Economy · June 23, 2022

The Crypto Trilemma – Conversable Economist

The Bank of International Settlements is owned by 63 central banks around the world, from countries that make up approximately 95% of the world’s GDP. Therefore, when the BIS takes a chapter in its most recent annual report to argue that decentralized cryptocurrencies that operate separately from central banks are a dead end, one possible answer is to point out that central banks are defending their territory. Which is true. But that doesn’t mean the argument is wrong. The BIS argues that many recent financial sector innovations such as decentralized finance, non-fungible tokens, and (reasonably) anonymous digital currencies will work better if they are based on central bank money rather than cryptocurrencies.

Here, I will try to summarize the BIS argument by breaking it down into two parts: the fundamental problem with cryptocurrencies and the alternative view for a future monetary system.

To describe the problem with cryptocurrencies, the BIS report offers what it calls a “scalability trilemma,” but I only consider it the cryptocurrency trilemma. A “trilemma” is a situation where you can only get two out of three desirable results. Here, the three potentially desirable outcomes are for a currency to be secure, scalable, and decentralized.

For example, conventional central bank money (the bottom line of the figure) is safe and scalable. But it is obviously not decentralized. Cryptocurrencies like Bitcoin and Ethereum are decentralized and safe. But around 2 billion digital payments are made every day around the world. The process of updating the blockchains used to track this type of cryptocurrency exchanges is remarkably costly in terms of resources and is, compared to methods such as modern credit card transactions, incredibly slow to deal with this volume of transactions. In other words, these secure and decentralized cryptocurrencies have not proved scalable so far. Therefore, the scale expansion of cryptocurrencies is partly driven by the arrival of new ones, which are decentralized but often turn out to be less secure. A recent example is the collapse of Terra’s “stablecoin,” a cryptocurrency that was supposed to set a value in US dollars but ended up worthless and wiped out about $ 60 billion in value. In April, the Wall Street newspaper published a story titled “Crypto Thieves Get Bolder by the Heist, Stealing Record Amounts”. They point out that in the last 38 weeks, there have been 37 major hacks to cryptocurrency / blockchain organizations here.

The BIS report puts it this way:

The limited scale of blockchains is a manifestation of so-called scalability
trilemma. By their nature, permissionless blockchains can only get two out of three
ownership, i.e. scalability, security or decentralization (Graph 3). safety is
enhanced through incentives and decentralization, but supporting incentives through tariffs
leads to congestion, which limits scalability. There is therefore a mutual incompatibility
between these three key attributes, preventing blockchains from serving adequately
the public interest.

Does this trilemma have to be true? Or could it be possible, for example, to have a cryptocurrency that is scalable and secure? In the article providing the “scalability trilemma” above, Vitalik Buterin argues that a process called “sharding” can provide the answer. He writes: “Sharding is the future of Ethereum’s scalability and will be the key to helping the ecosystem support many thousands of transactions per second and enable large portions of the world to regularly use the platform at an affordable cost.” The general idea is that the blockchain verification process would be randomly split into many smaller chunks (“fragments”), so that the transaction blockchain is actually verified by a “committee”.

The technical side of how “sharding” would reduce the resource requirements for updating and verifying the blockchain in a way that is equally secure but much cheaper is a little beyond my reach, at least without more effort than that. that I’m willing to spend on an idea right now. I’ve also heard other tips for drastically reducing blockchain upgrade costs. Of course, the real test of the idea will be when or if it happens.

The BIS suggests the possibility that, rather than struggling to resolve the trilemma, financial innovation may be better served by building on central bank credibility. They suggest a metaphor that looks like this:

Central banks are the foundation. They continue to be hooked on the banking system and credit card companies. The central bank could also provide a central bank digital currency (CBDC). But in this description, central banks also link to “payment service providers,” which are non-bank corporations that provide decentralized finance, tokenized assets and deposits, e-money, self-executing smart contracts, self-contained wallets, and more.

The BIS goes into detail on all of this, delving into issues of regulation, accountability, practicality, financial stability, consumer protection, and the like. As I see it, the basic idea is that it is useful to think separately about cryptocurrencies and all the other financial innovations that are currently linked to cryptocurrencies. Instead, it might be better for society if central banks allowed the financial innovations of the future to be built on the proven ability of central banks to provide widely accepted and relatively valuable currencies.