Bank of International Settlements’ Report on Cryptocurrencies: Critical Analysis
The Bank of International Settlements (BIS) act as a global clearinghouse for central banks. They do what all central banks do, which is to provide monetary and financial stability, as well as trust for settlement finality between the entities which they serve. Through their provision of financial stability, they conduct research on matters which may impact this stability and frequently publish their results.
The BIS dedicated an entire chapter of their annual economic report to cryptocurrencies. They released the 24 page document a week earlier than the rest of the report, naming it V. Cryptocurrencies: looking beyond the hype. The chapter starts off with the history of money and evolves to describing the role of central banks in today’s economy. It emphasizes the importance of trust in settlements of transactions and builds at least 6 arguments as to why decentralized trust is an impossible concept.
The entire report rests heavily on the assumption that all cryptocurrencies make use of a Proof of Work (PoW) consensus algorithm. This assumption may be valid for now, since it is still debatable whether other consensus mechanisms may be able to scale towards global adoption. But, it is a short-sighted approach from the BIS to ignore scalability solutions such as Proof of Stake (PoS), Sharding, second layer blockchains, etc.
The 6 arguments from the BIS are summarized below, followed by a technical response to each:
1. The BIS argues: Private money never worked
The report starts with several examples of failed attempts of private money, like commodities, stones, shells, Tabaco etc. Their lack of success in acting as money is attributed to the dissipation of trust since no central authority would guarantee the value of the objects. These failed attempts at decentralized money gave rise to central banks, which would constitute money and provide an ultimate source of trust for the value of their issuance.
Modern monetary systems comprise of a two-tiered trust system, in which central bank reserves are used as means of payment settlements between commercial banks. The transacting parties trust that the first layer in this process, namely the commercial banks, would update their ledgers according to the values transacted. The banks trust that the central bank does the same for interbank settlements. The trust in these reserves is generated through regulation, supervision and deposit insurance schemes, which ultimately depends on a sound constitution upheld by the state government. This trust also encompasses payment systems and confidence that once a payment is made, it will not be reversed or double spent.
Response: Cryptocurrencies fix fundamental errors in historic forms of “private money”
The lack of fungibility, durability and portability of historically failed money are ignored by the BIS. It is compared to cryptocurrencies without appreciating the improvement that digital currencies provide. Cryptocurrencies are fundamentally borderless, which means that apart from absolute durability and near absolute fungibility, it also brought an immense improvement in portability compared to conventional digital currencies which are bound by geographical borders. Similar to sending an email, a Bitcoin transaction does not differentiate between a payment to yourself, your neighbour or a foreign country. All payments reflect within a second and settle within an hour at negligible cost.
Another important difference between commoditized money and cryptocurrencies is the process of modification to the system. Once issued, it is virtually impossible to do any further development to the monetary system of commodities. Cryptocurrencies on the other hand, provide a foundation for permissionless innovation. Improvements to the technology are implemented every day, typically through a structured reviewing process which involves any willing participator in the world. The Bitcoin protocol has been upgraded multiple times during the last 9 years and responses to all of the negative arguments by the BIS can be countered from only the improvement proposals that are already implemented on Testnet (an alternative to the Bitcoin blockchain, used for testing improvement proposals).
2. The BIS argues: The internet cannot handle a blockchain scaled to global transaction demands.
The Bitcoin protocol can only process about 10 transactions per second. Contrasting to this, VISA and MasterCard processes around 6000 transactions per second. The Bitcoin blockchain grows by 50GB per year and transaction throughput has hard limits. The BIS states that all nodes and users store a copy of the full blockchain and updates it for every transaction that occurs. For the Bitcoin blockchain to thus scale to typical digital transaction volumes of today, it would swell beyond the storage capacity of typical smartphones in a matter of days and beyond that of typical servers in a matter of months. The exchange of ledger updates between nodes will bring the internet to a halt. Apart from that, transactions are frequently delayed due to the 10min block time of Bitcoin. Should more than 1Mb of transaction occur within this timeframe, it results in congestion and payment delays. This makes the currency useless for day-to-day transacting.
Response: There is some merit to this argument, but SPV nodes are ignored
First, the statement that all users and nodes need to store the entire ledger is wrong. The original Bitcoin white paper describes a framework for lightweight clients to also utilise the blockchain. These nodes are called Simple Payment Verification (SPV) nodes and query full nodes when transactions are made, which allows mobile devices, such as smartphones, to host Bitcoin applications. It is already widely adopted on millions of devices and SPV storage requirements scale linearly with the height of the block chain at only 80 bytes per block header, or up to 4.2MB per year, regardless of total block size.
There is some degree of merit to the argument that the current internet infrastructure might not be able to handle the amount of transactions required to reach global demand. A typical digital transaction today requires at most about 10 operations of data-exchange between clients and servers. As an example of this, when a conventional digital payment commences then a request of payment needs to be made by the initiator to the bank. The bank will then communicate confirmation back to the initiator and payment recipient. A series of payment confirmations will then follow between all parties.
