Gate Ventures: Liquidity fragmentation problem in the Layer2 era

Introduction

Since Ethereum turned to a Layer 2-based expansion solution, coupled with the rise of tools such as RaaS, a large number of public chains have developed rapidly. Many entities want to build their own chains to represent different interests and seek higher valuations. However, the emergence of many public chains has made it difficult for the development of the ecosystem to keep up with the pace of public chains, resulting in many projects breaking the issue price at TGE.

With the help of OP Stack, Coinbase launched its own Base Layer 2, Kraken released Ink; with ZK technology, OKX launched XLayer; Sony launched Soneium, LINE launched Kaia, etc. Today, the financial and technical barriers to building a chain have been greatly reduced, and the cost of operating a chain based on OP Stack is about $10,000 per month.

The future will definitely be an era of coexistence of multiple chains. Although these Layer 2 chains may choose EVM compatibility to achieve interoperability, it is difficult for them to build applications and reach consensus on the same chain because the Web2 entities behind them have a large number of downstream applications.

TVL Breakdown, source: Defillama

The current multi-chain ecosystem brings a new challenge: liquidity and state decentralization. Since the existence of multiple chains is inevitable, interoperability is an area that must be explored and solved. There are many liquidity solutions at present, such as chain abstraction (Particle Network, Socket, XION, INFINIT, Borsa), intention (Anoma, Khalani), Clearing Execution (Connext), Native CrossChain (Cross), ZKSharding (=nil; Foundation), but their core essence is the same.

Chain Abstraction Stack, Source: Frontier Research

We use the industry-recognized Cake architecture to introduce the core components of cross-chain abstraction from top to bottom:

Application Layer

This is the layer that users interact directly with, and it is also the most abstract layer in the liquidity solution because it completely shields the details of liquidity conversion. In the application layer, users interact with the front-end interface and may not understand the underlying liquidity conversion mechanism.

Permission Layer

Located below the application layer, users satisfy their trading intentions by connecting their wallets to dApps and requesting quotes. The "intention" here refers to the final transaction result (i.e., output) expected by the user, rather than the specific execution path of the transaction.

Key Management and Account Abstraction

Due to the existence of a multi-chain environment, an account management and abstraction system that adapts to different chains is required to maintain the unique account structure of each chain. For example, SUI's object-centric account system is completely different from EVM. One Balance is a representative project in this field. It has built a trusted account system without the need to establish inter-chain consensus, only trusted commitments between existing account systems. Near Account achieves abstract management by generating multi-chain account wallets for users, greatly optimizing the user experience and reducing UX fragmentation. However, the liquidity aspect mainly integrates existing public chains.

Solver Layer

This layer is responsible for receiving and implementing the user's transaction intentions, where the Solver role competes to provide a better user experience, including faster transaction times and execution speeds. Based on this, intent-based projects such as Anoma have built various intent-driven solutions. Derivatives of such intents, such as Predicate components, can implement user intent under specific rules.

Settlement Layer

This is the middleware layer used by the Solver Layer to implement user intent. The core components of the solution for liquidity and state decentralization include:

• Oracle: Used to obtain state information on other chains.

• Cross-chain bridges: responsible for cross-chain information and liquidity transmission.

• Pre-Confirmation: shorten cross-chain confirmation time.

• Data Availability (DA): provide data accessibility.

In addition, factors such as inter-chain liquidity, finality, and Layer 2 proof mechanism need to be considered to ensure the efficient operation of the entire multi-chain system.

Solution

Currently, there are many solutions to solve liquidity fragmentation on the market. After reviewing a large number of solutions, we found that there are mainly the following ways:

1. RaaS-centric: Similar to Rollup solutions such as OP Stack, specific shared sorters and cross-chain bridges are added to assist Rollups built on OP Stack in sharing liquidity and status. This hopes to solve the liquidity and status dispersion in a higher-level direction. One of the more detailed ones is the separate design of a shared sorter. This solution is more targeted at Layer2 and is not universal, such as Astria, Espresso, and Flashbots.

Chain Abstraction, source: NEAR

2. Account-centric:Similar to NEAR, build a full-chain account wallet, and support signing and executing transactions across multiple blockchain protocols through a technology called "chain signature". The core component is the MPC network, which signs multi-chain transactions on behalf of users. Although this solution can greatly solve the problem of UX fragmentation, for developers, this involves complex backend implementation and does not fundamentally solve liquidity and state dispersion.

