Blockchain Scalability and the Fragmentation of Crypto

The crypto universe saw explosive growth in the last two years. From January 2020 to November 2021, the value of cryptocurrencies rose more than tenfold, peaking at $2.8 trn, before crashing to $1.2 trn in June 2022. Assets locked in the decentralised finance (DeFi) space rose 180 times, to $109 bn. As the system grew, it started to fragment. Initially, most DeFi protocols ran on the Ethereum blockchain, which has relatively high fees. Yet since early 2021 newer rival networks, touted as “Ethereum killers”, have gained market share (Graph 1, left-hand panel). In particular, Binance, Avalanche and – until recently – Terra rapidly increased their footprints. In early May 2022, the total value of cryptocurrencies associated with protocols on Ethereum made up just half of the overall assets locked into DeFi.

The fragmentation of the crypto landscape stands in stark contrast to traditional (payment) networks, which benefit from strong network effects. In the traditional system, the more users flock to a particular platform, the more attractive it becomes for new users to join that platform, creating a virtuous circle. This drives costs down, improves service quality and promotes financial inclusion (BIS (2021)). The recent launch and rapid adoption of Brazil’s Pix instant payment system illustrates these dynamics. In just over a year since its launch, Pix has seen 114 million users sign up, or 67% of the adult population (Duarte et al (2022)).

This BIS bulletin argues that fragmentation arises from inherent limitations of blockchains. To maintain a system of decentralised consensus on a blockchain, self-interested validators need to be rewarded for recording transactions. Achieving sufficiently high rewards requires the maximum number of transactions per block to be limited. As transactions near this limit, congestion increases the cost of transactions exponentially. While congestion and the associated high fees are needed to incentivise validators, users are induced to seek out alternative chains. This leads to a system of parallel blockchains that cannot harness network effects, raising concerns about the governance and safety of the entire system.