BIS researchers raise spectre of poor governance for DLT in credit economy

In a recent paper, researchers from the Bank for International Settlements (BIS) explore the economics and optimal design of “permissioned” distributed ledger technology (DLT) in a credit economy. Designated validators verify transactions and update the ledger at a cost that is derived from a supermajority voting rule, thus giving rise to a public good provision game.

This paper addresses the incentives validators need to sustain honest exchange. Two economic forces that differentiate permissioned DLT from conventional centralized marketplaces in terms of efficiency include (i) that it is easier to achieve good governance in decentralised settings and (ii) that the actions of multiple validators need to be coordinated via economic incentives.

The latter in particular requires rents for the validators to overcome free-riding. The optimal design hence balances the greater robustness derived from a more decentralized governance structure with the increasing difficulty of coordinating a larger network of validators.

Without giving proper incentives to validators, their records cannot be trusted because they cannot commit to verifying trades and they can accept bribes to incorrectly validate histories. Both frictions challenge the integrity of the ledger on which credit transactions rely.

In this context, researchers examined the conditions under which the process of permissioned validation supports decentralized exchange as an equilibrium, and analyze the optimal design of the trade and validation mechanisms. They solve for the optimal fees, number of validators, supermajority threshold and transaction size.

A stronger consensus mechanism requires higher rents be paid to validators. Results suggest that a centralized ledger is likely to be superior, unless weaknesses in the rule of law and contract enforcement necessitate a decentralized ledger.

Read the full report

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