Bridge Liquidity Paradox: Most of the time, TVL is just a vanity metric – Bridges should rethink their approach to liquidity aggregation and place more emphasis on capital efficiency and dynamic rebalancing strategies, he says Ramani Ramachandran and Watsal Gupta of the router protocol.
Acknowledging the need for a mechanism to port liquidity across blockchains and increase capital efficiency in the system, various cross-blockchain protocols have come to the fore over the last year. While the potential of cross-chain infrastructure goes well beyond inter-chain liquidity migration, it nevertheless remains one of its most critical use cases. In fact, several other use cases of cross-chain bridges, including but not limited to cross-chain yield farming, cross-chain forecasting markets, and cross-chain lending/borrowing, directly rely on the bridge’s ability to pass funds across Transfer across chains in a secure and efficient manner.
In order to facilitate money transfers between chains, the bridges must have sufficient liquidity. But a key question here is what counts as “sufficient.” The launch of Uniswap V3 made it clear that TVL is not the most important metric for a DeFi protocol. The key to running a successful protocol is not the amount of liquidity it can accumulate, but how efficiently it uses its liquidity – mindlessly spending millions of dollars in protocol tokens as a reward for often exceeding necessary TVL tightening proves counterproductive.
This article examines the shortcomings of liquidity aggregation approaches currently trending in many cross-chain protocols, arguing that TVL is merely a vanity metric and arguing that capital efficiency should take precedence over TVL.
TVL is not the whole story
The years 2020 and 2021 marked the “Liquidity Era of DeFi” – a time when protocols didn’t have to worry about anything other than securing liquidity, a time when TVL was seen as the primary measure of a project’s success. For example, during the bull run in the first half of 2021, DEXs with over $200 million in TVL were automatically flagged as “performing well” without reporting other key metrics such as metrics. B. daily active users, trading volume and earned income other things to consider. And while the “let’s get as much liquidity as we can” strategy gained legitimacy in the early days of DeFi, the emphasis on TVL soon became redundant; More and more people were beginning to realize that in the long run, using a protocol’s TVL as the sole indicator of its growth often backfired. Because as basic as it is, TVL only provides a small part of the whole picture – TVL can track how much capital is stored in a contract, but it doesn’t track how that capital is used.
Capital Efficiency: A better indicator of a bridge
As the term suggests, capital efficiency is a measure of how efficiently a company uses its capital. In the traditional finance world, this term is often used interchangeably with return on capital employed (ROCE), which estimates the profit a company makes per $1 of capital employed. However, in the world of DeFi, there is no standard way to calculate capital efficiency; it varies from protocol to protocol. For example, many measure capital efficiency in a DEX by its utilization ratio, defined as the ratio of a DEX’s 24-hour trading volume to its TVL. However, the same metric cannot be extended to a lending/borrowing protocol. However, what all protocols have in common is that higher capital efficiency indicates a protocol that is using its capital wisely.
On a bridge, similar to a DEX, capital efficiency can be measured using two key metrics –
- Usage Ratio = Daily Trading Volume / TVL
- System Return (ROI) = Total Revenue generated / Total Amount Spent Procuring the TVL
Since the advent of Uniswap v3, capital efficiency in DEXes has become a hot topic; However, the importance of capital efficiency in bridges has often been underestimated. Let’s use an analogy to illustrate the importance of capital efficiency for cross-chain bridges. Imagine a real bridge connecting two cities. Taxis are stationed at both ends of the bridge to transport users from one end to the other. As the number of cabs increases, more passengers can travel from one end to the other at the same time. However, if the maximum number of people wanting to travel at any given time is less than 10, then having 100 idle taxis is pointless. Now imagine that these taxis also have to be paid some sort of ‘parking fee’ even when they are not being used; This will undoubtedly exacerbate the problem.
Regardless of this knowledge, most leading high TVL cross-chain bridges tell a similar story. Ideally, given the nature of the application, the focus on increasing the capital efficiency of a bridge should be much more relevant than that of a DEX. But surprisingly, upon in-depth analysis, we found that the utilization rate of the major cross-chain bridges was much lower than that of the DEXs, a clear indicator of their inability to use their capital efficiently.
