Bank for International Settlements Says Cryptocurrencies Have One Huge Disadvantage to Traditional Finance

The Bank for International Settlements (BIS) says that crypto assets may have one massive downside compared to the traditional financial system.

In a new bulletin from BIS, the institution says that blockchain-based digital assets are subject to fragmentation, which ultimately renders them unable to fulfill the role of money in a society.

A crypto asset’s ecosystem becomes fragmented when users break into distinct groups over time, diminishing the benefits of network effects, the BIS says.

“The fragmentation of the crypto landscape stands in stark contrast to traditional (payment) networks, which benefit from strong network effects. In the traditional system, the more users flock to a particular platform, the more attractive it becomes for new users to join that platform, creating a virtuous circle.

This drives costs down, improves service quality and promotes financial inclusion. The recent launch and rapid adoption of Brazil’s Pix instant payment system illustrates these dynamics. In just over a year since its launch, Pix has seen 114 million users sign up, or 67% of the adult population.”

The BIS says that fragmentation takes place when congested blockchains create high transaction fees, in turn prompting users to seek out alternative chains.

“This bulletin argues that fragmentation arises from inherent limitations of blockchains. To maintain a system of decentralized 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 the associated high fees are needed to incentivize 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.”

The study concludes by saying that virtual assets are unfit to take the social role of being used as money.

“Fragmentation means that crypto cannot fulfill the social role of money. Ultimately, money is a coordination device that facilitates economic exchange. It can only do so if there are network effects: as more users use one type of money, it becomes more attractive for others to use it. Looking to the future, there is more promise in innovations that build on trust in sovereign currencies.”

Featured Image: Shutterstock/delcarmat/Natalia Siiatovskaia