Hey there,
I remember 2013. There were maybe ~50-100 tokens and 3-5 layer ones, as far as I recall. The first ICO was still distant, and Mt Gox was one of the largest exchanges. It went bust around that year. Times are different now. The number of tokens ranges anywhere from 3000 to 10,000, and there are over 100 protocols a founder can build on today. Safe to say - blockchain-based networks have evolved. They evolve much as it occurs in nature. Market forces such as demand for a feature (e.g., lower fees) and a growing base help them find relative strength. An excellent example of this is EOS vs Ethereum.

Inspite of the $4 billion EOS raised, Ethereum dominated much of the discourse through 2021. Why? Because it is where DeFi and NFT took off. As of writing this, I don’t know anyone building on EOS. Much like survival of the fittest, there is survival of what finds product-market fit among networks. This matters because after ~13 years of Bitcoin being released - we are seeing cross-pollination of networks. The ability to combine the benefits of two different networks, depending on the situation. Bridges are becoming a crucial element in enabling this transition. Today, we will dig into what they are and their emergent business models. This is part 1 of a three-part series looking at bridges, a framework to assess them and the aggregation of bridges.

Bringing Bitcoin to Ethereum

When DeFi took off in 2019 - Bitcoin owners had a problem. They held an asset that appreciated but struggled to make meaningful yield. The lightning network could generate small amounts in return, but it had little traction. Conversely, locking up bitcoin in a platform like Celsius could mean giving custody of the underlying to a third party. One could always sell their Bitcoin and buy Ethereum to do yield farming - but that meant losing exposure to what was then considered the hardest form of money. What’s a solution?

You find a way to port the underlying (Bitcoin) to where all the action is happening. Wrapped assets became a way for Bitcoin holders to interact with the likes of Aave and Compound while having access to an IOU token that could be redeemed for an actual bitcoin. This allowed users to have exposure to the financial possibilities Ethereum made possible. There are over 237k Bitcoin in WBTC alone, which takes a clear lead for wrapped Bitcoin on Ethereum.

Let’s take a step back and observe what happened. Using my evolution analogy - the market just found a way to combine the best features of two assets. You traded centralisation - by sending your Bitcoin to a custodian, who in turn issued WBTC on Ethereum. In exchange for the composability, speed and access to DApps built on Ethereum. Wrapping Bitcoin was an early indication of what was to happen soon. We learned that representing assets of one chain on the other was an eloquent way of benefitting from the best of what each chain had to offer.

As retail interest in on-chain apps increased, it became clear that the same asset would be represented soon on multiple chains. An excellent example of this is USDC. The dollar-denominated token holds the same value on  Ronin, Polygon, Solana and Ethereum. But using it on Ronin would mean savings in the hundreds of dollars if you are a small business. What if you wanted to use Ronin for transactions but save on Ethereum's Compound? That’s where a bridge comes into play.

Functionalities and Varieties

A blockchain bridge passes messages from one network to another at its crux. This message can be regarding an asset's movement or issuance (minting). Bridges typically have a few key components. Most of them have a smart wallet that has custody of the assets provided by liquidity providers. These individual users provide capital to the bridge in exchange for a percentage of fees.

In some instances, these fees are incentivised by native tokens issued by the bridge. Hop protocol’s bonders, for instance, earn 0.02% in fees. Relayers conduct transactions on the receiving network when a user sends an asset to a different network. They do this by monitoring changes on both networks. Verifiers check if the necessary assets were provided by the user and if the transaction is legitimate. For the more technically inclined - this piece by Dmitry Berenzon is an insightful piece on how Bridges work. You can also refer to this piece by the LI.FI team for added context.

We found close to ~50 bridges in the market and tried categorising them. (It is still a work in progress, but you can see the ones we identified.) One way to categorise bridges is through observing the use-case they hold. The vast majority of activity today is on chain-specific bridges. The teams behind a particular chain typically maintain these to help with the portability of assets towards it. Polygon’s bridge, for instance, has some ~5 billion in total value locked. Avalanche and Arbitrum - have over ~3 billion each. A subset of chain-specific bridges, such as Wormhole, specialises in a few networks but is not run by the teams behind the networks themselves.

Asset-focused bridges are usually run by DAOs determining the fees and supporting assets. The largest among these today is WBTC. They typically tend to specialise in a vertical. Wombat exchange, for instance, focuses on swapping stablecoins across multiple chains. TofuNFT, on the other hand, is an NFT exchange built on LayerZero. Asset-focused NFTs typically support a handful of assets that have deep liquidity pools. A variation of this is application-specific bridges. Hashflow for instance, allows users to swap assets across networks in an AMM model. These bridges usually don’t market themselves as bridges and focus on the underlying application they enable.

It is unlikely that the market needs so many bridges. Part of the challenge is the fragmentation of liquidity. Multiple bridges could mean fewer people put fewer sums of money in individual pools - making it harder for multi-million dollar positions to be swapped between networks. This is why specialisation will be a differentiator for the bridges. By focusing vertically - on the asset, application type or chain- bridges can tap into developers that may otherwise have been harder to find.

Being an early adopter with substantial TVL will play well for bridges. We saw a variation of this in DeFi. Uniswap, Compound and Aave- were each some of the earliest to come to the market. This, in turn, helped them attract liquidity, which attracted whales who brought even more capital to the product. Liquidity begets liquidity. 

