In the wake of the collapse of the Terra blockchain last month, monetary authorities are taking a more critical look at the prospects of cryptocurrency ever becoming a widely used monetary system.
The Bank for International Settlements has published a paper, Blockchain scalability and the fragmentation of crypto, arguing that the inherent fragmentation of decentralised finance means that blockchains and cryptocurrency cannot fulfil the role of money.
Over the two years to the end of 2021, the value of cryptocurrencies rose more than tenfold to US$2.8 trillion, before crashing in June.
Over the same period assets traded in the decentralised finance space rose 180 times to US$109 billion.
As the system grew it started to fragment. Initially, most DeFi protocols ran on the Ethereum blockchain but by 2021 a number of rival network had emerged, including Binance, Avalanche and Solana.
By May this year, the value of cryptocurrencies associated with protocols on Ethereum was down to half of all assets locked into DeFi.
The BIS paper said: “The fragmentation of the crypto landscape stands in stark contrast to traditional payments networks, which benefit from strong network effects. In the traditional system, the more users flock to a particular system the more attractive it becomes for new users to join that platform, creating a virtuous circle.”
The benefits of these networks may include lower costs, higher service standards and financial inclusion.
The paper argues that crypto’s fragmentation arises from “inherent limitations” of blockchains.
Crypto is built on permissionless distributed ledger technology – blockchains. Rather than putting trust in centralised intermediaries, such as banks, the blockchain is sustained by a multitude of pseudo-anonymous, self-interested validators incentivised via rewards and fees.
Any participant can transact on a public ledger without the need for a centralised intermediary that keep track of transactions. Cryptocurrencies are the means of exchange among users and are used to reward validators for running the decentralised system.
The paper said: “To maintain a system of decentralised consensus on a blockchain, self-interested validators need to be rewarded for recording transactions. Achieving sufficiently high rewards requires the maximum number of transactions per block to be limited. As transactions near this limit, congestion increases the cost of transactions exponentially.
“While congestion and associated high fees are needed to incentivise validators, users are induced to seek out alternative chains.
“This leads to a system of parallel blockchains that cannot harness network effects, raising concerns about the governance and safety of the entire system.
“It is the inherent features of blockchains – first and foremost the need to incentivise decentralised nodes to validate transactions – that drive the fragmentation of the crypto landscape.”
Fragmentation of the crypto system introduces risk. Different blockchains are not interoperable. “Cross-chain bridges” have emerged to deal with this problem but they pose security risks.
“Fragmentation without interoperability implies that cryptocurrencies cannot fulfil the role of money as a co-ordination device,” the report said
Markets can unravel quickly. The Terra blockchain, which collapsed in May, relied on a coin, Luna, and an algorithmic stablecoin, TerraUSD.
“As TerraUSD lost its peg, users rapidly lost confidence that the price of Luna would further increase. As a consequence, both TerraUSD and Luna experienced a classic run, causing their prices to collapse.
“As the value of validators’ Luna stakes fell to almost zero, anybody could have acquired a large amount of Luna at almost no cost and become the dominant validator, thereby drastically increasing the risk of governance attacks. Terra had to halt its blockchain.”