A single Bitcoin transaction on the other hand requires thousands of data-exchange operations, as it floods a ledger update to hundreds of thousands of nodes. The nodes are also in constant communication with each other to try and establish if their version of the blockchain is still correct. Running a full node today requires about 40GB of uploading and 20GB of downloading data per month.
Apart from several technical improvements such as Sharding and second layer scaling technologies which promises to fix this problem, the argument lies in the way that technology develops. The amount of internet communication in Bitcoin is linear to the amount of transactions, which in turn is a linear function of global Gross Domestic Product (GDP). We know that GPD also follows a linear growth path, while technological advancement follows Moore’s law of exponential growth. This means that although the internet infrastructure might not be able to handle millions of on-chain transactions per second today, it will probably be able to do so in the near future. It was impossible to imagine high definition video streaming a mere 10 years ago.
The author however agrees that Bitcoin will primarily be used as a store of value and not as a medium of exchange until this matter is resolved.
3. The BIS argues: Decentralised trust is an environmental disaster
The BIS explains that the ability of a cryptocurrency, like Bitcoin, to act securely as a trusted system rests on three important aspects. First, it must be costly for transaction validators to add transaction data to the ledger. This is achieved through PoW, and should a miner include an invalid transaction, it would lose out on the block reward as well as the resources it spent to participate in the validation process. Second, all of the miners and users verify that a block is valid before adding it to the blockchain. All nodes act as validators to other nodes. Third, the protocol specifies rules to achieve a consensus on the order of updates to the ledger. These rules are important to resolve cases where two valid blocks are simultaneously communicated by different miners.
Following these three aspects, the BIS then asks if this cumbersome way of trying to achieve trust come at the expense of efficiency. And whether trust can truly and always be achieved.
The BIS answers these questions by comparing the electricity use of Bitcoin to that of Switzerland and labelling the network as an environmental disaster, stating that the electricity consumption would swell to enormous amounts should the network scale to global payment requirements. It does not include specific power consumption figures.
Response: Electricity requirement is NOT linear to transactional demand
By comparing the electricity demand of Bitcoin to that of Switzerland, the BIS makes the conclusion that Bitcoin will result in an environmental disaster if the world would need to replace today’s financial services industry with Bitcoin.
First, it must be stressed that Bitcoin mining does not require more electricity to validate more transactions. The mathematical problems that mining equipment needs to solve (this is what consumes electricity) is entirely independent on the amount of transactions that are included in a block. The only function of these mathematical operations is to provide immutability, which can be translated to security of the blockchain. There are many sources, including the BIS, which form conclusions on this incorrect assumption that electricity usage is linear to the amount of transactions.
In other words, since the electricity requirement is only dependant on security and nothing else, the question that needs to be asked is “Is the current power demand of Bitcoin enough to provide a secure platform for global financial services”. The author answered this question in another article (https://medium.com/@careldj/a-review-of-the-power-requirements-for-a-bitcoin-majority-attack-c314c67eecb3).
The permissionless nature of the Bitcoin protocol means that anyone in the world can host a node, run a miner, develop its code, use the currency or build applications. This level of openness and decentralisation cannot be achieved without a rigid set of rules and cumbersome processes. The protocol for examples requires that every node validate every piece of information it receives from another node. The fact that mining is expensive is a vital function which keeps dishonest validators from including fraudulent transactions.
Labelling Bitcoin as an environmental disaster is at most a trivial opinion without comparison to the energy usage of the systems Bitcoin may replace. Today’s financial services consist of mega-buildings, expensive infrastructure, obsolete paper-based procedures and millions of humans. Every financial operation that takes place today accounts for some form of energy, whether as a capital expenditure or operational use. This is not an easy number to quantify, but one would expect any noteworthy critique of Bitcoin’s energy usage to at least mention a comparable industry’s demands.
4. The BIS argues: Cryptocurrencies cannot achieve the levels of trust required for a monetary system
One of the biggest issues with cryptocurrencies is the fragile foundation of trust and uncertainty, specifically with regards to the finality of payments. In today’s systems, a payment is final once a central bank confirms it to be settled. Cryptocurrency payments are never final, since the work can always be re-done to reverse a transaction. One can never be sure of payment settlement since a concentration of miners is able to hide a fraudulent version of the ledger until they are sure of success.
Another issue with payment finality is the ability of a chain to fork. The report references a Bitcoin soft fork on 11 March 2013, classifying it as a proof of a fatal error in the protocol since it shows that transactions can be undone through a centralised coordination of the miners.
Response: Trust is achieved with secure code
The finality of payments in today’s financial systems is as reversible as, or more than that of Bitcoin. A quick Google search returns many court judges in favour of transaction reversals to those on the receiving end of an incorrect payment. All commercial banks also have debit order reversal processes, usually with the click of a button if done within 40 days.
The Bitcoin protocol is written in such a way as to make it exponentially more difficult to reverse a transaction as time goes on. This is because a transaction reversal requires a fork in the blockchain which essentially mean that more than half of the mining resources would need to support the reversal. Since the miners are incentivised by the price of the currency and thus accuracy of the ledger, it is in their interest to prevent such an occurrence. A general rule of thumb is to wait for 6 confirmations or 1 hour after a transaction was included in the ledger for complete finality. This is comparable to settlement periods of current financial services.
