Can Ethereum provide a settlement layer for financial markets?

Public blockchains have a role to play in the future of financial markets, and ethereum is well positioned among them to act as a settlement layer. Understanding risk in the ethereum ecosystem is vital to building robust applications for financial markets.

The benefits of blockchain and tokenization

For years, institutions have been exploring the use of blockchain and tokenization in financial markets. Their goal is to save time and money by streamlining settlement processes, using blockchain as a single source of truth between transaction participants, and reducing the need for cumbersome reconciliation efforts between participants’ records.

Institutions also expect that it will be easier to use more types of assets as collateral for transactions and to manage liquidity more efficiently by allowing intraday transactions. Holding assets as tokens on a blockchain should be an improvement over existing systems for most investors, and it should be possible to tokenize most financial assets. So, in the long run, shouldn’t all assets be tokenized?

Real use cases but small volumes

The main use cases so far in traditional financial markets are digital bonds (the issuance of a bond as a token on a blockchain) and tokenized treasury bonds (or tokenized money market funds – shares of a fund containing US Treasury bonds). We have rated digital bonds of sovereign governments, local governments, banks, multilateral institutions and corporations.

We have also seen traditional financial operators create tokenized money market funds, such as Blackrock’s BUIDL fund. However, to date, volumes of digital bonds and tokenized money market funds remain a tiny fraction of the volumes issued in traditional markets. What is holding back their adoption?

Challenges for adoption

Interoperability

The first key challenge is interoperability. Investors need access to the blockchains on which tokenized assets are built, and institutions need to connect their legacy systems to those blockchains. To date, digital bond issuers have primarily used private permissioned blockchains, each a “walled garden” created by a specific institution. This does not support a liquid secondary market for trading these bonds, hindering broader adoption. Different paths are emerging to address these challenges, including the use of:

• Public blockchains. In recent months we have seen the issuance of digital bonds on public blockchains, including ethereum and Polygon. Blackrock also issued the BUIDL fund on ethereum;
• Private blockchains with permissions shared between a network of partner institutions;
• Cross-chain communication technologies to allow different private and public chains to interact while mitigating security risks.

Chain payments

The second key challenge is running the cash part of on-chain payments. Most digital bonds have used traditional payment systems rather than on-chain payments. This limits the benefits of issuing on-chain, weakening the incentive for issuers to issue and the interest of investors in buying digital bonds. However, in recent months we have seen a seen the first digital bonds from traditional issuers using on-chain payments in Switzerland, using a wholesale digital Swiss franc issued by the Swiss National Bank specifically for this purpose.

In jurisdictions where central bank digital currencies are further from crystallizing, privately issued stablecoins can also be tools supporting the on-chain cash component of financial market transactions. Emerging regulatory frameworks in key jurisdictions will increase investor appetite to interact with stablecoins and the features they enable, driving the adoption of on-chain payments.

Legal and regulatory considerations

Institutions remain cautious due to legal and regulatory concerns, particularly regarding their privacy, KYC/AML obligations, and whether it is possible to meet these obligations when using a permissionless public blockchain like ethereum. Technical innovations are emerging that address these challenges at different levels rather than ethereum’s core settlement layer. For example, zero-knowledge proof technology can support privacy applications, while new token standards (such as ERC-3643 for ethereum) enable asset-level transaction authorization.

ethereum's position in financial markets

Among public blockchains, ethereum is well positioned to gain adoption in a financial market context. It is where most of the liquidity in institutional-focused stablecoins currently resides. It benefits from relatively mature and battle-tested technology in its execution and consensus mechanisms, as well as its token standards and decentralized financial markets.

In fact, some of the major private blockchains used in financial markets have been developed to be compatible with the ethereum Virtual Machine. By converging around a common standard, institutions hope to keep pace with innovation and talent.

Managing the risks of the ethereum ecosystem

ethereum’s success as a tool in financial markets will depend on institutions’ ability to understand and monitor ethereum’s concentration risks, as well as the ecosystem’s ability to manage these risks. ethereum requires consensus from two-thirds of the network’s validators to finalize each new block added to the chain. If more than one-third of the validators are offline at a time, blocks cannot be finalized. Therefore, it is crucial to monitor any concentration risks that may cause this to happen. In particular:

• No single entity controls one-third of the validator nodes. ethereum/dashboard/network/centralization?tr=1w” target=”_blank” rel=”nofollow”>bigger Staking concentration (29%) is done through the decentralized staking protocol Lido: these nodes share the risk exposure of the Lido smart contract, but are operated by a multitude of different operators.
• The diversification of client software packages run by validators (consensus and execution clients) mitigates the risk of a network outage as a result of any bug in this software. This is an advantage over most public blockchains, which currently use a single client each. However, the risk of client concentration remains, as seen in the single delayed network termination event in May 2023.
• Validators are not concentrated through a single cloud provider: the largest exposure hosted by a single provider is ethereum/dashboard/network/centralization?tr=1w” target=”_blank” rel=”nofollow”>only 16% of validators.