Money View of the Polygon Bridge Drama
Crypto bridges in the hierarchy of money but balance sheets only no drama
We are not arguing for or against the specific Polygon proposal, but rather wanted to explore what fractionalization could mean in the context of bridges and ‘defang’ or demystify it a bit. Studying balance sheets dispassionately can help us understand what the full range of tradeoffs are in design choices for crypto bridges.
Crypto twitter is once again ablaze with heated passions, this time about the “Polygon Bridge Drama” that proposed allocating over $1bn in bridge assets to lending markets on Ethereum mainnet, as a way of creating returns that could feed back into the Polygon ecosystem. Let’s leave emotions to the side and look under the hood of the balance sheets involved to see what the money view of the situation is.
A ‘bridge’ in crypto-speak is a gate between two blockchains. Most blockchains are not immediately compatible with one another. There is therefore a problem when people want to use assets issued on one blockchain on another blockchain, for whatever reason. To do this, users can rely on a bridge, which ‘locks’ their assets on one side of the bridge and mints a corresponding liability on the other. This allows users to freely exchange tokens on one blockchain that may have been natively issued on another.
The bridge is therefore, like almost every smart-contract based application, a balance sheet or accounting ledger that matches sources of funds to uses of funds. In the case of a bridge, the ‘sources’ is the user’s demand to hold tokens on another blockchain, for e.g. Polygon. The ‘uses’ of those assets are kept reserved in the original asset deposited. This ensures that the users that want to move back from Polygon to Ethereum, say, always have 100% liquidity reserved to do just that.
The root of much of the scandal is the perception that a user’s deposit is enshrined in the bridge and the perception that allocating that liquidity to something other than liquidity inflicts an undue risk. A natural temptation is to view the bridge as a "vault" holding one unit of underlying asset for each bridged token—essentially a full-reserve model that seems safer at first glance.
From a money-view perspective, any financial system is a hierarchy of promises. The trust, liquidity, and acceptance of instruments at each layer depend on their perceived safety and convertibility into more fundamental monetary claims. Similar to how we reorganized Perry Mehrling’s Hierarchy of Money for stablecoins and crypto dollars, we can do the same for ‘bridge money’. A fiat money hierarchy goes from money to credit starting with central bank money and ending in credit or securities. Much of the conflict with Polygon’s proposal is because users have the perception of bridge money that starts with the reference asset (whatever the user is depositing), so in their mental framework it looks something like the below:
A full-reserve architecture treats a bridge like a warehouse, where every asset deposited is simply kept indefinitely as a 1:1 reserve. The perception is that this model provides a high degree of safety as, in theory, all users can withdraw their claims eventually and nobody is left on the ‘wrong’ side of the bridge. However, the money-view shows us that this one-dimensional perception of risk is incomplete. It solves fully for liquidity, but does nothing for solvency.
Since the bridged assets inherit the risk of the underlying asset, if the underlying asset is compromised or loses value, the full-reserve model by itself does not offer any protection from risk materializing. Notably, all of the hack scenarios in major bridges have taken place on ‘full-reserve’ bridges (e.g. Wormhole and many other examples). Allocating a bridge fully to liquidity ensures that everyone can redeem at the warehouse door, but does not offer any guarantees on impairment for what those users can redeem for.
By contrast, a fractional-reserve bridge architecture acknowledges that a bridge is more than just a warehouse and that the money-view reality is a bit more complex. The redemption path for bridged liabilities is much further down the credit axis, as it represents claims that have to be redeemed for promises higher up in the hierarchy. The bridged asset’s monetary quality—how “money-like” it is—depends on whether it can be credibly redeemed for its underlying asset at par, on demand:
Instead of being a mere warehouse or full-reserve custodian, a money-view perspective on bridges acknowledges that it also plays a role transforming money into credit, potentially with long-term durations if users remain on a new blockchain. This perspective introduces new risk relative to full-reserve bridges. With fractionality, there is always the possibility that users cannot redeem all at once without liquidation losses or delays. However, this scenario (immediate full withdrawal of all bridged assets) seems like it would be quite unlikely, judging by a back of the envelope view of the amount of bridged assets that haven’t moved in months, if not years.
