular EVM-compatible blockchains include Binance Smart Chain, Avalanche, Cardano, Polygon, xDAI, and Tron.

Here are some of the ways in which EVM is helping to improve interoperability in DeFi:

Cross-Chain Smart Contracts: EVM-compatible blockchains like Binance Smart Chain and Polygon enable cross-chain communication by supporting the same smart contract language as Ethereum. This means that developers can create smart contracts that work across multiple blockchains, allowing for seamless interoperability between them.

Decentralized Bridges: EVM-compatible blockchains are also making it easier to build decentralized bridges between different blockchain networks. These bridges allow users to transfer assets between different blockchains without relying on centralized intermediaries.

Layer 2 Scaling Solutions: EVM-compatible blockchains are also leading the way in developing layer 2 scaling solutions like Optimistic Rollups and ZK-rollups. These solutions help to increase the scalability of DeFi protocols by processing transactions off-chain and then aggregating them on-chain. This makes it easier for DeFi protocols to operate across multiple blockchains and reduces the barriers to interoperability.

EVM-Compatible Tokens: Many DeFi protocols are based on Ethereum and use Ethereum's ERC-20 token standard. However, EVM-compatible blockchains are also introducing their own token standards that can be used across multiple blockchains. These token standards allow for easier interoperability between different blockchains, as tokens can be easily transferred between them.

So, what does the future look like for interoperability in DeFi?

Looking ahead, we can expect to see several exciting developments in the future of interoperability in DeFi. One area that is likely to see significant progress is the continued development and refinement of current interoperability solutions.

This could include improvements to bridges and gateways, wrapped tokens becoming more user-friendly, and decentralized exchanges becoming even more seamless in integrating with multiple blockchain networks.

Another area of interest is the emergence of new interoperability-focused protocols and technologies. For example, the Polkadot parachain network is designed to enable interoperability between different blockchain networks, while Layer-2 solutions like Optimism and Arbitrum are expected to improve interoperability and increase scalability.

Finally, as the DeFi ecosystem continues to grow and mature, we may see increased collaboration and standardization efforts among DeFi protocols. This could involve standardizing token standards, communication protocols, and governance structures, which could greatly enhance the efficiency and effectiveness of interoperability.

All of these developments suggest a bright future for interoperability in DeFi, with ongoing improvements to existing solutions and the emergence of new protocols and technologies.

As the DeFi ecosystem expands and evolves, we can expect interoperability to play an increasingly important role in providing access to diverse financial instruments, promoting innovation, and connecting global markets.

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