3. Centered on the off-chain intention network: This is the Solver Network in the cake architecture diagram in our "Introduction". The core is that users send intentions to the Solver network, and the Solver role competes for quotes to give the best completion time and transaction price. These Solvers can be AI Agents, CEXs, Market Makers, and even integrated protocols such as Liquorice. Projects in this area include Anoma, Khalani, Enso, aori, and Valantis. Although intentions can theoretically achieve complex cross-chain operations of arbitrary difficulty, they do require Solvers with sufficient liquidity to assist in implementation, and when encountering some off-chain needs, Solvers are likely to commit fraud. If fraud proofs and other means are introduced, the difficulty of implementing the Solver Network will become higher, and the threshold for running Solvers will also be higher.

4. Focusing on the on-chain liquidity network:This direction is specifically aimed at optimizing cross-chain liquidity, but does not solve the problem of decentralized state on other chains. The core is to build a liquidity layer on which applications can be built to share full-chain liquidity. Some projects include: Raye Network, INFINIT, Everclear, Elixir, etc.

5. Focusing on on-chain applications:This type of application builds high-liquidity applications by integrating large MMs or third-party applications, such as Liquorice, Socket, Radiant Capital, 1inch, Hedgemony, etc. Such projects need to manage complex cross-chain processes and have extremely high requirements for developers, so they are also prone to hacker attacks. Solving the liquidity problem is a very important proposition. In the financial world, liquidity often represents everything. If we can build an integrated liquidity platform, especially to integrate scattered full-chain liquidity, it will have great potential, and we have also looked at many different solutions. In the above two categories, we can see that according to the cake structure, the Settlement Layer is the most atomic solution. On top of these atomic solutions such as cross-chain, oracle, and Pre-Confirmation solutions, a more abstract layer is built, namely the Solver Layer, Permission Layer, and Application Layer. The different levels of abstraction or liquidity solutions listed above that conform to this set in different directions can be understood as upstream and downstream relationships. However, these solutions are still not atomic solutions. The entire problem of liquidity fragmentation has brought about the emergence of many complex derivative problems. Therefore, a variety of solutions have been derived for interoperability. But in essence, it still depends on these components. Next, we will discuss several typical chain abstraction concept projects to see how each of them solves the problem of liquidity fragmentation from its own starting point.

INFINIT

INFINIT Structure, source: Infinit

INFINIT has built a DeFi-based RaaS service that can provide DeFi protocols with components needed for direct construction, such as Oracle, Pool Type, IRM, Asset, etc., and can also provide immediately enabled components such as Leverage Trading and Yield Strategy. It is equivalent to other application construction ends, but the final liquidity is placed on the liquidity layer of Infinit. However, it has not yet disclosed the underlying working principle. INFINIT has received $6 million in seed round funding from Robot Ventures, Electric Capital and Maelstrom Capital.

Khalani Network

Khalani Network Structure, source: Khalani Network

Khalani has built three core components, namely the Intent Compatibility Layer, Validity and the Universal Settlement Layer.

External applications or intent layers can publish intents to Khalani, and then Khalani's Intent Compatibility Layer can convert external intents into a format that the protocol Solver can recognize. The standardized format used is the Validity language. Khalani nodes are responsible for submitting the final results to the general settlement layer through cross-chain bridges, fast settlement technologies, etc. This project is still under construction and no further details of the work have been disclosed. In August, it received $2.2 million in seed round financing from Ethereal Ventures, Nascent, Maelstrom Capital, etc.

Liquorice

Liquorice Structure, source: Liquorice

Liquorice is a decentralized application that enables auction-based price discovery and unilateral liquidity pools. Liquorice's main mission is to provide professional trading companies with efficient inventory management tools and easily connect to core DeFi protocols such as 1inch and Uniswap X when using intent to settle transactions. At the same time, Liquorice has created a lending market for it to conduct lending transactions. This application is more focused on the transaction itself. It is still in the development stage. It announced in July that it had received a $1.2 million Pre-seed round of financing led by GreenField.

Xion

Xion is an upgrade of the Burnt brand. In the past, Burnt was an application focused on consumer applications. After that, the team found that there was a huge fragmentation problem in the on-chain interaction, so Xion was built to improve this problem. Xion is built on the Comet BFT consensus protocol. The cross-chain communication it adopts is based on Cosmos IBC, so it is more native and secure than other cross-chain bridges. It has completed four rounds of financing, with investors including Animoca, Multicoin, Alliance DAO, Mechanism, etc.

