In a report published on Tuesday, economists at the Bank for International Settlements (BIS) say that the usage of public blockchains leads to fragmentation, which implies crypto will never be a suitable form of payment.
The research stated, “Fragmentation means that crypto cannot fulfill money’s social purpose.”
The paper suggests that when the number of transactions per block approaches its limit, the cost of transactions grows, prompting users to seek alternative blockchains. Because of this “fragmentation,” blockchains cannot take advantage of the beneficial network effects of the fiat.
According to the research authors, money is a coordinating mechanism designed to encourage economic transactions. It can only happen if there are network effects, in which the money becomes more appealing as more people use it. In other words, cryptocurrencies cannot serve this role without interoperability between contending blockchains.
Security Cracks in Crypto
“Cross-chain bridges” have evolved to address the issue of interoperability and enable the transfer of tokens across chains.
A user, for example, can send 100 Bitcoin to a third party (the bridge), which will store the Bitcoin. The Bitcoin blockchain would be used to validate this transaction.
The bridge then creates a new currency on a different chain with the same value as 100 Bitcoin and sends it to the user. This second transaction would take place on a different blockchain than Bitcoin.
The volume of bridges has expanded in tandem with the number of blockchains. Bridges alleviate the blockchain landscape’s fragmentation and signal that the consensus process is extremely concentrated, posing additional security vulnerabilities.
Moreover, bridges frequently require the majority of only a small number of validators to validate transactions.
These consensus algorithms allow for speedier transactions, but they rely on the credibility of a small number of validators, putting security at risk by raising the possibility of an attack. Indeed, cross-chain bridges have been at the center of several high-profile hacks recently, including the one that hit Axie Infinity, showing the vulnerability to security breaches.
So-called “layer 2” solutions are another attempt at scalability.
Layer 1 networks, such as Ethereum, Avalanche, Binance, and Solana, are usually referred to as such. Any transaction is validated and stored on the public ledger on a layer one blockchain, i.e., “on-chain.”
Whereas most transactions on layer two solutions (such as the Bitcoin Lightning Network) take place off-chain, transactions are only relayed to the underlying layer one chain in bundles on rare occasions. Layer 2 blockchains enable higher transaction limits and reduced fees at the expense of decentralization, introducing concerns similar to those posed by bridges.
Crypto and DeFi strive to create a radically alternative monetary system based on permissionless blockchains, but they have intrinsic limits.
Network effects cannot emerge in a system that relies on fees to reward a group of decentralized yet self-interested validators. Instead, the system is prone to fragmentation and is too expensive to operate. Because of its fragmentation, crypto cannot fulfill money’s social function.
Fiat is, in the end, a coordinating mechanism that makes the economic transaction easier. It can only do so if network effects exist: as more people use one sort of money, it becomes more appealing to others. Looking ahead, technologies based on faith in sovereign currencies hold more promise.