Blockchain Interoperability

The emergence of smart contract platforms that directly compete with Ethereum, such as Solana, Terra and Avalanche suggest that the future will most likely be a multichain world. In such a world, interoperability is key, as it ensures the exchange of information and transfer of value between different blockchains. In this post, we discuss the benefits and challenges of interoperability, as well as some of the early use cases.

Introduction

One of the big stories of 2021 was the emergence of several new blockchains, such as Solana, Terra and Avalanche. They have grown tremendously in terms of market capitalisation, developer community and user base, and now directly compete with the established networks, Ethereum and Bitcoin. Their emergence suggests that the future is most likely a multichain world, without a `winner takes all’ blockchain that dominates the entire market. In such a world, interoperability is key, as it ensures the exchange of information and transfer of value between different blockchains.

The emergence of a multichain world is not surprising given blockchains differ in their design and the trade-offs, particularly in terms of the trade-offs that they make between decentralisation, security and scalability. For example, Bitcoin is decentralised and secure, but not scalable, whereas Hyperledger’s Fabric, which is targeted towards enterprises, is secure and scalable, but not decentralised. These differences are due to design choices but also technological constraints; the scalability trilemma suggests that it is very difficult (if not impossible) to achieve all three dimensions equally well.1 Further, even if two blockchains are technologically similar, market conditions and network effects may lead them to support a very different mix of applications and activities.

In this post, we describe the benefits and challenges of blockchain interoperability, as well as some of the early use cases.2

Benefits of Blockchain Interoperability 

The main benefit of interoperability is that it supports a diverse ecosystem of blockchains, each optimised to achieve certain objectives and cater to specific needs and use cases. Interoperability lowers the barriers to enter a market, thus promoting competition. These barriers are due to the network effects that an incumbent blockchain enjoys, as new users and developers usually gain more benefit from a network that already has the most users and applications. However, if a new blockchain can instantly communicate with the existing ones, the advantage for the incumbents diminishes. Interoperability makes the market more agile and adaptable because as conditions change, new blockchains enter and compete with the incumbents more easily, forcing the incumbents to adapt as well via market competition. For example, Ethereum is being very slow to upgrade to Ethereum 2.0, which is required to increase platform throughput, transaction speed and decrease transaction costs. In 2021, the percentage of total value locked of DeFi projects in Ethereum dropped from 100% to 70% and it is now under a lot of pressure to accelerate the transition, as newer third generation blockchains are much quicker than Ethereum, are more scalable, and have lower transaction fees.3 Moreover, they build bridges so that users can seamlessly transfer tokens between blockchains.

Another key benefit of interoperability is composability. A user can create the optimal bundle for themself by combining services from different blockchains, rather than picking one blockchain that does everything. For example, interoperability can enable multi-token transactions that are recorded in smart contracts which are blockchain agnostic. Composability is one of the key features of Decentralised Finance (DeFi) that have been instrumental to its success, where a user can create their own bespoke financial services by combining different protocols and Decentralised Autonomous Organisations (DAOs), thus benefitting from greater customer choice, rather than being sold a specific bundle of services by a bank.

Looking at the bigger picture, a key benefit of blockchain technology is the breaking up of information silos, removing the monopoly power of centralised database owners and giving more power to the users. Interoperability ensures that these benefits are maintained, reducing the ability and possibility of any blockchain to achieve meaningfully harmful market power.

Challenges of Blockchain Interoperability

The main challenges of interoperability are technological and legal.

If two blockchains employ different security and trust models, there is a danger that the less secure blockchain compromises the security of other blockchain. For example, tokens from blockchain A are transferred to blockchain B and then they are lost. A smart contract that locks tokens from two different blockchains may be compromised if one of them has security flaws. Effectively, when two blockchains interoperate, they adopt the risk of the least secure blockchain, unless there are specific restrictions on how value and information are exchanged.

