Imagine traveling around in a world without credit cards. After arriving in a new country, you must trade your currency for local currency at an exchange. Then, when you leave to go somewhere else, you’ll need to exchange the currency again. Each time, you’re paying a commission and losing money on the exchange rate.
Does this sound familiar?
Cryptocurrencies operate in much the same way. For example, you may need to sell Ethereum and purchase an altcoin to play a crypto-native game. And unfortunately, these transactions involve gas fees, transaction fees, and even incurring capital gains taxes.
Fortunately, new crypto innovations are making cross-chain transactions possible. Rather than selling Ethereum to play a crypto-native game, you could lock up your Ethereum and receive the equivalent in altcoins to play the game. That way, you’re not actually “selling” any Ethereum or incurring any of the associated trading costs.
In this article, you’ll learn what cross-chain interoperability is, why it matters, and some of the most cutting-edge solutions to the problem.
What is Cross-Chain Interoperability?
Blockchains are decentralized ledgers that maintain a record of transactions. But what happens if you want to make a transaction across blockchains? You can’t simply send a token from one blockchain to another because there’s no guarantee that the token identifier is unique. In addition, the receiving blockchain has no trustless way to validate the token.
Fortunately, cross-chain interoperability solutions enable blockchains to exchange data with other blockchains freely. Smart contracts and other techniques allow you to cross-chain interoperability solutions to facilitate communication between different blockchains without sending actual tokens. The result is a system that bypasses the two obstacles.
Why Does Cross-Chain Interoperability Matter?
To understand the importance of cross-chain interoperability, imagine a world where credit card readers only read a single brand. Customers using a Visa might be unable to make payments in a store that only accepts MasterCard. And, if merchants wanted to support every payment method, they might need five different machines.
A lack of interoperability among blockchains poses similar problems. But fortunately, cross-chain interoperability solutions address these concerns and others:
- Maximizing Utility – Different blockchains have different strengths and features. When blockchains communicate seamlessly, users can choose the best blockchain for the job rather than locking themselves into a single one-size-fits-all solution.
- Liquidity – Cross-chain interoperability could help increase liquidity in the broader crypto markets. With assets moving freely across blockchains, traders and investors can easily access different markets without worrying about market-specific economics.
- Innovation – Cross-chain interoperability fosters innovation by allowing developers to combine the features and functionalities of different blockchains to address new, hybrid solutions that weren’t possible on a single chain.
- Adoption – As the blockchain ecosystem grows, users will engage with multiple blockchains. Ensuring these chains work together helps create a more seamless user experience and could speed up mainstream adoption.
Approaches to Cross-Chain Interoperability
Developers have come up with several novel approaches to solving cross-chain interoperability challenges. These approaches generally seek to facilitate transactions across blockchains without relying on centralized intermediaries or inadvertently creating security vulnerabilities.
The most popular approaches to cross-chain interoperability include:
- Bridges – Bridges are one of the most common mechanisms for achieving cross-chain interoperability. These protocols or smart contracts can lock up assets on one chain and issue equivalent assets on another. Then, if the original assets are unlocked or moved back, the equal asset on the other chain is burned or locked up.
- Relays – Relays are nodes that communicate between blockchains. They relay information like proofs and confirmations from one chain to another, ensuring that actions taken on one chain are valid and you can confirm them on the other. The performance and security of relays depend on the relay chain’s consensus mechanism.
- Notaries – Notaries are trusted third-party providers that verify and forward cross-chain transactions. While a single-signature approach is the most straightforward, it involves a high level of centralization, so many blockchains leverage a multi-signature approach that requires a consensus among multiple notaries to sign transactions.
- Locks – Hash-time locks involve the initiating blockchain, choosing a random number, computing the hash value, and sending it to the receiving blockchain. The “lock” has a timing mechanism that reverses the transaction if it’s not complete by a specific time. The receiving blockchain provides the other end of the transaction similarly. Then, a smart contract unlocks both transactions with the hash algorithm to complete the trade.
Cross-Chain Interoperability Examples
The crypto community has leveraged these approaches to create several open-source protocols and projects to facilitate cross-chain transfers – and new approaches continue to emerge every year. While we will cover some of the most popular projects, others focus on a limited set of blockchains or use pioneering approaches that have yet to gain traction.
Chainlink’s Cross-Chain Interoperability Protocol (CCIP) is one of the most popular open-source standards for cross-chain communication. By using a network of decentralized oracles and standardized message formats, the blockchain-agnostic protocol validates the authenticity and integrity of cross-chain transactions while reducing any single points of failure.
The Wormhole protocol is a cross-chain bridge enabling the transfer of messages and tokens between blockchains. Unlike Chainlink, Wormhole “wraps” tokens on one blockchain and “mints” them on another. Meanwhile, Guardian nodes validate and submit cross-chain transactions, ensuring their validity and security.
LayerZero is another blockchain-agnostic interoperability protocol that provides a secure way to transact between blockchains without trusting a centralized intermediary. By using a network of ultra-light nodes and a relayer, the protocol supports a broad array of cross-chain applications, such as decentralized exchanges or yield aggregators.
Cosmos is an ecosystem of networks and tools for creating interoperable blockchains. The Cosmos Hub acts as a central ledger for compatible blockchains, known as Zones. The Inter-Blockchain Communication (IBC) protocol ensures interoperability between these zones through a minimal set of functions defined in its Interchain Standards (ICS).
What Are the Tax Implications?
Cross-chain interoperability may be essential to unlocking the power of blockchain ecosystems, but using these solutions could trigger some taxable events. The IRS treats cryptocurrencies as “property” rather than “currencies.” Moreover, recording these transactions can be challenging since they’re not necessarily “sold.”
As of late 2023, the IRS hasn’t provided specific guidance on treating cross-chain interoperability protocols, such as bridges. While “wrapping” a token may not seem like “selling” to you, the IRS could consider these taxable events since it’s economically similar to a sale transaction. So, conservatively, you might pay capital gains on these transactions.
Fortunately, ZenLedger can help you track these complex transactions. By connecting your wallets and exchanges, our platform automatically aggregates transactions to ensure that you fully understand where every token is and what taxes you may owe on it. Then, you can generate the IRS forms you need to file at the end of each year in a few clicks.
The Bottom Line
Cross-chain interoperability could help blockchains achieve broader adoption while maximizing liquidity and utility for traders and investors. While the concept is still somewhat nascent, there are several approaches to cross-chain interoperability gaining steam, including cross-chain brides, relays, notaries, and locks. And the innovation continues regularly.
This material has been prepared for informational purposes only and is not intended to provide tax, legal, or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.