Liquidity Fragmentation
Last updated
Last updated
Even if the technical challenges can be overcome and the wrapped asset remains synchronised with the underlying reserve asset, relying on token-wrapping alone introduces liquidity fragmentation. Instead of assets being “swapped,” assets are locked and then new, synthetic tokens are issued on another chain. As a result, liquidity is locked on various blockchains, increasing the number of digital assets not available to the market. In deflationary token economies especially, this is an issue, as it reduces the operational liquidity of that blockchain.
The additional problem is that wrapped tokens are still not interoperable with native tokens on the destination chain. Thus, wrapping has not solved the problem of liquidity fragmentation. It allows chains to communicate, but in doing so, only makes the fragmentation of liquidity occur within chains rather than between them.
Even worse, if there are multiple bridges between the same chains, the bridges produce different wrapped tokens which are not interchangeable. Thus having multiple wrappings of the same token contributes to liquidity fragmentation – the main problem the bridges were built to solve. Each new bridge brings a collection of bridge-wrapped tokens, and the proliferation of bridges has brought with it a proliferation of bridge-wrapped tokens. For example, Avalanche had about 650M USDC¹, 1.6B Avalanche-Bridge-Wrapped USDC², and a paltry 680M Wormhole-wrapped USDC³.
Similarly, in addition to native USDC⁴, Solana has 47M Sollet-wrapped USDC⁵, 5M Wormhole-wrapped USDC⁶, and 1.9M Allbridge wrapped USDC (from Ethereum)⁷. Further complicating things, Allbridge wraps USDC differently depending on the source chain, so Allbridge wrapped USDC from Avalanche⁸ is controlled by a different contract than Allbridge wrapped USDC from Ethereum.
The situation worsens as Allbridge also offers wrapped USDC from chains like BSC⁹ and Polygon¹⁰, neither of which chains natively support USDC. As a result, these tokens are wrappings of wrappings.
Protocol developers now realize that having multiple bridges into their ecosystem is undesirable. For example, Osmosis recently solicited applications to be the one “canonical” bridge to their blockchain¹¹.
Avoiding the wrapping issue, stablecoins like USDT¹² and USDC¹³ are natively available on Ethereum, Solana, Avalanche, Algorand and Tron. Nevertheless, moving value across chains is still a cumbersome and risky process.
A superior model for cross-chain projects is to maintain pools of assets on each blockchain. The project's custodians can release these “real” (native) assets on the destination chain when they observe a deposit on the source chain. This is the approach taken by the cross-chain DEX Thorchain and is the approach taken by Kima.
As with the wrapping solutions, the core technical challenge with using liquidity pools to facilitate cross-chain swaps is keeping the pools synchronised, i.e., ensuring that tokens are only released on the destination chain when corresponding tokens are deposited on the source chain. When the source chain has an efficient light-client implementation, then the destination chain can validate source-chain deposits without the help of trusted, off-chain entities.
¹ ² ³ ⁴ ⁵ ⁶ ⁷ ⁸ ⁹ ¹⁰ ¹¹Stevie Woofwoof. Osmosis town hall — choosing a bridge service provider., 2022.
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