A bridge too far

The BIS on ledger fragmentation

At this point in the crypto deflation, an apparent attack on the Solana blockchain does little more than add insult to the financial injuries of the last few months. Solana has styled itself as a contender to unseat Ethereum among public distributed ledgers—it boasts a high transaction throughput, low transaction costs, and a lively development ecosystem. The Solana heist appears at this point to be modest in size, with users relieved of tokens valued at some $5 million via a security flaw in a Solana wallet provider.

The Solana post-mortem may yet turn up some systemic insights. But already, it has raised the fundamental question of why there are multiple distributed ledgers in the first place. Why should there be both Solana and Ethereum, especially as this creates a need for cross-chain protocols to connect them? These have been frequently targeted: the $200 million loss recorded this week by the cross-chain Nomad protocol makes one wonder if anything was learned from last year’s $600 million Poly Network heist.

This short piece from the BIS, from June of this year, gets to the heart of the matter. Like IOSCO’s DeFi report, released in March, the BIS piece is fluent in both the language of crypto and that of central banking and financial regulation. With every such move, DeFi is more bound by the emerging regulatory regime. In particular, the piece makes two key points about the fragmentation of the crypto world.

The congestion double bind

The BIS researchers’ first key point speaks to the founding thesis of public (i.e., permissionless) distributed ledgers: public transaction verification should be profitable. Bitcoin mining is the most familiar example; other ledgers offer variations on the principle. All public ledgers compensate profit-motivated validator nodes. (Permissioned ledgers, by contrast, can treat validation as a loss-making utility.)

The compensation paid to validators derives from users’ transaction fees, which must therefore be sufficiently high to attract enough honest validators to keep the ledger running. So ledgers throttle transaction throughput by design, creating congestion and so increasing users’ willingness to pay fees to avoid it.

This amounts to a double bind for public ledgers. Congestion and fees rise as ledger use grows, rather than conferring economies of scale. Ledgers become the victims of their own success. This will make it hard for a single public ledger ever to gain a secure hold over the others. Such instability is in sharp contrast to the stability of the global dollar system, for example. The dollar’s centrality makes it likely that the dollar will remain at the center. This is one of the deepest criticisms of crypto I have come across, presented here in understated form by the BIS.

The seven bridges of …

A side-effect of the congestion problem has been the proliferation of multiple chains, fragmentation in the language of the BIS piece. Solana, for example, responds to inefficiencies of Ethereum, which responds to limitations of Bitcoin.

Each blockchain is a self-contained universe of transactions, not unlike different currency areas. I have used the term “payment communities” to encompass both: they draw a boundary, inside of which transactions are cheap and easy. Crossing the boundary is harder. In the world of bank money, one has to undertake a foreign exchange transaction, selling dollars for euros for example.

In the world of distributed ledgers, bridge protocols have arisen to solve this problem. Each bridge protocol (and there are many) is set up to transact on multiple ledgers. The bridge will accept payment on one ledger and make payment on another, so allowing cross-chain transactions. These T accounts illustrate the financial structure. The Nomad protocol holds inventories of USDC on the Ethereum ledger, and USDT on Avalanche (among many others). Users can, for example, send USDC to Nomad, triggering smart contracts to make payment in USDT.

As I have shown, bridge protocols have to hold balances in each of the tokens, secured only by smart contracts, in which they transact (or risk not being able to pay). For this reason, as the fragmentation paper points out, they are sitting ducks for hacking attempts.

All this to allow bridge protocols to collect a fee for solving a problem that only exists because of the proliferation of ledgers. Fragmentation begets complexity.

The BIS perspective is a helpful one

The BIS is used to dealing with the fragmented network of payment communities, stitched together by banks and dealers, that is the global monetary system. Perhaps that makes it easier for them to see how crypto has replicated this rather than solving it. It might become more obvious still, as the tide goes out.

Previously on Soon Parted

• New names for old ideas.

• Division by zero.

• Some of the underlying ideas will survive.