The legal and regulatory issues may be more complicated. When two blockchains exchange information and value, the purpose of that exchange will determine which regulatory framework applies. However, the issue of which country has the authority to regulate may be less clear, especially when the blockchain is decentralised. If a dispute arises between two entities whose main business originates in two different but interoperable blockchains, the issue of which court should solve the dispute could lead to a long legal battle. Moreover, the authorities of a country may claim that if a blockchain is within their jurisdiction to regulate, the same should hold for any blockchain with which it interoperates. Otherwise, users may effectively face different rules across the two blockchains in relation to the same risks.

Although there is currently no regulation on interoperability, this can quickly change without the need for new laws. The key for authorities is the market function of interoperability and its consequences, not the technology that it is employed. For instance, interoperability could in the future be considered a merger, hence the authorities may apply anti-trust remedies in order avoid the formation of a dominant market participant and anti-competitive practices.

Use Cases

Interoperability is still underdeveloped and there are currently limited use cases. However, this is slowly changing. Almost all new blockchains have some degree of interoperability already built in, aimed at attracting liquidity by building bridges with the more established blockchains. The most notable examples of blockchains with an explicit interoperability design are Polkadot and Cosmos. Polkadot is designed as a `blockchain of blockchains’, where developers can build their own parachains which interact with each other and other blockchains. Cosmos has developed the Inter Blockchain Communication Protocol, which allows different blockchains to communicate with each other, with Cosmos network operating as the central hub.

In the world of permissioned blockchains, several central banks are trialling the interoperability of blockchains for payments and securities settlement. An example is the project Stella, a collaboration between the European Central Bank and the Bank of Japan. Digital identity is another use case. Proving one’s identity and sharing their digital credentials, such as KYC, would add limited value, unless this can be done across many different blockchains. The W3C Working Group are developing a framework for this use case.

Finally, interoperability is currently being explored in the supply chain and the healthcare sectors. In both industries, firms have their own legacy databases which are often incompatible with each other. However, the sheer complexity of their current IT and database systems means that it would be practically impossible for all these firms to agree on a common design of a single blockchain that can store everyone’s data. Instead, it is easier to agree on a minimum set of standards that each firm’s blockchain adheres to, so that some types of data are transferrable.4 Then, these blockchain can also interoperate with the blockchains from different industries and use cases, that may differ significantly in design and use.

Conclusion

Although interoperability has clear benefits for consumers, it is still underdeveloped. This is due to blockchain technology being relatively new, but also because the incumbent chains have limited incentive to facilitate it, given it will erode their competitive advantage. One way of promoting interoperability is by adopting a commonly agreed set of standards, which will ensure that blockchains can easily communicate with each other. Standardisation needs the consensus of the big players, or alternatively it can be enforced through regulation. For example, the European Interoperability Framework stresses that the European Single Digital Market needs to “guarantee the secure and free flow of data, develop standards and ensure interoperability”.5 However, we need to be wary of too much standardisation for the sake of interoperability, as this may lead to blockchains that are too similar in terms of their design characteristics, which can hurt competition and the ability of the market to be dynamic and innovative to change.

Footnotes

1 See “An Introduction to Distributed Ledger Technology” for more information on the scalability trilemma, at https://en.aaro.capital/Download.aspx?ID=b82c52e7-b8e5-42a3-a771-9fd27f8cfb4d&inline=true

2 For an in-depth discussion of blockchain interoperability, see the report by the World Bank Group at https://documents1.worldbank.org/curated/en/373781615365676101/pdf/Blockchain-Interoperability.pdf

3  For more information, see https://www.coindesk.com/business/2022/01/06/jpmorgan-says-ethereums-defi-dominance-at-risk-due-to-sharding-delays/?utm_source=Sailthru&utm_medium=email&utm_campaign=NODE%20JAN%206%202021&utm_term=The%20Node

4 For more information on interoperability and supply chains, see https://mneguidelines.oecd.org/Is-there-a-role-for-blockchain-in-responsible-supply-chains.pdf.

5 For more information, see https://ec.europa.eu/isa2/sites/default/files/eif_brochure_final.pdf.

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