Decrypting Interoperability in the Age of Third Generation Blockchains

What is interoperability? Why is it a core component of third generation blockchain tech?

Interoperability is the idea that there will never be just one coin to rule them all.

Instead, you’ll have Ethereum, Bitcoin, Ripple and even legacy systems like banks running protocols like SWIFT. Like the UN, each of these protocols speak their own language and there is a need to be able to translate from one to the other.

Imagine interoperability as the idea of having a universal language that all protocols can speak and understand easily.

Currently, when Bitcoin tries to talk to another protocol like Ethereum, all it hears is gibberish. It’s even worse when trying to interact with SWIFT which is a protocol that most of the legacy financial institutions run on. Add to the mix that many of the Wells Fargo’s and Morgan Chase’s of the world require vast amounts of metadata to accompany every transaction and it becomes damn near impossible to get everyone to play nice.

Charles Hoskinson, co-founder of Ethereum with Vitalik Buterin expands on the problematic nature of getting different protocols to cooperate.

“The problem is that if you don’t have a single standard, and if you don’t have a canonical way of communicating with these systems, then you run into a situation where value gets really fragmented. So regardless of how decentralized any of these particular ecosystems happen to be, the kingmaker will be the small on and off boarding hubs that control the movement of value between these systems”

At the time of this writing, exchanges are the major focal points for this process of on and offboarding that are bridging this gap of interoperability. The major weakness of exchanges are their vulnerability. Exchanges are big targets for both hackers and “draconian regulation”.

It’s ironic that an ecosystem predicated on the values of decentralization and permissionless transactions is now facing a landscape where interoperability can only be found in exchanges, which are naturally centralized actors.

“Furthermore, when people do business in this world [Bitcoin, Ethereum, Ripple], if these businesses are regulated or even semi-regulated, they usually do have to interface and interact with the traditional financial world”

Imagine you created your own ERC 20 token and did a crowdsale where you raised millions of dollars of ether. Then, since you’re a legitimate business operating legally, you decide to sell that ether and move millions of dollars to your bank account. Taking an interest in this large transaction the bank will ask you where the money came from and who your clients are. Well , it turns out that “internet folks” is not a valid answer.

What many people fail to realize about banks is that they are legally required to report behavior that seems suspicious and report back to the Treasury Department and other financial organizations. Therefore, these kinds of transactions where there is no data to be had on the who, what, when, where and why of your transaction, you immediately become a major red flag to legacy financial institutions.

“We have fragile interlinks throughout cryptocurrencies as well as the legacy financial system and there’s really no way to escalate transactions in a very natural way so that when one wants to do business with the legacy world, that metadata, attribution and compliance information that one would want to have is not present. As a consequence anyone doing business [via Ethereum, Bitcoin, Ripple, etc.] becomes a high-risk business” says Hoskinson.

So being able to keep an eye on and interpret other cryptocurrencies is the crux of interoperability and third generation blockchain tech.

Imagine Alice being able to send some ether to Bob using the Ripple network and the network being able to verify that it’s a legitimate transaction. This is one of the hallmarks of a third generation blockchain. These are also known as cross chain transfers.

“[Cross chain transactions] should be able to do this without needing a trusted third party. That’s the single most important thing because we want to create an internet of blockchains, an internet of value that flows around just as easily as Bitcoin flows around… We want to move cross chain.”

But how do we make cross chain transactions a reality?

Well sidechains are a promising frontier because they give you a compressed version of the blockchain that will allow for cross chain transaction verification. As a whole, the idea of achieving a scalable cross chain solution that requires a full version of both blockchains to verify transactions is ludicrous.

“There are over a thousand cryptocurrencies in use and cryptocurrencies are becoming larger and larger. So you can’t say ‘Well the only way to understand the other system is to have a copy of the entire blockchain of the other system’’ - this is not a scalable solution. You have to be able to look at these systems in a very compressed way.”

But even if there is a solution and all blockchains are able to effortlessly communicate with one another, interfacing with the legacy financial institutions is still very much fitting a round peg in a square hole, to put it mildly.

The bridge between these two worlds will be made up chiefly of developments in metadata, attribution and compliance capabilities.

Right now these three features are the life-giving elixir of the legacy financial institutions and cryptocurrency’s kryptonite.