Cryptotrilemma – Conversable Economist

The Bank for International Settlements is owned by 63 central banks around the world from countries that account for about 95% of global GDP.. Thus, whene BIS takes a chapter in its latest annual report To argue that decentralized cryptocurrencies operating separately from central banks is a dead end, one possible answer is to point out that central banks are protecting their territory. What is true. But that doesn’t mean the argument is wrong. The BIS argues that many recent innovations in the financial sector, 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 into two parts: the fundamental problem with cryptocurrencies and an alternative vision of the future monetary system.

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

For example, conventional central bank money (bottom line of the figure) is secure and scalable. But it is clearly not decentralized. Cryptocurrencies like Bitcoin and Ethereum are decentralized and secure. But every day, about 2 billion digital payments are made in the world. the process of updating the blockchains used to track such cryptocurrency exchanges requires significant resources. and, compared to methods such as modern credit card transactions, incredibly slow to process this volume of transactions. In other words, these secure and decentralized cryptocurrencies have yet to be proven to be scalable. Thus, the expansion of the scale of cryptocurrencies is partly due to the emergence of new ones, which are decentralized, but then often turn out to be less secure. BUT A recent example is the collapse of the stablecoin Terra. a cryptocurrency that was supposed to have a fixed value in US dollars, but ended up worthless and wiped out about $60 billion. In April Wall Street Journal published an article titled “Cryptocurrency thieves get bolder by committing robberies, stealing record amounts.” They note that there have been 37 major hacks in crypto/blockchain organizations in the last 38 weeks.

The BIS report says:

The limited scale of blockchains is a manifestation of the so-called scalability.
trilemma. By their nature, public blockchains can only achieve two of the three goals.
properties, namely scalability, security or decentralization (Chart 3). Safety
enhanced by incentives and decentralization, but supports incentives through fees
entails congestion, which limits scalability. Thus, there is a mutual incompatibility
between these three key attributes, which prevents blockchains from adequately serving
public interest.

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

The technical side of how “sharding” will reduce the resource requirement to update and validate the blockchain in a way that is equally secure but much cheaper is a bit beyond my understanding – at least not without more effort than I’m willing to spend. on an idea just now. I have heard other proposals to drastically reduce the cost of updating the blockchain. Of course, the real proof of the idea will be when or if it happens.

The BIS suggests the possibility that, instead of fighting the solution of the trilemma, financial innovation could be better served by relying on central bank credibility. They offer a metaphor that goes like this:

Central banks are the backbone. They are still linked to the banking system and credit card companies. The central bank can also provide central bank digital currency (CBDC). But in this description, central banks also become associated with “payment service providers,” which are non-banking firms that provide decentralized finance, tokenized assets and deposits, electronic money, self-executing smart contracts, offline wallets, and more.

BIS goes into detail on all of this, delving into issues of regulation, accountability, practicality, financial stability, consumer protection, and more. In my opinion, the main idea is that it is useful to think separately about cryptocurrencies and all other financial innovations that are currently associated with cryptocurrencies. Instead, society might be better off if central banks allowed the financial innovations of the future to be built on the proven ability of central banks to provide currencies that are widely accepted and of relatively high value.