On Sunday, 17 June 2018, the Bank for International Settlements (BIS), released chapter V of its Annual Economic Report 2018 (the full report is due on 24 June 2018). BIS was established in 1930 and is based in Basel, Switzerland. Its aims are “to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.” In this chapter, which is titled “Cryptocurrencies: looking beyond the hype”, the author, Hyun Song Shin, who is an Economic Advisor and Head of Research, argues that cryptocurrencies’ inherent limitations (described in detail) means that they are poor substitutes for fiat currencies.

Huge Cost of Creating Decentralized Trust

Shin says that most cryptocurrencies use a “Proof-of-Work” (PoW) consensus algorithm, which means that mining them has huge energy and environmental costs:

“At the time of writing, the total electricity use of bitcoin mining equalled that of mid-sized economies such as Switzerland, and other cryptocurrencies also use ample electricity… Put in the simplest terms, the quest for decentralised trust has quickly become an environmental disaster.”

Shin has a good point here, although we do have cryptocurrencies that use more energy-efficient algorithms, such as NEO, which use a “Proof-of-Stake” (PoS) algorithm and EOS, which uses a “Delegated Proof-of-Work” (DPoS) algorithm.

Inability to Scale With Growth in Number of Transactions

Once again, Shin’s criticism applies only to cryptocurrencies based on a PoW model:

“At the most basic level, to live up to their promise of decentralised trust cryptocurrencies require each and every user to download and verify the history of all transactions ever made, including amount paid, payer, payee and other details. With every transaction adding a few hundred bytes, the ledger grows substantially over time. For example, at the time of writing, the Bitcoin blockchain was growing at around 50 GB per year and stood at roughly 170 GB. Thus, to keep the ledger’s size and the time needed to verify all transactions (which increases with block size) manageable, cryptocurrencies have hard limits on the throughput of transactions.”

Even then, is it really necessary for every Bitcoin user to keep his/own copy of the Bitcoin blockchain? What about those users who keep their holdings on centralized exchanges like Coinbase and Binance?

Shin then goes through a thought experiment to show what would happen to the internet if (PoW-based) cryptocurrencies gained widespread adoption:

“A thought experiment illustrates the inadequacy of cryptocurrencies as an everyday means of payment… To process the number of digital retail transactions currently handled by selected national retail payment systems, even under optimistic assumptions, the size of the ledger would swell well beyond the storage capacity of a typical smartphone in a matter of days, beyond that of a typical personal computer in a matter of weeks and beyond that of servers in a matter of months. But the issue goes well beyond storage capacity, and extends to processing capacity: only supercomputers could keep up with verification of the incoming transactions. The associated communication volumes could bring the internet to a halt, as millions of users exchanged files on the order of magnitude of a terabyte.”

Low Transaction Throughput

It is true that currently Bitcoin would not be suitable as a means of payment if mass option took place since its transaction processing capacity maximum is estimated to be between 3.3 and 7 transactions per second. Shin says that network congestion will mean very long transaction times and very high transaction fees, hence limiting the usefulness of cryptocurrencies that have the same scalability issues as Bitcoin for everyday transactions such as a paying for a coffee.

However, there are many people working on solving Bitcoin’s scalability problem. For example, one proposal is the Lighning Network, a “second layer” payment protocol operating on top of the Bitcoin blockchain, that is very fast, very scalable, and very low cost.   

Also, many of the newer cryptocurencies, already offer much higher transaction throughputs and much much lower transaction costs; for example, TRON, which launched its mainnet earlier this month, already can handle around 2,000 transactions per second, and claims to be able to increase this number in the near future to 10,000 transactions per second.

Price Volatility

Shin says that the potentially wild price volatility of cryptocurrencies “arises from the absence of a central issuer with a mandate to guarantee the currency’s stability.” It is true that lack of price stability can make a cryptocurreny less useful as a means of payment. However, there are projects in the crypto space, such as Circle's dollar-pegged coin (USDC) and Basis (which is a stablecoin with an algorithmic central bank), which are aware of this issue and are addressing it.

Fragile Foundation of Trust

Shin says that here is talking about “uncertainty about the finality of individual payments, as well as trust in the value of individual cryptocurrencies.” With mainstream payment systems, he says that once an individual payment reaches the central bank’s books, it can’t be revoked, whereas permissionless cryptocurrencies cannot make such guarantees. This is how Shin explains one of the reasons for this:

“Although users can verify that a specific transaction is included in a ledger, unbeknownst to them there can be rival versions of the ledger. This can result in transaction rollbacks, for example when two miners update the ledger almost simultaneously. Since only one of the two updates can ultimately survive, the finality of payments made in each ledger version is probabilistic.”

Featured Image Credit: Photo by “David McBee” via Pexels