=nil; Foundation

nil is the developer of Ethereum's ZK computing power market, ZK coprocessor and Layer2, and the team has a deep foundation in ZK technology. It proposed the zkSharding solution, which uses ZK technology to horizontally expand the Ethereum mainnet, execute shards to process transactions in parallel and generate ZKP, while the main shard verifies data, communicates with Ethereum and synchronizes network status between all validators. The main shard also manages the distribution of validators and accounts in the execution shard. The consensus protocol used by the verification committee is also Hotstuff, which is common in the latest parallel execution projects. =nil; L2 embeds cross-shard communication into the protocol from the beginning. Cross-shard messages are verified as transactions by the validator committee of each shard.

The basic idea is to build an embedded cross-shard communication architecture similar to IBC through the sharded Layer2 architecture, so as to solve the problems of liquidity and state dispersion. However, the core idea is not reasonable, because the problem solved by liquidity dispersion is the problem of multiple chains, and it builds a single Layer2, which means that if you want to solve it, all chains need to become a shard of ZK-sharding, which is difficult to achieve.

ERC-7683

ERC-7683, source: Across

Ethereum is also working on solving this cross-chain liquidity problem. Currently, Arbitrum, OP, and Uniswap first publicly support the ERC7683 standard, which also uses an Intent-based cross-chain approach. Its core goal is to establish a common standard for cross-chain operations across L2 and side chains, standardize order and settlement interfaces, and achieve seamless cross-chain execution. Its main core is a Filler, which can also be said to be a Solver role in chain abstraction. The proposal was jointly built by Uniswap and Across and is currently being reviewed by the Cake working group.

OP Stack

OP Stack, ERC-7683, and zkSharding are all solutions to the fragmentation of liquidity between Layer2s within Ethereum, which are solved at the architecture level, consensus level, and application level respectively. OP Stack solves the problems of information transmission and sequencer decentralization at one time by designing a complete multi-Layer2 solution. When you use the OP Stack architecture, cross-chain contracts will be automatically deployed, and there will be a Supervisor to challenge and avoid the transmission of false cross-chain information. Currently, Coinbase, Uniswap, Kraken, etc. use the OP Stack architecture.

Among them, Unichain is a typical one. Unichain mainly solves the problem of cross-chain liquidity fragmentation by integrating with the Superchain network. This setup facilitates seamless liquidity movement by providing the following features:

• Intent-based cross-chain bridge:This bridge enables fast and reliable liquidity transfers between blockchains, allowing users to set intents that help the system automatically select the best path for liquidity movement. This approach abstracts away complexity for users, making cross-chain transactions smoother and faster.

• Unichain Verification Network (UVN):This decentralized network of node operators verifies cross-chain transactions, providing faster economic finality. Faster finality is critical to ensure efficient settlement of cross-chain transactions, thereby minimizing the risk of liquidity fragmentation caused by delayed settlement.

• Flashblocks and Verifiable Block Construction:By using Flashblocks, Unichain has significantly reduced block times, improved liquidity provider efficiency, and enabled a more synchronized cross-chain market. Flashblocks helps ensure that liquidity is always available and reduces the negative impact of block confirmation delays, which may lead to fragmentation of liquidity.

Summary

Solving the problem of cross-chain liquidity is a very complex field with many solutions. For example, Layer2 solutions are divided into cross-chain messages embedded in Ethereum, especially ERC-7683, and Layer2 such as OP Stack built by OP to share Sequencer. Out of the context of Layer2, all Layer1s also face the problem of liquidity, status, and user experience fragmentation. There are application-centric solutions specifically for liquidity, off-chain solutions based on Solver Network, and even account-centric solutions like NEAR, but they also need to be based on off-chain roles such as Solver.

We tend to agree that the fragmentation of cross-chain liquidity, status, and user experience is a problem for the entire blockchain industry. If we think about it as a whole, we need to do it in a more abstract way, similar to chain abstraction. This is equivalent to the real entrance to Web3, which solves the fragmentation in user experience. At the same time, the integration of liquidity and status is done in a place that users cannot perceive. The specific integration is divided into using the Solver network under the chain and atomic integration of cross-chain bridges and other facilities, which are all worth discussing. In general, the future must be multi-chain. Solving the problem of dispersed liquidity is a problem that the industry must face. This integration of full-chain liquidity has a vast growth space and may build the Google of the Web3 era.