Stablecoin = Fracturedcoin

Yes, money is a mind-blowing abstract social technology without which it’s hard to imagine human society. But to be useful, it has to be a way to pay the milkman. And usefulness depends on singleness. Or at least so reckons Hyun Song Shin, head of the Monetary and Economic Department at the Bank for International Settlements.

Shin has made the case before that stablecoins fail the case of singleness (and we’ve made the joke before that, for any crypto bro living in their mum’s basement, failing at singleness sounds like a laudable aim). Shin’s now back with a working paper stuffed with equations to prove that this isn’t just a bug, but rather a necessary feature that cannot be excised.

Given that Kraken has just been granted access to FedWire, and so it may not be long before Americans can pay their milk delivery person with stablecoins in a way that will presumably look to them very much like money, we thought it would be worth translating his fascinating paper into short-form human.

Shin’s argument is not that stablecoins aren’t a neat bit of kit. It’s just that they’re built on decentralised public permissionless blockchains, which need validators in place to sustain consensus — aka seal the deals. And these validators need paying.

Moreover, it’s users who have to stump up the so-called congestion rents that rise the more popular a blockchain becomes. As such, Shin reckons the network effect that gives money its social value is short-circuited. What we’re left with is a fractured mess.

What mess? What exactly is the problem?

Stablecoins on different blockchains are not interoperable. A USDC token sitting on the Ethereum ledger should have the same value as a USDC token sitting on the Solana ledger, but they are fundamentally different, non-fungible, tokens. Tether’s USDT sits on 107 different ledgers. Which means there are 107 different non-fungible Tethers. USDC sits on 125.

It’s possible to transfer a stablecoin from one ledger to another using a bridge — “specialised software protocols that lock tokens on one chain and issue equivalent tokens on another”. But bridging takes time and a bit of money. Furthermore, it hasn’t proved exactly riskless: Chainalysis estimates that cumulative losses from bridge exploits netted hackers and bad actors more than $2.5bn between 2021 and 2024.

The result, Shin argues, is stablecoins “from the same issuer existing in multiple non-fungible forms across different blockchains, fragmenting liquidity and undercutting the network effects that should be the strength of a widely adopted payment instrument”.

You could call this sour grapes from the central bankers’ central banker, cheesed off with the idea that the coordination function of a central bank issuing a common currency and maintaining a ledger among commercial banks could be substituted by the distributed consensus of validators.

But Shin’s logic looks pretty sound, and the data . . . seems to fit?

Gas fees — transaction fees that users pay to have transactions processed and recorded on the blockchain — have increased with transaction volumes. These fees are set by auction so, in times of high demand, bidding wars can break out among users as they compete to be processed first:

Some content could not load. Check your internet connection or browser settings.

According to Shin’s model, as congestion rises, price-sensitive users who get annoyed at being rinsed each time they try to make a payment move to cheaper blockchains. But users who care most about security stick around on the expensive chain, because a busy network is a decentralised one. Higher fees = higher coordination threshold = better security. And this division between (a) folks who’ll pony up for a more secure ledger, and; (b) folks who please just want a cheap means of payment, leads to a proliferation of blockchains.

Here’s how the layer one blockchain (the base level network that processes and finalises transactions on ledger) landscape has evolved:

Some content could not load. Check your internet connection or browser settings.

So, according to Shin, it’s not like you can just build a better blockchain — one that doesn’t have gas fees that jump higher the more people actually want to use it. Because, [emphasis ours]:

… more secure blockchains with a higher threshold for successful coordination have to provide higher rewards to the validators to compensate them for the risks that arise from potential miscoordination. The higher the threshold for successful coordination, the higher must be the reward. . . .

The capacity of the blockchain is set from the outset so as to ensure that a sufficiently high stream of rents accrues to the participating validators. In this sense, congestion of the blockchain is a feature, not a bug. The congestion is necessary to ensure that users pay sufficiently high gas fees to reward the validators.

What about so-called layer two chains, which move transactions off the base-layer network to promise faster processing and lower fees? Shin argues they don’t share a common liquidity pool or settlement mechanism, and so they’re basically fragmentation agents in the same way as new blockchains.

What are the takeaways?

OK — let’s skip to the end. First up, decentralisation comes with irreducible costs, and these costs are borne by the users. The more decentralised a system, the higher the costs, and this has more to do with incentives than computational costs.

Second, to be economically sustainable, blockchains need to be congested. Layer-two solutions haven’t eliminated congestion; they’ve just led to more fragmentation across non-fungible platforms.

Third, stablecoins inherit the fragmentation of the blockchains on which they reside. And because what makes money valuable is its universal acceptability, this “fragmentation is not merely inconvenient — it is structurally incompatible with the network effects that give money its social value”. It’s the economics of blockchain rails, formalised in Shin’s paper, that drive this fragmentation.

Or as Shin puts it:

Decentralised infrastructures come with a built-in tendency toward fragmentation that works against the very network effects that give money its social value. The fragmentation argument is the flipside of blockchain’s “scalability trilemma,” as described by Vitalik Buterin (Buterin (2021)), who posed the problem as the impossibility of attaining, simultaneously, a ledger that is decentralised, secure, and scalable.

**Further reading:
**— The stablecoin war: Wall Street vs crypto over the future of money (MainFT)
— The case against stablecoins (Unhedged)
— Year in a word: Stablecoins (MainFT)
— Stablecoins might revolutionise payments, but what if they don’t? (FTAV)
— Are stablecoins money? (FTAV)