Research on the Liquidity Fragmentation Issue in the Layer 2 Era

Introduction

With Ethereum's shift towards Layer 2-centric scaling solutions and the rise of tools like RaaS, a large number of public chains have rapidly developed. Many entities wish to build their own chains to represent different interests and pursue higher valuations. However, the emergence of numerous public chains has made it difficult for the ecosystem to keep up with the pace of public chains, leading to many projects facing price drops at the time of their initial token issuance.

With the help of OP Stack technology, a trading platform has launched its own Layer 2 network Base, while another trading platform has released Ink; utilizing ZK technology, a trading platform has introduced XLayer; Sony has released Soneium, and LINE has launched Kaia, among others. Nowadays, the capital and technical thresholds for building a chain have been greatly reduced, and the cost of operating a chain based on OP Stack is about $10,000 per month.

The future will undoubtedly be an era of coexistence of multiple chains. Although these Layer 2 chains may choose EVM compatibility for interoperability, it is difficult for them to build applications and reach consensus on the same chain due to the large number of downstream applications backed by their Web2 entities.

The current multi-chain ecosystem presents a new challenge: liquidity and state fragmentation. Given the inevitability of multi-chain existence, interoperability is a field that must be explored and addressed. Currently, there are many liquidity solutions, such as chain abstraction, intent, Clearing Execution, Native CrossChain, ZKSharding, etc., but their core essence is similar.

We use the industry-recognized Cake architecture to introduce the core components of cross-chain abstraction from top to bottom:

Application Layer

This is the layer where users interact directly, and it is the most abstract layer in the liquidity solution because it completely shields the details of liquidity conversion. In the application layer, users interact with the front-end interface and may not necessarily understand the underlying liquidity conversion mechanism.

Permission Layer

Located below the application layer, users connect their wallets to the dApp and request quotes to fulfill their trading intentions. Here, "intent" refers to the expected final trading outcome (i.e., output) rather than the specific execution path of the trade.

Key Management and Account Abstraction

Due to the existence of a multi-chain environment, there is a need for an account management and abstraction system that adapts to different chains to maintain the unique account structures of each chain. For example, SUI's object-centric account system is completely different from EVM. One Balance is a representative project in this field, building a trusted account system that does not require inter-chain consensus, only a trusted commitment between existing account systems. Near Account achieves abstract management by generating multi-chain account wallets for users, greatly optimizing the user experience and reducing UX fragmentation. However, in terms of liquidity, it mainly integrates existing public chains.

Solver Layer

This layer is responsible for receiving and executing user trading intentions, where the Solver role competes to provide a better user experience, including faster transaction times and execution speeds. On this basis, various intention-driven solutions have been built based on intentions. Derivatives of such intentions include the Predicate component, which can realize user intentions under specific rules.

Settlement Layer

This is the middleware layer used to implement user intent in the solution layer. The core components of liquidity and state decentralization solutions include:

• Oracle: Used to obtain state information from other chains.
• Cross-Chain Bridges: Responsible for the transmission of information and liquidity across chains.
• Pre-Confirmation: Shorten cross-chain confirmation time.
• Data Availability (DA): Providing accessibility to data.

In addition, factors such as inter-chain liquidity, finality, and Layer 2 proof mechanisms need to be considered to ensure the efficient operation of the entire multi-chain system.

Solution

Currently, there are various solutions in the market to address liquidity fragmentation. After reviewing a large number of solutions, we found that there are mainly these few methods:

1. Centered around RaaS: Similar to Rollup solutions like OP Stack, it assists in building Rollups on OP Stack by adding specific shared sequencers and cross-chain bridges to share liquidity and state. This aims to address the decentralization of liquidity and state at a higher-level direction. A more detailed aspect here is the separate design of shared sequencers, which is more targeted towards Layer 2 and lacks universality.

2. Account-Centric: By building a full-chain account wallet, it supports signing and executing transactions across multiple blockchain protocols. The core component is the MPC network, which replaces users in signing multi-chain transactions. This solution, while greatly addressing the issue of UX fragmentation, presents complex backend implementations for developers and does not fundamentally solve liquidity and state dispersion.

3. Centered around the off-chain intention network: the core idea is that users send intentions to the Solver network, where the Solver competes for quotes, providing the optimal completion time and transaction price. These Solvers can be AI Agents, CEXs, Market Makers, or even integrated protocols themselves. Although intentions can theoretically achieve cross-chain operations of any complexity, in practice, there needs to be sufficient liquidity Solvers to assist, and when encountering certain off-chain demands, there is a possibility of fraud from the Solvers.

4. Centered on the on-chain liquidity network: This direction is specifically optimized for cross-chain liquidity issues, but it does not address other on-chain state decentralization problems. Its core is to build a liquidity layer on which applications are built to share liquidity across the entire chain.

