What are DeFi bridges?
Imagine you're traveling between two cities separated by a river. To move from one city to the other, you'd need a bridge. Similarly, in the world of blockchains, we have several distinct networks (“cities”) like Ethereum, Bitcoin, and Solana. To communicate or transfer assets between them, we need digital "bridges".
A blockchain bridge (or cross-chain bridge) is a method that allows for the transfer of tokens and information between two separate blockchain networks.
Buy why is this needed? Because blockchains are siloed ecosystems. Blockchains exist as separated distributed networks with their own tokens. As such, the native assets on one chain are not transferable to another as these blockchains can't natively "talk" to each other. This is where bridges come in. They act as intermediaries, enabling the flow of information, assets, and more between blockchains.
Types of DeFi bridges
Cross-chain bridges play a pivotal role by enhancing interoperability between disparate blockchain networks. These bridges typically operate using one of two mechanisms:
- Lock-and-mint (wrapped token) bridges: The first, and perhaps the most common, involves the process of freezing or locking the asset on the original blockchain and then issuing or minting an equivalent token on the destination chain. This newly minted token is often referred to as a “wrapped” token. It represents the original asset but is tailored to be compatible and functional on the destination network, thereby bridging the gap between two different blockchain ecosystems.
- Liquidity pool bridges: The second mechanism leverages the concept of liquidity pools present on each blockchain involved in the bridge. In this approach, users contribute to these pools by providing liquidity, and in return, they are rewarded with fees or other incentives. These rewards are generated from the transaction fees paid by those transferring assets across the bridge. For example, when an asset is transferred using the bridge, a small fee is incurred. This fee is then distributed among the liquidity providers as a reward for facilitating the bridge transactions. This method not only aids in the seamless transfer of assets across blockchains but also creates an opportunity for users to earn passive income through their participation in these liquidity pools.
Where does the yield come from in DeFi bridging?
Bridging allows the transfer of digital assets between blockchain networks, and liquidity providers earn transfer fees for each transaction. Cross-chain bridges only generates yield from the liquidity pool model. Under this design, any user can provide liquidity to earn income from two sources:
- Bridging fees: This is the amount of money that bridge users pay to the bridge providers for using their service. For example, if a bridge user wants to transfer USDC from Ethereum to Avalanche, they will pay a fee to the bridge provider who facilitates the transfer.
- Token rewards: This is the amount of money or tokens that bridge providers or users receive for participating in a platform or protocol. For example, if a user provides liquidity on Across, they will receive additional rewards in the form of ACX tokens.
Are DeFi bridges safe?
Cross-chain bridges are a critical infrastructure in the crypto ecosystem as it connects disparate networks together. However, the safety of these bridges is an ongoing concern given the inherent risks associated with transferring crypto assets across separate blockchains. Like all new technology, cross-chain bridges come with several risks:
- Centralization risks: Bridges are categorized as either trusted or trustless. Trusted bridges are operated by centralized entities, which can be a single point of failure. During bridging, the asset moves from the user to a central authority. Users must trust the integrity and efficiency of the centralized entity to perform the transaction.
- Smart contract vulnerabilities: Bridges are a new technology that has not been well battle tested. In fact, the majority of bridge hacks to date have been due to a vulnerability in the underlying code rather than a trust issue. If the underlying code of the bridge has flaws, it can be exploited by hackers.
- Liquidity risks: For liquidity providers, there's a risk of asset shortages on specific chains as the bridge needs to ensure ample reserves of assets on each blockchain to support transfers. If there's a heavy preference for transferring assets in one direction, it can lead to an imbalance where one side of the bridge has depleted reserves. This imbalance can cause delays or increased costs for users trying to transfer assets back in the opposite direction, as the bridge may not have enough of the required asset readily available.
What are the advantages of DeFi bridging?
Bridging in DeFi can offer several benefits including:
- Interoperability: Bridges connect isolated blockchain networks, allowing assets and data to flow between them.
- Speed and cost: Using bridges can often be faster and cheaper than traditional exchanges.
- Increased utility: Assets from one blockchain can be used in another, unlocking new use cases and functionalities.
Where can I start bridging in DeFi?
If you want to start staking in DeFi, you can check out some of these liquid staking protocols: