DeFi Enigma: L2s is Amazing but not yet for Real Financial Assets

The difficulties migrating digital assets such as bonds or NFTs with residual payments between different L1 or L2 chains

Authors: Andreas Freund, Co-Chair of L2 WG, on behalf of the LEA Working Group on Community Projects of EEA

We all know that Web3 will rule the world, despite consumers addicted to the ret2 mode of instant gratification by furiously hitting (back) buttons and screaming at screens when their Ethereum transactions don’t end after 2 seconds. L2s will give those consumers their Speed ​​for the Web3 world of tomorrow, today.

L2s can give Fortnite nerds their favorite, rare in-game skins or weapons like NFTs that can be exchanged in or out of the game, generating striking profits. They can also provide full privacy in trading assets through esoteric zk-zk rollups. Full privacy is a dream come true for all traditional financial asset managers and is rejected by global tax authorities.

So what is not to love or to hate or to love and hate about L2s?

As our asset managers enthusiastically create L2 trading accounts, they are quickly faced with the relatively meager choice of financial assets that can be traded on L2s. Want to move any of your Ethereum’s Maker, Aaave, Compound or Centrifuge debt instruments? No! Anus? No! Dividend-paying shares? No! How about moving them to other Blockchains or moving them from other Blockchains? No!

Well, you can make simple NFTs or tokens, or you can create and trade your debt instruments directly on L2, but they will stay there. At that moment, our asset manager sighs, shuts down his laptop, and leaves. Because our asset manager represents about $ 40 Billion of trades per quarter globally, and because more complex assets make up 95% + of those trades, L2s are difficult to occupy traditional finance, and thus will continue to grow exponentially over a long period of time. time, unless they can deal with the market of digital assets paying residues.

The question is therefore why these kinds of complex digital assets are available on Ethereum markets like Aave but cannot be moved to L2s?

Let’s take a step back and look at the current situation. Currently, the method of bridging digital assets such as ERC20 tokens or NFTs between networks – for example, Ethereum <> L2, Ethereum <> Zksync, Ethereum <> Polygon – immobilizes the assets on the source network and then instantiates them on the target network. . .

This approach works well if the digital asset does not have relevant trading rules that infer rights or obligations to owners of assets such as stable currencies or simple NFTs. Examples of important digital assets that include rights to the holder of digital assets are residual payments / assets such as dividend-paying shares, bonds, annuities, securities, digital assets with a shareholding, and so on.

Unfortunately, such digital assets currently cannot be transferred between networks because a transfer would break the link between the asset and the rights or obligations associated with it.

Given the importance of digital assets with remnants in traditional finance, the emerging proliferation of DeFi assets that mimic traditional assets such as bonds or securities, and more and more value locked into bridges and L2s, is a major danger that L2- will do. hit a growing plateau because they can’t offer what most of the world wants to trade.

So, what could be possible solutions to this puzzle?

The answer is, not many … at least not yet!

Figure 1: Simple link on L1 block chain

Using the simple example of a Bond on Ethereum paying on schedule in DAI (see Figure 1 above), we outline some of the challenges (in Figure 2 below):

1. Because Alice, the payer of the scheduled bond payments, generally does not know that Bob, the payee, has moved an obligation from Ethereum (L1) to L2, Alice would send payments to L1 Bond’s smart contract with Bob’s Ethereum address. Since Bob is no longer the owner of the bond, but rather the bridge contract is, the payment would fail.
2. If the bond contract was still aware that Bob was the payee, then it could still accept a bond payment, but the payment would be owned by the bridge contract.
3. Therefore, when the bond is locked in the bridge, the expected DAI bond payments must be instantiated on the L2 side in the Bond contract, now where Bob’s L2 address is the owner of both the Bond token and the wrapped DAI.
4. This means that when payment is received in the Ethereum bond contract, the bridge network must be notified of the payment by event and cash the payment amount as wrapped DAI on the DAI bridge contract on the L2 side, for Bob. This is problematic because there is no corresponding DAI in the bridge on the side of Ethereum. After all, it is associated with Ethereum’s (L1) league contract. This means that Bob’s WDAI on L2 would be worthless. Therefore, the payment amount in DAI can only be cashed as Ethereum IOU in the L2 Bond contract, as the DAI cannot be taken out of the L2 bridge contract. So, the DAI payments that the bondholder receives are useless on the L2 side. That, of course, is not desirable.
5. If the bond is exchanged to Claire on L2, Claire is now entitled to receive bond payments and Bob is no more. This means that after Claire has purchased the Bond, the bridge network must notify the new owner’s L1 bond contract for the payment Claire received on the Ethereum side. This also means that Alice needs to know that she needs to send her bond payments indexed to Claire and not Bob. And after Claire gets paid, the bridge network has to create the same Ethereum DAI IOU on the L2 side. And so on for every change of ownership.

These open-ended questions are for the simple case of connection. Competence for example, where the payments are largely independent of token ownership and typically more than one party receives a portion of the payment, is even more complex because not all payments need to be bridged. However, the (net present) value of the digital asset depends on overall payment flows.

Generally speaking, it is unclear how to carry complex digital assets between networks when the value of the asset depends on payments on the origin network but the asset is traded on the target network.

A promising first attempt was made to address this complex challenge with the GPACT protocol and Crosschain Protocol Stack, which is currently being developed within the EEA Crosschain Interoperability Working Group.

The newly formed EEA Community Projects Working Group L2with the participation of the EEA, Matter Labs, Polygon, Offchain Labs, Accenture, VMWare, ConsenSys, Perun, Connext, Provide and the Ethereum Foundation, also took on the challenge and published Eth Magicians and Eth Research post on the topic, calling on the Ethereum community to request comments and address this challenge, and is working with the EEA Crosschain Interoperability Working Group to see if the GPACT protocol can be successfully utilized in PoC to transfer complex digital assets between L2 networks.

We invite all interested parties to join us and address this important challenge for the entire public, enterprise and Blockchain ecosystem together!

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