5. Application-Centric on the Blockchain: These types of applications build high liquidity applications by integrating large MM or third-party applications, etc. These projects require managing complex cross-chain processes, which places high demands on developers, making them very susceptible to hacking incidents.

Solving liquidity issues is a very important proposition; in the financial world, liquidity often represents everything. If we can build an integrated liquidity platform, especially one that consolidates fragmented on-chain liquidity, it will have tremendous potential, and we have also examined many different solutions.

In the above two categories, we can see that based on the cake structure, the Settlement Layer is the most atomic-level solution. Above these atomic solutions like cross-chain, oracles, and Pre-Confirmation schemes, there is a more abstract layer constructed, which includes the Solver Layer, Permission Layer, and Application Layer. The various solutions we listed above that are constructed in different directions for abstraction or liquidity solutions align with this set of different levels, which can be understood as a relationship between upstream and downstream. However, these solutions are still not atomic-level solutions. The entire liquidity fragmentation issue has led to the emergence of many complex derivative problems, thus giving rise to a variety of solutions for interoperability. But fundamentally, it still relies on these components. Next, we will discuss several typical projects of chain abstraction concepts to see how each of them addresses the issue of liquidity fragmentation from their own starting points.

INFINIT

INFINIT has built a RaaS service in the DeFi space that can provide the components necessary for the direct construction of DeFi protocols, such as Oracle, Pool Type, IRM, and Asset, as well as immediately deployable components like Leverage Trading and Yield Strategy. It is equivalent to other application construction ends, but the final liquidity is placed on Infinit's Liquidity layer. However, it has not yet disclosed the underlying working principles. Currently, INFINIT has secured $6 million in seed funding.

Khalani Network

Khalani has built three core components: the Intent compatibility layer, Validity, and the universal settlement layer.

External applications or the intent layer can publish intents to Khalani, and Khalani's Intent compatibility layer can convert external intents into a format that the protocol Solver can recognize, using the standardized format known as Validity language. The Khalani node is responsible for submitting the final results to the universal settlement layer through cross-chain bridges, rapid settlement technologies, etc. This project is still in the construction phase, and more work details have not yet been disclosed. It received $2.2 million in seed round funding in August.

Liquorice

Liquorice is a decentralized application that enables auction-based price discovery and unilateral liquidity pools. The main mission of Liquorice is to provide professional trading firms with efficient inventory management tools and to easily connect to core DeFi protocols when settling trades with intent. At the same time, Liquorice has created a lending market for its lending transactions. This application focuses more on the trading itself. It is still in the development stage, and it announced in July that it had raised $1.2 million in a Pre-seed round of funding.

Xion

Xion is an upgrade from the Burnt brand, which previously focused on consumer application apps. The team later discovered a significant fragmentation issue in on-chain interactions, leading to the development of Xion to address this problem. Xion is built on the Comet BFT consensus protocol. Its cross-chain communication is based on Cosmos IBC, making it more native and secure than other cross-chain bridges. It has gone through four rounds of financing.

=nil; Foundation

nil is a ZK computing power market, ZK co-processor, and Layer 2 developer for Ethereum, with a team that possesses deep ZK technical expertise. They proposed the zkSharding solution, which uses ZK technology to horizontally scale the Ethereum mainnet, executing sharded parallel processing of transactions and generating ZKPs, while the main shard verifies data, communicates with Ethereum, and synchronizes the network state among all validators. The main shard also manages the distribution of validators and accounts in the execution shards. The consensus protocol used by the validation committee is also Hotstuff, which is common in the latest parallel execution projects. =nil; L2 has embedded cross-shard communication into the protocol from the very beginning.

The basic idea is to build an embedded cross-shard communication architecture similar to IBC through a sharded Layer 2 architecture, which can solve the problems of liquidity and state dispersion. However, the core idea is not reasonable, because the problem of liquidity dispersion is a multi-chain issue, and what is being built is a single Layer 2. This means that to solve it, all chains need to become a shard of ZK-sharding, which is difficult to achieve.

ERC-7683

Ethereum is also working to address the issue of cross-chain liquidity. Currently, multiple platforms publicly support the ERC7683 standard, which is based on an Intent-based cross-chain approach. Its core goal is to establish a universal standard for cross-chain operations across L2 and sidechains, standardizing order and settlement interfaces to achieve seamless cross-chain execution. The main core is a Filler, which can also be referred to as the Solver role in chain abstraction for payment on behalf. This proposal is currently under review by the Cake working group.

OP Stack

OP Stack, ERC-7683, and zkSharding are all solutions for the fragmentation of liquidity between Layer 2s within Ethereum, addressing issues at the architectural, consensus, and application layers, respectively. OP Stack designs a complete multi Layer 2 solution to address the problems of information transmission and Sequencer decentralization at once. When you use the OP Stack architecture, cross-chain contracts are automatically deployed, and there will be a Supervisor to challenge and prevent the transmission of false cross-chain information. Currently, several well-known trading platforms use the OP Stack architecture.

Among them, a typical example is