Speaking to Cointelegraph, director of capital markets at Chainlink Labs Ryan Lovell said blockchains lacking interoperability are akin to computers functioning in isolation without the Internet — unable to exchange data and value across networks.
Lovell said a blockchain ecosystem could only achieve full interoperability on a large scale if it establishes an open communication standard similar to TCP/IP, which is currently the default connection protocol used for the Internet.
Lovell said that having a uniform standard for blockchain networks would create a smooth and seamless experience similar to the Internet for both the platform and its applications.
This standard is crucial considering the recent surge in new Layer-1 blockchains during the last bull market. However, the majority of these blockchains currently function in isolation from each other.
Lovell maintained that establishing blockchain interoperability is essential for financial institutions seeking to tokenize real-world assets. By doing so, liquidity can be prevented from being stifled within a closed ecosystem, paving the way for broader adoption and usage of such investments.
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Adequate risk management system is important
Founder and CEO of Umee Brent Xu told Cointelegraph that adequate risk management frameworks should be implemented before the on-chain integration of real-world assets to enable this interoperability.
Xu emphasized the importance of having proper procedures to mitigate the risk of on-chain disasters. He explained that financial institutions must first ensure the authenticity of real-world assets through Know Your Customer (KYC) credentials before tokenizing them on-chain.
Institutions also must ensure that on-chain proof-of-reserve audits can identify these assets. Xu cautioned against shortcuts to avoid potential on-chain issues, as the risks outweigh the benefits.
He gave an analogy to explain the risks of cutting corners in establishing proper risk management systems for blockchain interoperability. He compared it to the 2008 mortgage crisis, where a broken legacy system caused the loss of a significant amount of financial value.
Xu warned that contagion could result in tremendous value loss if this value were to be ported into the blockchain ecosystem without proper risk management.
Different solutions, such as cross-chain bridges to achieve blockchain interoperability, independent layer-2 sidechains and oracles, have been used. The first two solutions operate entirely on the blockchain, while the third solution involves bringing off-chain data onto the blockchain.
Several solutions have been employed to achieve blockchain interoperability, but cross-chain bridges still have some issues.
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A report from October 2022 indicated that 50 percent of all decentralized finance (DeFi) attacks happened on cross-chain bridges, with the most notable instance being the $600 million Ronin bridge hack in March 2022.
According to Xu, multi-signature security setups or proof-of-authority consensus mechanisms have been the source of many hacks. He also mentioned that many interoperability solutions prioritized “speed of development” over security early on, leading to negative consequences.
Xu explained that integrating interoperability into the platform is essential to achieve a more secure end-to-end transaction rather than relying on third-party bridges.
Several commonly used blockchain interoperability protocols include Chainlink’s Cross-Chain Interoperability Protocol (CCIP), the Inter-Blockchain Communication (IBC) protocol from Cosmos, Quant Network’s Overledger and Polkadot.
Polkadot, for example, uses a heterogeneous multichain translation system that allows specialized sidechains to communicate with public blockchains. Cosmos allows the creation of blockchains with or without permission. It has hubs and zones that use the IBC protocol to communicate with each other.
These cross-chain systems highlight the significance of creating standards, APIs and similar technologies to allow broad interoperability among blockchain platforms.
