BIS publishes report on crypto ecosystem and risks

BIS has published a report outlining the key elements of the crypto ecosystem and their structural flaws. The report was submitted to the G20 Finance Minister and Central Bank Governors. The three key takeaways are:

Fragmentation and congestion

Due to underlying economic incentives, the crypto ecosystem suffers from inherent limitations of permissionless blockchains and is characterised by congestion and high fees, which lead to fragmentation. The reasons for these limitations are not technological, but stem from incentive structures.

On the blockchain, self-interested validators are responsible for recording ownership and transactions. However, in the pseudo-anonymous crypto system, they have no reputation at stake and anonymity impedes accountability. Instead, they must be incentivised through sufficiently high monetary rewards to report truthfully and sustain the system of decentralised consensus. Honest validation must yield higher returns that the potential gains from cheating

A common way to reward validators so as to maintain incentives is to limit the capacity of the blockchain, thereby maintaining high fees sustained by congestion. As validators can choose which transactions are validated and processed, periods of congestion see users offering higher fees to have their transactions processed. On blockchains that rely on a larger network of validators, it is harder for one validator to manipulate the ledger, but this also means that transaction validation takes longer, implying higher costs for users and more rapid congestion. On blockchains with fewer validators, there is more potential for a smaller group of validators to manipulate the network.

False decentralisation claims

Despite an original ethos of decentralisation, crypto and DeFi often feature substantial de-facto centralisation, which introduces various risks. DeFi’s inherent need to obtain information from the real world represents an important impediment to decentralisation. The reporting of data that underpins smart contracts relies on “oracles”, third party mediators that provide information that resides “off-chain”.

The problem with oracles arises because they introduce centralisation to a decentralised system, overriding the reliance on consensus as a trust mechanism. In the extreme, some use a single data source or have a single person/entity in charge of transmitting information to the platform. This introduces a single point of failure and leaves room for the ability to corrupt the system by misreporting data. Currently, there are no clear rules as to how oracle providers are incentivised or vetted, or who is held accountable if a smart contract acts upon incorrect off-chain information.

Centralisation is also present in crypto trading activities, where investors rely mainly on centralised exchanges (CEXs) rather than decentralised ones.

Nominal anchors and speculative influx of new users

While there is no such thing as a central crypto bank, there must be a unit of account. Stablecoins attempt to serve this function, but do so by tying their value to fiat currencies. In this sense, stablecoins represent crypto’s search for a nominal anchor.

As DeFi does not finance activity in the real economy, its growth is driven by the speculative influx of new users, with substantial risks to investors. The report gives the example of the collapse of the TerraUSD stablecoin in May 2022.

The report outlines policy options to mitigate the multiple risks crypto poses to investors, the traditional financial system and the economy at large, including by encouraging sound innovation within the traditional financial system or through the use of central bank digital currencies.

Laura Wiles