Can Ethereum provide a settlement layer for financial markets?

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

Benefits of blockchain and tokenization

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

Institutions also hope to make it easier for more types of assets to be used as collateral for transactions and to manage liquidity more efficiently by enabling daily transactions. Holding assets as tokens on a blockchain should be an improvement over current 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 primary use cases in traditional financial markets have so far been digital bonds (the issuance of a bond as a token on a blockchain) and tokenized Treasury bonds (or tokenized money market funds, shares in a fund that holds U.S. Treasury bonds). We have rated digital bonds across sovereign, local governments, banks, multilateral institutions, and corporations.

We’ve also seen traditional financial incumbents launch tokenized money market funds, such as Blackrock’s BUIDL fund. But to date, volumes of digital bonds and tokenized money market funds remain a tiny fraction of volumes issued in traditional markets. What’s holding back adoption?

Adoption challenges Operability

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 these blockchains. To date, digital bond issuers have primarily used private permissioned blockchains, each a “walled garden” established by a specific institution. This does not support a liquid secondary market in which to trade these bonds and hinders wider adoption. Different ways are emerging to address these challenges, including:

Public blockchains. In recent months, we have seen the issuance of digital securities on public blockchains, including Ethereum and Polygon. Blackrock also issued its BUIDL fund on Ethereum; Private permissioned blockchains shared between a network of partner institutions; Cross-chain communication technologies that allow different private and public chains to interact while reducing security risks. On-chain payments

The second major challenge is to conduct the cash leg of payments on-chain. Most digital bonds have used traditional payment systems instead of on-chain bond payments. This limits the benefits of issuing on-chain, weakening the incentive for issuers to issue and investors to buy digital bonds. However, in recent months, we have seen the first digital bonds from traditional issuers using on-chain payments in Switzerland, using wholesale digital Swiss francs issued specifically by the Swiss National Bank.

In jurisdictions where central bank digital currencies are less crystallized, privately issued stablecoins could similarly serve as vehicles to support the on-chain cash pillar of financial market transactions. Emerging regulatory frameworks in key jurisdictions will increase investor appetite for engaging with stablecoins and the features they provide, increasing the adoption of on-chain payments.

Legal and regulatory issues

Institutions remain cautious, particularly due to legal and regulatory questions regarding their privacy, KYC/AML obligations, and the feasibility of meeting these obligations when using a public permissionless blockchain like Ethereum. Technical innovations are emerging that address these challenges at different levels beyond the main Ethereum settlement layer. For example, zero-knowledge proof technology can support privacy applications, while new token standards (like ERC-3643 for Ethereum) enable transaction permissioning at the asset level.

Ethereum’s position in financial markets

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

Indeed, some of the major private blockchains used in financial markets have been developed to be compatible with Ethereum’s virtual machine. By uniting around a common standard, institutions hope to keep pace with innovation and talent.

Managing Ethereum’s ecosystem risks

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

No single entity controls a third of the validator nodes. The largest concentration of staking (29%) occurs through the Lido decentralized staking protocol: these nodes share Lido’s smart contract exposure but are operated by a large number of different operators. The diversification of client software packages run by validators (consensus and execution clients) reduces the risk of a network outage from any bug in this software. This is a strength relative to most public blockchains, which currently use a single client each. However, the risk of client concentration remains, as seen in the network’s only delayed finality event in May 2023. Validators are not concentrated through a single cloud provider: the largest exposure hosted by a single provider is only 16% of validators.

Andrew O’Neill

Andrew O’Neill is a managing director and digital asset analytics leader at S&P Global Ratings. Andrew leads S&P Global’s research on digital assets and their potential impact on financial markets. In early 2022, he began focusing on crypto and defi-related risks, with an emphasis on understanding their potential impact on ratings and financial markets more generally. Andrew also participated in the development of S&P Global Ratings’ Stablecoin Stability Assessments, which launched in November 2023. He joined S&P in 2009 as an analyst on closed-end bond ratings, and subsequently primarily worked on the development of rating methodologies for Structured Finance ratings. Prior to joining S&P Global Ratings, Andrew worked as an Investment Banking, Acquisition and Leveraged Finance analyst at JP Morgan. Andrew holds a CFA charter and a Masters in Aerospace Engineering from the University of Bath.