Public blockchains have a significant role to play in the future of financial markets, and Ethereum is well-positioned among these blockchains to act as a settlement layer. Understanding risk within the Ethereum ecosystem is crucial for building robust financial market applications.

The Benefits of Blockchain and Tokenization

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

Institutions also aim to make more asset types easier to use as collateral and manage liquidity more efficiently through intraday transactions. Holding assets as tokens on a blockchain offers an improvement over existing systems for most investors, potentially allowing for the tokenization of most financial assets. In the long run, this could lead to the tokenization of all assets.

Real Use Cases but Small Volumes

Key use cases in traditional financial markets include digital bonds (issuance of a bond as a token on a blockchain) and tokenized Treasuries (shares in a fund holding US Treasuries). These digital bonds span across sovereign, local governments, banks, multilateral institutions, and corporates.

Traditional financial incumbents have also set up tokenized money market funds. However, the volumes of digital bonds and tokenized money market funds remain a tiny fraction of those in traditional markets. What are the barriers to broader adoption?

Challenges to Adoption

Interoperability

The first key challenge is interoperability. Investors need access to the blockchains where tokenized assets are built, and institutions need to connect their legacy systems to these blockchains. Digital bond issuers have primarily used private permissioned blockchains, creating “walled gardens” that hinder a liquid secondary market.

Different paths are emerging to address these challenges, including:

  • Public blockchains: Recent months have seen digital bonds issued on public blockchains like Ethereum and Polygon.
  • Private permissioned blockchains shared between partner institutions.
  • Cross-chain communication technologies to enhance interaction between different private and public chains while mitigating security risks.

On-chain Payments

The second key challenge is executing the cash leg of payments on-chain. Most digital bonds still use traditional payment systems, limiting the benefits of on-chain issuance. However, recent developments in Switzerland have seen the first digital bonds using on-chain payments with a wholesale digital Swiss Franc issued by the Swiss National Bank.

In other jurisdictions, privately issued stablecoins may support the on-chain cash leg in financial transactions. Emerging regulatory frameworks will enhance investor appetite for stablecoins, boosting the adoption of on-chain payments.

Legal and Regulatory Considerations

Institutions remain cautious due to legal and regulatory questions, particularly regarding privacy, KYC/AML obligations, and whether these can be met using public blockchains like Ethereum. Technical innovations are emerging to address these challenges, including:

  • Zero-knowledge-proof technology for privacy applications.
  • New token standards (such as ERC-3643 for Ethereum) for transaction permissioning at the asset level.

Ethereum’s Position in Financial Markets

Among public blockchains, Ethereum is well-positioned to gain adoption in financial markets. It holds most of the liquidity in institutional-focused stablecoins and benefits from mature technology in its execution and consensus mechanisms, token standards, and decentralized finance markets.

Many private blockchains used in financial markets are compatible with Ethereum’s virtual machine, allowing institutions to keep pace with innovation and talent.

Managing Ethereum’s Ecosystem Risks

Ethereum’s success in financial markets will depend on institutions’ ability to understand and monitor concentration risks within its ecosystem. Ethereum requires the consensus of two-thirds of the network’s validators to finalize each new block. If more than one-third of validators are offline, blocks cannot be finalized. Therefore, it is crucial to monitor concentration risks, particularly:

  • No single entity should control a third of validator nodes. The largest staking concentration (29%) is through the Lido decentralized staking protocol, but these nodes are operated by various operators.
  • Diversification of client software packages run by validators mitigates the risk of network outages from software bugs. Client concentration risk persists but is monitored closely.
  • Validators are not concentrated through a single cloud provider, with the largest exposure hosted by a single provider at only 16% of validators.

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