Thin Layers and Vampire Attacks

One of the concepts I have been tinkering with lately is thin layers in web3. It is an extension of what Joel Monegro famously wrote in 2016. It argues that “the market cap of the protocol always grows faster than the combined value of the applications built on top since the success of the application layer drives further speculation at the protocol layer”. This has been the guiding principle behind investing in emergent layer ones for the longest period. Instead of betting on which application will be dominant, you simply invest in the infrastructure on top of which founders would build.

The challenge is that as protocols age - their valuations begin looking less like Series A ventures and more like listed firms. As nascent markets like crypto become more organised, capital allocation would become more rational. This is where a thin layer becomes relevant. I define a thin-layer venture as one that captures value by interfacing between the protocol layer and applications. They are typically capital market infrastructure providers that capture a small percentage in fees for high transaction volumes. 

More often than not, thin layers also have high capital velocities. That is - money changes hands very frequently. Think of a decentralised exchange or an AMM like Uniswap. Capital shifts between hands more often than it does with lending pools. The composability of smart contracts enables thin layer ventures to plug into a myriad of apps with a few lines of code. As they grow - it is likely that a customer doesn’t even realise they are interacting with the venture in question.

Fat protocols and thin layers come into play at different protocol stages. In the early days, when picking a winner was hard, investing in the protocol was conservative play. As a protocol age and building atop it becomes the norm. That is when investing in thin layers is relevant as they can generate cash flows. 

Bridges are the perfect example of a thin layer as they sit between protocols and applications - and handle high volumes. Currently, bridge fees are a variable. Avalanche’s bridge takes $3 or $20, depending on the direction of each deposit. Hop charges a percentage of the transaction size. On the high end, it comes to around 0.1%. Granted, different parties are getting the revenue - assuming a volume of $1 billion, that is ~$1 million in revenue.

For a sense of scale, Polygon’s bridge (whose fee documentation I could not find) - has handled over $60 billion in volume. The fees behind bridges are minuscule today, but they can add up fast given the pace at which layer 2s and new layer ones are coming of age.

The trap most bridges will face is that of a race to the bottom in terms of fees. Today, dApps already subsidise the cost of bridging for users. dYdX covers bridge costs for users depositing at least $1000. For teams behind dApps, covering this expense is part of their cost of acquiring customers. However, it prohibits most retail users as they don’t do transactions worth $1000 or more. 

Bridges will likely compete on two verticals going forward. One will be the number of assets supported and the TVL they bring. In this regard, supporting smaller tokens can quickly build a user base. Teams will focus on the tail end of assets not worth pursuing by the large bridges. This is partly how Binance found a wedge in the market and eventually became the behemoth it is today.

On the other end, bridges will compete on fees. Large bridges like those run by Polygon or Avalanche may never truly integrate fees as it makes more sense to subsidise costs for them. These bridges will see substantial volume but rarely have fees and simultaneously make it harder for non-native bridges with fees to attract users.

Synapse and Multichain are good examples of non-native bridges that scale meaningfully with fees. Both of them command billions in TVL. Synapse’s claimed revenue is at ~$17 million. All of that is fees that have gone to the protocol treasury, not individual liquidity providers. This is at risk if a vampire attack is made by an external protocol offering more fees to liquidity providers, mainly if the fee is boosted by a native token, as we saw during the yield farming craze. Uniswap has avoided enabling a fee switch that gives 0.05% of the exchange’s fees to the protocol due to concerns of liquidity providers moving elsewhere. It will be interesting to see how bridges build moats in the coming months.

The Future of Bridges

Bridges handle as much capital as some traditional banks do in their current form. The risks associated with running one are evident from the hacks that took Wormhole or Ronin down. But at the same time, they are highly lucrative businesses that can sit right in the middle of billions of dollars in transaction volume.

While writing this, standalone dApps like dyDx have seen ~50k users on their bridge. The figures are higher for chain native bridges such as those of Axie’s or Polygon’s. Cumulatively, the largest bridges have seen around ~$150 billion flow through them. For a sense of scale - Uniswap has seen ~$1 trillion flow through it in its lifetime.

These are still early days, and the risk is writing off bridges as a business model. What may likely happen is that the industry shifts from a focus on TVL to capital efficiency. Instead of parking large pools of capital, we will see ventures enabling larger transfers with smaller sums of money. Diminishing the amount of capital parked in bridge-related pools (should ideally) makes them less attractive for hackers looking to break in. Biconomy’s Hyphen is one instance of a venture taking that approach. 

We will also see increasing financialisation around bridges. The simplest primitive that can be launched right now is likely micro-insurances. These small sums of money added to each bridge transfer cover any potential loss of capital incurred from the bridge transaction itself. In the traditional world, this happens when we purchase airline tickets. Similarly, bonds could be issued to sell or purchase fees collected from a Bridge’s liquidity pool in advance. A third model that is highly relevant is that of aggregating bridges. We will be writing a long form on that soon.

In their end state-  a bridge would ideally be just a thin layer that the user doesn’t know exists. The complex machinery that balances liquidity, fees, and security does not need to be exposed to the 20-year-old trying to play a web3 game. Bridges must also expand to support different asset types, such as NFTs and credentials. It will be a while before we reach there, but the foundations are being laid.

This piece was made possible with an abundance of help from Sumanth - make sure to give him a follow here. In our following piece, we will be breaking down the different bridges in the market from a technical lens and laying a foundation to assess their credibility. Stay tuned.

Also, come hang out at our Telegram if you enjoyed reading this.

Signing out,
Joel John

Disclosure: I have exposure to multiple ventures named above.
None of this is financial advice.