The risk-aversion view is well represented by (we think) the Head of Research at Circle, Gordon Liao, who weighed in on the trade-offs in a forum post:
“If a bridge invests the collateral into lending protocols, the bridged asset on the new chain becomes fractionalized and loses its full fiat backing. This means users would perceive the bridged token as distinct from the original, and its market value would reflect the fractionalized and rehypothecated nature of its collateral. As a result, the bridged asset would lose fungibility with the original token.”
This is a reasonable view that presents bridges as claims aligned with the expectation for 100% allocation to liquidity. However, it nevertheless slightly misframes how fractional-reserve balance sheets work in practice, or how they are valued by holders of the liability. To wit, the most successful fiat-backed stablecoin, USDT, is fractional-reserve and yet holds a stable secondary market price relative to the higher-value redemption asset (a USD bank deposit). Notably, it was USDC that was exposed to the vagaries of edge-case risks of solvency exposure when Circle was unable to redeem 10% of USDC’s assets from Silicon Valley Bank. This was in spite of being a full-reserve fiat-backed stablecoin that only invested in “high-quality, liquid assets such as U.S. Treasury bills”.
The benefits of a fractional-reserve bridge architecture can accrue to the new blockchain in meaningful ways. By carefully managing credit exposures and liquidity buffers, the bridge can generate income through fractionalization. This income can accrue to the ecosystem as a whole, by funding incentives to users, reducing transaction fees, or strengthening the bridge’s own financial resilience through the accumulation of a surplus buffer.
In the case of the Polygon proposal, the idea hinged on using strategies such as lending against high-quality liquid collateral types like tokenized US treasuries or stablecoins like USDS or USDA, to generate a return. Notwithstanding the many specific risks of these strategies, the returns could have been directed to fund incentives and activity on the Polygon blockchain. The adjacent benefit to Ethereum as a whole could have been an increase in liquidity in DeFi applications on the ‘home’ blockchain.
While fractionalization of bridge assets certainly introduces new dimensions of risk, the tradeoff benefits may be underexplored in the discussion as a whole, independently of the merits of the specific implementation proposed. Part of the potential of crypto is the transparency with which fractionalization can take place, potentially creating conditions under which risks can be better mitigated, for example.
“Though much has been said about the expectation of bridged assets and the implied contract between a bridge and its users, I want to take a second and focus on the beauty of the proposal and its ability to leverage what makes crypto so unique to create a flywheel that will be replicated by other ecosystems, if not Polygon.”
One of the key insights from the money-view is that risk does not vanish but can be managed, transferred, and socialized. A fractional-reserve bridge, if designed prudently, can use first-loss capital, insurance funds, and risk tranching to maintain solvency. By holding a dedicated surplus of high-quality collateral or by allocating a portion of accrued yield to a safety module, the bridge can absorb losses from credit events—such as bad debt in a lending protocol—without immediately imperiling the redeemability of its bridged tokens.
This approach effectively "taxes" the liquidity that would otherwise sit idle and uses that tax to create a more robust safety net. In the event of stress, the balance sheet of the bridge can protect its users better than a zero-yield warehouse that keeps no cushion beyond the strict 1:1 backing. In a sense, the fractional-reserve approach transforms idle capital into a mechanism for systemic resilience—if done with proper governance, risk management, and transparency.
Like with many situations in crypto, seeing the money-view in bridges requires adopting a new crypto-native perspective on the flexibility of balance sheet architecture in DeFi, and recognizing that there is no spoon. With that said, it is still a perfectly reasonable perspective to take, that bridges should only ever remain full-reserve balance sheets. As long as the expectation from the user is that the relevant redemption asset is the corresponding token on the original blockchain, it may well be the most reasonable design choice, particularly if these tradeoffs are changed under the user’s feet. This is what has been at the heart of most criticisms of the Polygon proposal as it stands.
We are not arguing for or against the specific proposal, but rather wanted to explore what fractionalization could mean in the context of bridges and ‘defang’ or demystify it a bit. Studying balance sheets dispassionately can help us understand what the full range of tradeoffs are in design choices for crypto bridges.