As we’ve moved through this series, we’ve discussed a wide range of DeFi primitives that facilitate trading, lending, and other financial operations.
This time, we’re going to investigate the backend DeFi infrastructure that makes the front-end primitives possible.
These infrastructure primitives include:
- Bridges
- Price Oracles
Infrastructure in DeFi is not merely about servers or code; it encompasses critical components such as Bridges and Price Oracles, each playing a pivotal role in maintaining the ecosystem’s interoperability, security, and reliability.
Bridges connect disparate blockchain networks, while Price Oracles serve as the linchpin for accurate, real-time data provision to smart contracts.
Bridges
Cryptocurrency bridges, also known as blockchain bridges, are technologies that enable the transfer of assets and information between two distinct blockchain networks. These bridges play a crucial role in the blockchain ecosystem by enhancing interoperability between blockchains that would otherwise operate in isolation.
Bridges “wrap” an asset from one chain in a token wrapper of another chain. They do this by holding a token from one chain in a secure wallet and “mint” a new token on a second chain that can be redeemed for the original token at any time thus reversing the process.
The mechanisms for locking, minting, and burning tokens vary depending on the design and technology of the bridge. Right now, there are two primary types of cryptocurrency bridges:
- Trusted Bridges
- Trustless Bridges
Trusted Bridges
Trusted (or centralized) bridges require users to place trust in a central authority or entity that manages the bridge. The entity is responsible for securely locking assets on one blockchain and minting or releasing an equivalent amount of assets on the other blockchain.
While trusted bridges can offer faster transactions and potentially lower costs, they also introduce points of vulnerability, such as the risk of hacking or misuse by the managing entity.
As an example, let’s look at Wrapped Bitcoin (WBTC) — the largest wrapped asset token by market capitalization and represents Bitcoin (BTC) on the Ethereum blockchain. It allows Bitcoin holders to participate in decentralized finance (DeFi) applications on Ethereum by converting their BTC into WBTC, which is an ERC-20 token. This process maintains the pegged value of WBTC to Bitcoin, enabling users to engage with Ethereum’s ecosystem without having to sell their Bitcoin.
The WBTC is trusted and centralized as it is managed by the consortium WBTC DAO. The members of this DAO are responsible for issuance, management, integration, and utility within the Ethereum ecosystem.
Trustless Bridges
Trustless (or decentralized) bridges operate without the need for a central authority or intermediary to oversee the transfer of assets. They rely on smart contracts and cryptographic methods to ensure security and trust in the transaction process.
Trustless bridges are considered more secure and in line with the decentralized ethos of the blockchain world because they minimize the risk of censorship, fraud, and third-party interference. However, all decentralized bridges have centralized points of failure; typically, the foundation or team running the project.
There have been several attempts to make a truly decentralized custodian, but none so far have been truly decentralized. Most notably, RenBTC, which represented Bitcoin on Ethereum similar to Wrapped Bitcoin, attempted to make a decentralized Bitcoin custodian by employing a network of nodes called Darknodes that power a trustless and decentralized custody service to lock Bitcoin and mint RenBTC. Users would send their BTC to a Ren protocol’s smart contract, and in return, they receive an equivalent amount of RenBTC, which they can use across Ethereum’s DeFi platforms. The original BTC is locked in the protocol’s smart contract, and when users want to convert their RenBTC back to BTC, the RenBTC is burned, and the corresponding BTC is released from the lockup.
Unfortunately, Ren protocol’s foundation was purchased outright in February 2022 by the late cryptocurrency exchange FTX. After FTX’s insolvency and bankruptcy in November 2023 a court ordered Ren to turn over all of their assets to the FTX estate so they could be processed through normal bankruptcy proceedings.
Despite the promise of decentralization Ren had a centralized point of failure in its foundation which was exploited to wipe out user wealth.
Price Oracles
Price oracles are mechanisms in blockchain and decentralized finance (DeFi) ecosystems that provide external data, particularly price information, to smart contracts. Since blockchains are closed systems by design, they lack the ability to directly access or verify data from the outside world, including the current prices of cryptocurrencies, fiat currencies, or other assets.
This is where price oracles come in, acting as a bridge between off-chain data sources and on-chain smart contracts. Price oracles are used in all DeFi primitives mentioned in this series including DEXs, money markets, CDPs, algorithmic stablecoins, etc..
However, relying on oracles introduces a new set of challenges and risks, primarily around the accuracy and manipulation of the data they provide. These manipulation risks are reduced by diversifying oracle sources and/or bringing in the oracle in house, thus aligning its incentives with the DeFi protocol.
Techniques such as staking (where oracle providers must lock up tokens as collateral) and reputation systems are also often used to incentivize honesty and penalize dishonest behavior.
The Central Role of Infrastructure
Bridges, both Trusted and Trustless, extend the capabilities of blockchain networks beyond their isolated ecosystems, allowing for a more interconnected and versatile blockchain landscape. Despite their differences, each type of bridge contributes uniquely to the ecosystem, offering users a spectrum of choices based on their trust preferences and transaction needs.
Price Oracles, on the other hand, bridge the gap between the on-chain and off-chain worlds, enabling DeFi applications to interact with real-world data in a reliable and efficient manner.
As we wrap up this installment, it’s clear that the infrastructure underpinning DeFi is as complex as it is crucial.
The development and refinement of Bridges and Price Oracles are ongoing processes, reflecting the broader evolution of the DeFi sector itself. With each advancement, we move closer to a more secure, transparent, and efficient decentralized financial system.