The fork referenced by the BIS in 2013 happened as a coordinated event between the miners to reverse a critical bug in the Bitcoin core software code. No transactions were reversed and those affected were merely delayed by about 3 hours. In contrast to this event being labelled a fatal error in the protocol, one can argue that the ability of a decentralised network to act against software bugs is in fact a sign of robustness.
The theoretical absence of absolute finality of transactions is also not a core function of any blockchain or consensus mechanism. Such a characteristic can be introduced with a simple modification in the core software to provide explicit finality after a certain time period. It is planned to be implemented in the Ethereum blockchain with the much anticipated Sharding protocol at the end of the year.
5. The BIS argues: The fact that there are so many cryptocurrencies is a sign of failure
The amount of cryptocurrencies cannot be limited. Anyone can create a coin and we see that with the rise in the number of new currencies. There are currently more than 4000 cryptocurrencies and this number is still increasing rapidly.
Response: Money needs only 2 parties to succeed
A fundamental attribute of money is the need for agreement on value between transacting parties and subsequent acceptance by the recipient of that value. The BIS themselves stated that objects with no intrinsic value create the best money.
The 4000+ cryptocurrencies have usages that range from mediums of exchange, utility tokens and community bound forms of value. A typical example of value contained within a community would be a cryptocurrency created by a family, rewarding members of that family for chores done around the house or other general achievements. Such a family token might develop a market driven value or be fixed to another asset such as the USD. It will be worthless to anyone outside of that family, and to assume that such a token will dilute the value of other currencies like Bitcoin is absurd.
Thus, stating the ease of new cryptocurrency creation as a failure has no basis. If such an argument would have any substance then all reward systems, online gaming points, cellular airtime etc. would have been an issue.
6. The BIS argues: Cryptocurrencies are too unstable to be used as a medium of exchange
Another issue with cryptocurrencies is their unstable value, which results from the absence of a central issuer with a mandate to guarantee the currency’s stability. A central bank can expand/contract its balance sheet to control the supply of a domestic currency according to trading frequency in order to provide stability. Most central banks have a mandate to trade against the market at certain times, even if this means taking risk onto its balance sheet and absorbing a loss and in return stabilize the value of a currency. In contrast, a cryptocurrency supply is fixed by its protocol and any fluctuation in demand results in a direct fluctuation of price.
Response: Volatility results from a lack of liquidity
Volatility in any currency is driven by rapid changes in the supply and demand and often results from a lack of market liquidity. This is no different to Bitcoin, but what distinguishes Bitcoin from any conventional asset class in this sense is that demand cannot be influenced by centralised governance. It is well known that conventional asset price fluctuation can in many cases be traced back to human decision making. Bitcoin, on the other hand, eliminates this risk through its open decentralised protocol which is backed by mathematics.
Another important distinction between conventional assets and Bitcoin is that there is no geographical resistance in cryptocurrencies which might hamper liquidity. Bitcoin is open to a truly global investor base and does not distinguish between social classes. Should the currency be available to such a massive market, it will allow it to eventually settle on a fair market value with enough liquidity to prevent sudden changes in the price.
As expected, the volatility in bitcoin’s price has proved to decrease as adoption and liquidity grows. This is illustrated in the chart below:
Decentralised stablecoins, which are cryptocurrencies whose value is fixed to an asset, proved that they can provide a safe alternative to FIAT during market turmoil. These coins already show promising capabilities which allows users and investors to stay within the cryptocurrency realm when prices fluctuate. Although the BIS report briefly criticizes the ability of asset backed cryptocurrencies to maintain a stable value, one would have expected more elaboration on its existence from the bank.
The report concludes on a positive note, stating that although cryptocurrencies cannot work as money, the underlying technology may have promise in other fields. The BIS is optimistic about using DLT as payment solutions in low-value cross border transactions and remittances. Although all of these applications will be deployed on private permissioned systems, the Bank is concerned about the regulatory challenges posed by the technology and calls for strengthened or new policies from authorities.
To conclude, the criticism from the BIS is exactly what one would expect from an institution trying to justify its existence when it is clear that technology is replacing all of its functions. Even the World Bank admitted that cryptocurrencies will replace some of the functions associated with central banking. But the BIS report is littered with technical falsehoods which scream prejudice throughout. It is of such low quality that even completely unbiased opinions labelled it as “shallow” and “poor research”. Many credible mainstream media outlets however designated the fake news as accurate and published it under headlines such as “Bitcoin is useless, unsafe, and dirty: this new report is withering in its verdict”, and “‘Environmental disaster’: BIS warns on cryptocurrencies”.
About the Author
Carel de Jager is currently employed in two diverse positions. He is a chemical engineer on a fossil fuel power generation plant in South-Africa, and he works as a consultant and public speaker to the Blockchain Academy Pty Ltd.
The Blockchain Academy delivers worldwide training on blockchain technology to individuals, corporations and financial institutions. LinkedIn profile: https://www.linkedin.com/in/careldejager/. Twitter Handle: @BlockchainJag