Liquidity pools

While the productization of HTLC-based atomic swap lags, the market demand for cross-chain bridges has exploded. That has given rise to alternative solutions that focus on usability but compromise on or even sacrifice decentralization.

Centralized crypto exchanges (CEXs) are perhaps the largest cross-chain bridges today. When you sell BTC for ETH on Coinbase, you have crossed from the Bitcoin blockchain to the Ethereum blockchain. However, the problems with centralized exchanges are also well-known. Sacrificing decentralization for usability is a very typical web2 trade-off, and it is increasingly felling out of favor by the community.

“I definitely hope centralized exchanges go burn in hell as much as possible.” — Vitalik Buterin, Founder of Ethereum.

“If you look at it in a longer-term, 15 years or 20 years, there’s no doubt DEXes will eat up centralized exchanges.” — Changpeng “CZ” Zhao, Founder and CEO of Binance.

The rise of decentralized exchanges (DEX) only solves part of the centralization problem. A smart contract-based DEX can only operate on a single blockchain. DEX does not solve the cross-chain problem. DEX + decentralized bridge is the true alternative to CEX.

Taking a page from the DEX playbook, the current leading “decentralized bridges” market is mostly based on liquidity pools. That is, to create smart contract-based token pools on both chains to facilitate cross-chain token exchanges or lock-and-mint operations. Examples of famous pool-based bridges are listed as follows (Data from Dune Analytics, CoinMarketCap, projects' dashboard on 5th Feb, 2022).

	Native Token	Market cap(mm)	TVL(mm, pool size)
Multichain(Anyswap)	MULTI	$358	$7,693
Avalanche Bridge	None	None	$5,479
Polygon bridge	None	None	$2,079
Near Rainbow Bridge	None	None	$1,040
Wormhole	None	None	$1,000
Synapse	SYN	$455	$892
Harmony Bridge	None	None	$510
Thorswap	THOR	$33	$301.29
cBridge	CELER	$284	$145.51

Challenges with pool-based bridges

Unlike the ephemeral HTLCs, the asset pools are long-lived and hence must be maintained and managed by their owner. That, by definition, is a centralized setup. Even with multiple owners or DAO-like governance structures (e.g., multi-party signatures, or multi-party computation, MPCs), those liquidity pools require users to trust their custodians. That leads to a multitude of challenges.

Weak security. Asset pools are notoriously prone to hacks. In fact, almost all leading bridges’ asset pools had security issues that resulted in fund loss in the past. The hackers could exploit asset pool smart contracts’ code errors, steal pool admin’s private keys, or even manipulate pool assets through flash loans. As Ethereum founder Vitalik Buterin has observed, pool-based bridges could bring security risks from a weak/vulnerable blockchain to a robust blockchain, and reduce the security of the entire ecosystem.

“If you move 100 ETH onto a bridge on Solana to get 100 Solana-WETH, and then Ethereum gets 51% attacked … The Solana-WETH contract is no longer fully backed, and perhaps your 100 Solana-WETH is now only worth 60 ETH.” Vitalik Buterin, Founder of Ethereum, explains why cross-chain bridge pools are unsafe. The hypothetical Solana-WETH contract here is the pool that holds the ETH asset for the bridge to lock-and-mint WETH.

Low capital efficiency. Liquidity pools lock up tokens and prevent the tokens from being used in other applications. That means the bridge projects must incentivize liquidity providers through yield farming. Oftentimes, the bridge project uses its own DAO token as liquidity incentives, essentially giving away future equity of the project and hampering the long-term viability of those projects.

The liquidity pool must be at least 10x larger than the largest transaction it aims to support in order to avoid excessive slippage. You would need a pool of $100m in order to support a $10m transaction. That means 90% of the fund in the pool is idle and not productive most of the time.

Regulation compliance is very hard. Without KYCed LPs, the pool itself could be a non-compliant exchange counterparty. While it is technically possible to KYC LPs in a pool, it is not commonly done and very hard to remove LPs when a problem emerges later.

Vulnerable to censorship. Large liquidity pools or lock-and-mint pools are centralized constructs that are managed by a few key holders. The pool operators can censor who has access to the pool. The censorship problem is further exacerbated by the pool's need for regulation compliance.

Slow withdraws. Since the asset pools are operated by multiple signers, they typically require anywhere from several hours to days for you to withdraw funds from it. That is especially true with lock-and-mint pools since the withdrawal entails "burning" tokens on one chain and authorizing transactions on another.

Now, we have seen that atomic swap and pool-based bridges have different problems and challenges. Can we have the bests of both worlds? Our answer is the Otomic!