Regulators Are Bringing the Multichain Era to a Close

The high cost of understanding multiple chain environments means enterprises are likely to stick to what they know, argues Paul Brody, head of blockchain at EY.

AccessTimeIconMar 2, 2023 at 9:20 p.m. UTC

As firms add more and more blockchains to their strategic road maps, I grow more and more frustrated. Where, I keep wondering, do firms have the money to properly understand and implement such an enormous array of blockchains in their operations? At EY, it costs us about $500,000 to add a new chain to our Blockchain Analyzer platform and we spend between 10%-20% of that amount each year keeping up to date.

While setting up network nodes may not be too difficult, understanding how networks operate and the mechanics of transfers and payments is another matter. When we add a network, we take a close look at the transaction processing model (how transactions are initiated, recorded, processed and reported); the cryptography that underpins those transactions; and the risks that might be associated with different steps in the process. When it comes to audits, we even identify control points where we can perform verification steps.

Paul Brody is EY's global blockchain leader and a CoinDesk columnist.

Nor are these networks static entities. Ethereum has two to four hard forks a year and other smart contract-enabled chains evolve at a similar rate. The result: Staying up to date on a large number of different blockchains is costly.

Cost isn’t the only factor, either. Liquidity becomes an issue as well. Polling Automated Market Makers (AMM) for their sample prices by volumes of proposed swaps on different token pairs shows how quickly liquidity drops off once you leave the Ethereum blockchain. Even within public Ethereum, trading is highly concentrated among the top tokens. Tokens without liquidity are much more vulnerable to price manipulation.

Insufficient liquidity in an inadequately regulated market is one of the main reasons the Securities and Exchange Commission has rejected applications for bitcoin (BTC) exchange-traded funds (ETF). The last year has shown, time and again, that crypto asset prices are often manipulated. So these concerns are unlikely to go away and will increasingly deter firms for interacting with, or transacting upon, less-liquid ecosystems.

As if it wasn’t complicated enough, just deciding which chains to add is a constantly changing mix. Over the last few years, there has been a constant stream of “Ethereum killer” chains taking up the #2 spot in the ecosystem. A good measure of “who’s on top” is the DeFiLlama scorecard showing Ethereum dominance of the decentralized finance (DeFi) ecosystem. DeFiLlama tracks nearly 140 different chains. At various times, Binance, Terra, Tron and Celo have been in second place, but none has ever represented more than about 20% of the total DeFi ecosystem value. Usually the second chain by volume is at 10% or less.

Nor is Ethereum Virtual Machine (EVM) compatibility a useful factor in de-risking a chain’s adoption. EVM compatibility means that (in theory) applications written for Ethereum’s virtual machine will run on any other chain making that claim. Theory doesn’t always match reality exactly, however. As a result, EVM compatibility may actually increase risk.

EVM compatibility is not perfect and the implementation on each chain is slightly different. While this can definitely make it simpler to deploy new smart contracts on a different chain, they may behave differently in a fully “compatible” environment and the claim of compatibility may increase risk that people deploy without careful consideration. We often encounter novel errors when moving smart contracts from bitcoineum testnets to the mainnet. I don’t see cross-chain deployment being easier under any conditions.

All of this aligns with our own experience, which has shown that the amount of work required to qualify a new asset or service for our audit tools on Ethereum is significantly lower than other chains. That’s because we already have a strong understanding of the underlying ecosystem. Ethereum also offers far more liquidity than any other chain, all of it inside the same ecosystem with no cross-chain bridge risk.

One way to anticipate how a much more regulated future looks is to examine how the biggest centralized or traditional finance firms are looking at the market for crypto assets. These firms are highly regulated and need to document their processes and work extensively to demonstrate they are not mishandling their client responsibilities. What you will see, over and over again, is that many of the biggest regulated firms have largely limited their offerings to BTC and ether (ETH) and have been very slow to grow that footprint.

When the most regulated firms do start adding to the mix, my own prediction is they will begin by adding more tokens from the Ethereum ecosystem and, perhaps, adding curated sets of DeFi services from Ethereum as well. I had, in the past, expected that we would have seen this expansion during 2022. But the market turmoil and increased regulatory scrutiny in the second half of last year caused many firms to move more slowly and increase their focus on compliance.

All of these challenges were much easier to ignore when every chain was growing, venture-capital funding was plentiful and regulatory scrutiny was light. All those sunny conditions are gone now and the game is different. Between slashing burn rates and regulatory scrutiny, the multichain era is drawing to a close.

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Paul Brody

Paul Brody is Global Blockchain Leader for EY (Ernst & Young). Under his leadership, EY is established a global presence in the blockchain space with a particular focus on public blockchains, assurance, and business application development in the Ethereum ecosystem.