Structural limitations of crypto
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
In addition to the immediate concerns around stability, crypto suffers from the inherent
limitations of permissionless blockchains, which lead inevitably to the system's fragmentation,
accompanied by congestion and high fees.11 Tracing the reasons for fragmentation is revealing,
as these highlight that the limitations are not technological but rather stem from the system's
incentive structure.
Self-interested validators are responsible for recording transactions on the blockchain.
However, in the pseudo-anonymous crypto system, they have no reputation at stake and cannot
be held accountable under the law. Instead, they must be incentivised through monetary rewards
that are high enough to sustain the system of decentralised consensus. Honest validation must
yield higher returns than the potential gains from cheating. Should rewards fall too low,
individual validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is to limit the
capacity of the blockchain, thus keeping fees high, sustained by congestion. As validators can
choose which transactions are validated and processed, periods of congestion see users offering
higher fees to have their transactions processed faster (Graph 2 A).12
The limited scale of blockchains is a manifestation of the so-called scalability trilemma. By
their nature, permissionless blockchains can achieve only two of three properties, namely
scalability, security or decentralisation (Graph 3). Security is enhanced through incentives and
decentralisation, but sustaining incentives via fees entails congestion, which limits scalability.
Thus, there is a mutual incompatibility between these three key attributes, preventing
blockchains from adequately serving the public interest.
The limited scalability of blockchains has fragmented the crypto universe, as newer
blockchains that cut corners on security have entered the fray. The Terra blockchain is just the
most prominent of a horde of new entrants (Graph*2.B). Even as recently as the beginning of
2021, Ethereum accounted for almost all of the total assets locked. By early May 2022, this share
had already dropped to 50%. The widening wedge (in red) accounted for by the failed Terra
blockchain is particularly striking. Terra's collapse highlights the tendency of the crypto universe
to fragment through its vulnerability to new entrants that prioritise market share and capacity at
the expense of decentralisation and security.
A system of competing blockchains that are not interoperable but sustained by speculation
introduces new risks of hacking and theft. Interoperability refers here to the ability of protocols
and validators to access and share information, as well as validate transactions, across different
blockchains. Interoperability of the underlying settlement layers is not achievable in practice, as
each blockchain is a separate record of settlements. Nevertheless, "cross-chain bridges" have
emerged to permit users to transfer coins across blockchains.13 Yet most bridges rely on only a
small number of validators, whom – in the absence of regulation and legal accountability – users
need to trust to not engage in illicit behaviour. But, as the number of bridges has risen (Graph
4.A), bridges have featured prominently in several high-profile hacks (Graph 4.B). These attacks
highlight the vulnerabilities to security breaches that stem from weakness in governance.
The striking fragmentation of the crypto universe stands in stark contrast to the network
effects that take root in traditional payment networks. Traditional payment networks are
characterised by a "winner takes all" property, whereby more users flocking to a particular
platform beget even more users. Such network effects stand at the heart of the virtuous circle of
lower costs and enhanced trust in traditional platforms. In contrast, crypto's tendency toward
fragmentation and high fees is a fundamental structural flaw that disqualifies it as the foundation
for the future monetary system.14
Despite fragmentation, speculation can induce high price correlations across different
cryptocurrencies and blockchains. Attracted by high returns and the expectation of further price
increases (Box B), the influx of new users can push up prices even more. As many
cryptocurrencies share a similar user base and are tied to similar protocols, there is strong price
co-movement. There are important concerns about what happens to a system that relies on
selling new coins when the new inflow of users suddenly slows.
The DeFi decentralisation illusion and the role of exchanges
Despite its name, the DeFi ecosystem shows a tendency towards centralisation. Many key
decisions are taken by vote among the holders of "governance tokens", which are often issued to
developer teams and early investors and are thus heavily concentrated. Smart contracts tied to
real-world events involve oracles that operate outside the blockchain. "Algorithm
incompleteness", ie the impossibility of writing contracts to spell out what actions to take in all
contingencies, requires some central entities to resolve disputes. Moreover, newer blockchains
usually aim for faster transactions and higher throughput by relying on concentrated validation
mechanisms. For example, proof-of-stake mechanisms build on a limited number of validators
who stake their coins.
Centralisation in DeFi is not without risks. Increasing centralisation of validators gives rise
to incentive conflicts and the risk of hacks, also because these centralised nodes are often
unregulated.15 Further, those in charge of an oracle can corrupt the system by misreporting data
(the so-called oracle problem). Currently, there are no clear rules on how to vet or incentivise
oracle providers.
Centralisation is also present in crypto trading activities, where investors rely mainly on
centralised exchanges (CEXs) rather than decentralised ones (DEXs). While the latter work by
matching the counterparties in a transaction through so-called automated market-maker
protocols, CEXs maintain off-chain records of outstanding orders posted by traders – known as
limit order books – which are familiar from traditional finance. CEXs attract more trading
activity than DEXs, as they feature lower costs (Graph 5.A).16 In terms of business model and the
way they operate, crypto CEXs are not fundamentally different from traditional exchanges, even
though they are not subject to the same regulation and supervision.
CEXs have seen substantial growth since 2020 and have reached volumes that make them
relevant from a financial stability viewpoint (Graph 5.B). Moreover, trading in CEXs shows a
strong tendency towards market concentration: trading volumes in three large CEXs represented
around half of the total in the first months of 2022. However, it is generally difficult to gauge the
actual size of crypto exchanges, because CEXs hold a significant share of their custodial
cryptocurrencies off-balance sheet. For example, the platform Coinbase reported publicly that it
had $256 billion of assets on platform (as of end-March 2022) but a balance sheet of only $21
billion as of end-2021. Securities and Exchange Commission staff recently argued that the
platform should report both liabilities (obligations to customers) and assets on its balance sheet.17
In addition, crypto service providers often perform a multitude of services, raising the question
whether activities are appropriately ring-fenced and risks adequately managed. For example,
together with third-party trading, they undertake proprietary trading, margin lending or token
issuance, and supply custody services. Often, transactions involve interactions between on-chain
smart contracts and off-chain centralised trading platforms, with the distributed nature of on-
chain settlement giving rise to distinct risks as compared with those arising from traditional
infrastructure operators.
A balanced assessment of the similarities and differences between the crypto market and
traditional finance is a prerequisite for considering appropriate regulatory policies. Some
activities of crypto service providers are common features in banks too, although their
combination in one entity is not currently common in traditional finance. Moreover, differences
in underlying technologies mean that risk features and drivers could differ between traditional
finance and the crypto ecosystem.
