Decentralisation in digital finance: possibilities and limits

Speech by Mr Hyun Song Shin, Economic Adviser and Head of Research of the BIS, London Business School, 17 November 2021.

Blockchain technology has breathed new life into the idea of money as a substitute for a universal ledger that keeps score of who owes what to whom. "Money is memory" is the motto. The rapid development of DeFi, or decentralised finance, is the latest manifestation of an old idea, now resurgent. The idea of everyone lugging around a huge ledger of past transactions was a fanciful notion. It was used merely to drive home the point that the convention of money is useful precisely because there is no need for such a ledger. The irony is that the tables have turned. Cryptography and digital technology have made the ledger possible through blockchain technology. Bitcoin and Ethereum are the two best-known instances, among many. However, there are limits to deploying the blockchain to operate at scale. Buterin's "scalability trilemma" states the inherent tension between maintaining a secure decentralised consensus and operating the system at scale.

This presentation draws on the findings of Raphael Auer, Cyril Monnet and Hyun Song Shin. In our BIS Working Paper, we show how intractable the scalability trilemma is. Even if the technical capacity could be raised, the economic incentives needed to maintain the blockchain as a self-sustaining arrangement through a robust equilibrium in a game mean that the validators – the insiders – would need to be rewarded sufficiently. They would end up collecting large rents, largely dissipating the underlying economic value.

In this way, the limits to the decentralisation agenda emerge from the laws of economics rather than the laws of physics. In stark contrast to the stated ideal of democratising finance and levelling the playing field, the decentralised blockchain tends to entrench the position of insiders. While the flow of new users can feed the rents in the blockchain's growth phase, its ultimate viability when the flow of new entrants dries up and rents are squeezed is uncertain and tenuous.