Distributed ledgers and the governance of money

Originally published in January 2021, revised in November 2021.

Summary

Focus

Blockchain technology breathes new life into the classical analysis of "money as memory," ie as a substitute for a ledger of all past transactions, where holding money is a record of goods sold and services rendered. Distributed ledger technology (DLT) is a record-keeping device that has no need of a central authority to support trading. But can it do so more efficiently and robustly than a traditional, centralised exchange? And how can a balance be struck between decentralisation, a robust consensus, and adequate transaction flow, as set out in Buterin's "Blockchain trilemma"?

Contribution

This paper models the incentives that validators need to sustain an honest exchange and asks whether it is optimal to have a central intermediary or a network of validators. DLT differs from conventional centralised marketplaces in that (i) it is easier to achieve good governance in decentralised settings and (ii) the actions of multiple validators need to be coordinated via economic incentives. Validators require rents in order to overcome free-riding. To reach an optimal design, therefore, two factors need to be balanced: (i) the need for greater robustness derived from a more decentralised governance structure, and (ii) the increasing difficulty of coordinating a larger network of validators.

Findings

We find that under specific circumstances, DLT may have economic potential in financial markets and payments due to its enhanced robustness and the potentially lower cost of achieving good governance in a decentralised network of validators, as compared with a central intermediary. However, such improvements do not come for free; ie market design matters, as does calibrating the incentives of the validators. To maintain a robust monetary equilibrium, it is necessary to prevent validators from exploiting their powerful position, which in turn requires high rents and the absence of unanimity. We examine these dynamics and derive the optimal number of validators, their compensation and the optimal voting rule. In this context, we pose Buterin's "scalability trilemma" formally within our monetary economy and show the optimal balance between decentralization, security (i.e. a robust consensus), and scale (ie the efficient volume of transactions).

Abstract

Blockchain technology breathes new life into the classical analysis of money as a substitute for a ledger of all past transactions. On this view, money is a record of goods sold and services rendered. While blockchain technology involves updating the ledger through a decentralised consensus on the unique truth, the robustness of the equilibrium that supports this consensus depends on who has access to the ledger and how it can be updated. To find the optimal solution, Buterin's "scalability trilemma" needs to be addressed, so that a workable balance can be found between decentralisation, security (i.e. a robust consensus), and scale (ie the efficient volume of transactions). Using a global game analysis of an exchange economy with credit, we solve for the optimal ledger design that balances the three objectives of this trilemma. We find that, depending on dynamic incentives, either decentralised or centralised designs can be optimal, with the case for decentralisation being stronger in myopic markets.

JEL Codes: C72, C73, D4, E42, G2, L86

Keywords: market design, money, distributed ledger technology, DLT, blockchain, decentralized finance, global game, consensus.