Unsustainable yield mining campaigns
As mentioned, most bridges today are still in an imaginary race to accumulate as much liquidity as possible. To do this, they are forced to engage in unsustainable liquidity mining campaigns – the brunt of which ultimately falls on the protocol itself.
a. Token issuance results in lower token prices and therefore a reduction in the yield on offer, causing yield farmers to inevitably withdraw capital from the protocol to pursue higher yielding opportunities.
b. The earnings metrics of most asset transfer bridges do not justify the costs they incur to operate cash-reduction programs. In the previous section, we briefly touched on the topic of system ROI – the amount of revenue generated by a protocol for every $1 spent to raise liquidity, which is a pretty good indicator of a protocol’s growth. Incessant liquidity mining campaigns with excessive emissions and very low revenues can be an indication of a protocol’s ill health.
To address these issues, we believe asset transfer bridges can spend a fraction of the cost of liquidity mining campaigns to incentivize crowdsourced rebalancing instead. By charging a negative fee, Bridges can encourage users to initiate transfers from low-liquidity chains to high-liquidity chains.
Suppose at a certain point in time the liquidity on Polygon is much higher than required, while the liquidity on Fantom is below the threshold. In such a case, Bridges can reward users for moving funds from Fantom to Polygon (resulting in more funds being locked on Fantom and excess funds being released on Polygon). To ensure that nobody improperly exploits this system, the rebalancing reward needs to be set carefully – it shouldn’t be too low so that nobody is interested in rebalancing the bridge. However, it should not be too high to tempt users to create a liquidity imbalance themselves.
The Honeydukes Problem
Cross-chain bridges have unwittingly emerged as the world’s largest bug bounty program of 2022, accounting for more than 70% of hacks in the DeFi/crypto space. The Bridge TVL acts as a honey pot for the black hat hackers looking for high value vulnerabilities. The anonymity of the ecosystem makes it even more lucrative for hackers, unlike the banking system where accounts are always subject to KYC.
The fact remains that most bridges are not yet mature enough to accommodate extremely large TVLs; Not only do they risk being compromised themselves, but they also risk having their entire liquidity base compromised if there is a potential security issue in the codebase of any of the other bridges to the same blockchains. We saw this case earlier this year when a hacker was able to siphon around $100 million in liquidity stored on Harmony’s Horizon Bridge.
As a result, USDC lost all of its support on Harmony, which led it to break away from the $1 level. As with most exploits, the loss was ultimately borne by the liquidity providers and not the protocol itself; Liquidity providers lost their 1USDC redeemability on Harmony.
Our thesis is that bridges need to have just enough or sufficient liquidity, since irrationally large liquiditys do no good to the community or the project, except perhaps appeal to those who want to build a comfortable narrative around TVL. As we all know, bridges are complex technologies. By focusing on increasing efficiency rather than increasing liquidity, protocols can ensure the same volume while limiting the amount of liquidity exposed to potential vulnerabilities. After all, bridges are rated based on how much traffic flows through them, not just how wide they are.
Bridge Liquidity Paradox: Concluding Remarks
Throughput is a more relevant measure of bridge efficiency. transaction volume versus blocked volume; The efficiency of a bridge in the real world is measured by the traffic that flows over the bridge. Current approaches to bridges, by overemphasizing TVL, detract from the true purpose they were originally designed for, which is to get tokens across chains quickly and safely.
Bridge Liquidity Paradox: About the Authors
Ramani Ramachandran is CEO and co-founder of Router Protocol and Dfyn Network. An MIT graduate, Ramachandran has been a serial entrepreneur in fintech and digital assets for almost a decade. He built and ran Asia’s earliest crypto fund with a 4x return; built Fordex, the world’s first stablecoin DEX; and Qume, an institutional crypto exchange. He also launched Asia’s first crypto index token.
Vatsal Gupta is a DeFi/Research Analyst at Router Protocol and Dfyn Network. Prior to working in the DeFi space, Vatsal worked extensively as an undergraduate researcher in blockchain applications, IoT and federated learning. He is co-author of 6 publications in peer-reviewed conferences and journals such as IEEE T-ITS, IEEE IoT Journal and ACM MobiHoc.
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