The Bank for International Settlements (BIS) dedicated a full chapter to cryptocurrencies in its 2018 Annual Economic report prerelease. The report concluded that design flaws and cumbersome cost of establishing decentralized trust make cryptocurrencies fail as a viable money substitute. However, it deems the technology underlying digital money as promising in specific applications, such as remittances and cross-border payments.

The BIS, commonly known as “the Bank for central banks,” issued a 24-page report on cryptocurrencies last week. The report emphasized on the economic problems that cryptocurrencies are intended to address and whether they would play a future role as a viable money substitute.

Basic Definitions

The BIS started by describing cryptocurrencies as an aspiring new form of money that promises to replace trust in institutions such as central banks with trust in a decentralized system underpinned by blockchain and related DLT (Distributed Ledger Technology).

Cryptocurrencies are divided into three elements: 1) a digital code or protocol that sets the rules for how participants should transact, 2) a ledger as a medium to record transaction history and 3) a decentralized network of participants that store, update and grant access to the transaction history.

The Basel-based financial institution pinpoints what distinguishes cryptocurrencies from other forms of digital money (i.e., bank deposits or banknotes) as its peer-to-peer settlement setting that cuts the need for central authorities to perform and oversee the exchange of value.

The document recalled the emergence of digital currencies as an efficient solution to the “double spending problem.” In fact, safeguarding other types of digital money transactions has always been performed by a centralized agent. Cryptocurrencies’ approach to the issue is, however, fundamentally different. It is performed through decentralized record keeping by means of a distributed ledger. The term “distributed ledger” was defined as the storing by each network user of up-to-date copies of transactions full record history since the time of distribution of the currency. The document distinguished between two classes of distributed ledgers based on how updates are performed, namely permissioned and permissionless.

In permissioned DLTs, the document explained that only trusted network nodes, chosen and overseen by a central authority, can update the ledger.

However, permissionless DLTs, like Bitcoin’s underlying technology, proposes a more radical approach as to reliance on any central authority as an ultimate source of trust. In fact, Bitcoin’s blockchain requires a consensus by all the network participants to update the ledger, as underlined by the report. Two groups of participants are distinguished, namely miners, or “bookkeepers,” who allocate computing power to verify transactions, and users, who actually transact the cryptocurrency.

Economic Limitations of Permissionless Cryptocurrencies

The research deemed the promise held by Bitcoin and other cryptocurrencies to establish a new model of trust and a convenient digital-based method of payment as hinging on a set of assumptions.

Those assumptions are identified as the fact that honest miners would control the majority of the network, that users would be incentivized enough to be able to verify all recorded transactions at any time and that the total supply of the currency is fixed by a digital code.

The BIS said that two basic questions arise from the assumptions when it comes to the usefulness of a digital asset. It breaks down to the extent to which this novel model of trust affects efficiency and to whether it can be achieved under all circumstances.

The document named the key limitation regarding efficiency as the cost to generate decentralized trust. In fact, Bitcoin miners alone reportedly consume as much electricity as Switzerland as of June 2018. The report concluded that promoting decentralized trust has turned into an “environmental disaster.”

Three other economic problems were also reported. The report says that cryptocurrencies “do not scale like sovereign money,” given that downloading and verifying the whole transaction history on a blockchain is an extremely challenging task for individuals. Today’s Bitcoin blockchain size is a little over 170 GB and is increasingly growing at an average of 50GB per year pace. Beyond storage issues, the document claims that data communication volumes associated with transaction processing “could bring internet to a halt” should huge numbers of users start exchanging hefty terabyte-sized files.

Network congestion caused by limited block sizes and prespecified intervals to add new blocks was another aspect of the scalability issues that the document identified.

The document reads:

“This limits cryptocurrencies’ usefulness for day-to-day transactions such as paying for a coffee or a conference fee, not to mention for wholesale payments.”

The second key issue was the cryptocurrencies’ volatility. The report explained that while central banks can successfully stabilize their sovereign money’s value by adjusting supply and demand, cryptocurrencies require that the total supply of the currency would be predetermined by the protocol to bring confidence in its value. This translates to the fact that any change in demand would drastically affect such currencies.

The third issue enumerated by the document is related to the uncertainty of finality related to cryptocurrency transactions. Technically, miners controlling substantial amounts of computing power can manipulate transactions and tamper with the ledger.

The fragility of decentralized trust is also exacerbated by forking, which can practically occur at any time.

The document concludes that cryptocurrencies display a broad range of shortcomings. It claims that creating decentralized trust comes at the expense of efficiency. This efficiency expense includes huge power consumption, inefficient decentralized storage, and the vulnerability of decentralized consensus.

However, the underlying technology behind such cryptocurrencies “may hold promises” in other fields, as commented by the BIS. Use cases like cross-border payments, where DLT can be quite efficient since the benefits of decentralized access outweigh the high operational cost of traditional centralized solutions, was highlighted.

Another promise for small-value cross-border transactions for countries with an important abroad living workforce was exhibited. Cryptocurrencies can reportedly cut the high cost and processing time entailed by numerous intermediaries and manual work involved.