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Crypto cannot fulfil ‘social role of money’ due to fragmentation: BIS

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Blockchains have “internal limitations” that lead to fragmentation, meaning that cryptocurrencies are not suitable as a means of payment, economists at the Bank for International Settlements (BIS) said in a June 7 report. report.

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As the crypto landscape began to grow rapidly, the decentralized finance (Defi) ecosystem began to fragment, the report claims.

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Until January 2021, Ethereum was the dominant Tier 1 blockchain, controlling over 90% of the total value locked (TVL) in Defi. Defillama data shows. As new Tier 1 blockchains emerged, mainly Binance Smart Chain, Avalanche, and Terra, before their fall, Ethereum’s share of Defi TVL dropped to around 54% by April 2022.

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The report argues that this market fragmentation is due to inherent flawed designs in blockchain systems. It is stated here:

“It is the inherent features of blockchains — most notably the need to incentivize decentralized nodes to validate transactions — that are driving the fragmentation of the crypto landscape.”

The consensus mechanism of decentralized blockchains requires validators to record transactions. These validators must be rewarded with block rewards and transaction fees.

For the blockchain to maintain its integrity, transaction fees must be high enough to incentivize validators. If transaction fees become too low, validators may be incentivized to cheat, compromising the security of the network.

Therefore, to ensure that all validators receive enough rewards, the number of transactions per block is limited. Thus, the transaction fee depends on the demand for transactions. This means that during periods of high congestion, transaction fees rise exponentially, making them extremely expensive.

Ethereum gas price fluctuations have long been a concern for investors. Even though Ethereum gas fees are currently hovering at their lowest, the high fluctuations have set the stage for contenders known as “Ethereum killers.” In fact, every instance of congestion in Ethereum led to the growth of other layer-one blockchains, the report says.

The emergence of several new blockchains has led to a fragmentation of the landscape. The report stated:

“…users are switching to other blockchains to complete transactions that have become prohibitively expensive on Ethereum. However, newer blockchains often aim for higher transaction limits, even if this comes at the cost of greater centralization and weaker security.”

The report states that the fragmentation problem is exacerbated by a lack of interoperability. While a number of internet bridges have sprung up, the recent spate of breaches and thefts of bridges has exposed problems with their security.

In addition, layer 2 solutions address scalability issues “but at the cost of not decentralizing, creating risks similar to those of bridges,” the report says.

The report states that Crypto’s fragmentation is “in stark contrast to traditional (payment) networks, which benefit from strong network effects.” He added:

“In a 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.”

The same is true for money, which also exhibits positive network externalities—the more people use a certain currency, the more people trust it.

But blockchains have negative network externalities. As the number of users on the blockchain grows, congestion and transaction fees increase. This encourages users to look for cheaper alternatives. Therefore, cryptocurrencies cannot become effective payment mechanisms, the report states.

The report concluded:

“Fragmentation means that cryptocurrency cannot fulfill the social role of money. Ultimately, money is the coordinating vehicle that facilitates economic exchange. This is only possible if there are network effects: the more users use one type of money, the more attractive its use for others.

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