Ethereum as a settlement layer on financial markets

Ethereum, among the public blockchains, is in a good position to be a settlement system. To build robust financial market applications, it is essential to understand the risks in Ethereum’s ecosystem.

Blockchain and Tokenization: Benefits

Institutions have studied the application of blockchain technology and tokenization to financial markets for years. The goal is to reduce time and costs by streamlining the settlement process, using blockchains as one source of truth for all participants in a transaction, and eliminating cumbersome reconciliation between participants records. 

In addition, institutions hope that intraday trading will make it easier for more assets to be used as collateral and help them manage their liquidity better. Tokenizing most financial assets should improve the current systems and make them more attractive to investors. Shouldn’t assets eventually be tokenized in order to improve the system for investors?

Small volumes but real use cases

To date, the key applications in traditional financial markets have been digital bonds (the issue of a Bond as a token on a Blockchain) and tokenized Treasuries. (Or tokenized money-market funds or shares in a US Treasury fund). Our ratings include digital bonds from sovereigns, local governments and banks as well as multilateral institutions and corporations. 

There are also traditional financial institutions that have launched tokenized money markets funds. Blackrock’s BUIDL fund. To date however, the volume of digital money market funds and bonds issued by traditional markets is a small fraction. What is holding back adoption of blockchain technology?

The challenges of adoption

Interoperability

First, interoperability. The blockchains upon which tokenized assets have been built must be accessible to investors, while institutions’ legacy systems need to be connected to these blockchains. As of today, most digital bonds are issued on private blockchains that have permissions. “walled garden” Set up by an institution. It is not possible to have a secondary market where these bonds can be traded, which hinders their wider adoption. There are many ways to overcome these obstacles, such as:

• Public blockchains. Recently, digital bonds have been issued on public chains, such as Ethereum and Polygon. Blackrock issued its BUIDL Ethereum fund;
• Shared private permissioned Blockchains between institutions in a partner network;
• Technology that allows different chains, both public and private, to interconnect while still minimizing the security risk.

Payments on the chain

On-chain cash payment execution is the second major challenge. In the past, most digital bonds used conventional payment systems instead of on-chain payments. The benefits of digital bond issuance on-chain are limited, as is the interest from investors and issuers to buy them. However, in recent months we’ve seen seen First digital bonds are issued in Switzerland by traditional companies using the on-chain system. A wholesale digital Swiss franc is used, which was created specifically for this. 

Privately issued stablecoins can be similarly used in countries where digital currencies from central banks are still a long way off. They could also support cash on the chain for financial transactions. The regulatory environment in certain jurisdictions is evolving and will increase investors’ interest to use stablecoins, as well as the capabilities they provide. This will boost the adoption of the on-chain payment system.

Considerations relating to legal and regulatory issues

Legal and regulatory concerns remain a concern for institutions, especially in regards to privacy and KYC/AML requirements, as well as whether these requirements can be met when using an open permissionless blockchain like Ethereum. There are new technical innovations that tackle these issues at other levels than Ethereum’s main settlement layer. As an example: zero-knowledge-proof Technology can be used to support privacy-related applications. New token standards, such as ERC 3643 for Ethereum, allow transaction permissions at the asset or asset class level.

Ethereum’s role in financial markets

Ethereum has a good chance of gaining adoption on the financial market. It is where most of the liquidity in institutional-focused stablecoins currently resides. The technology behind its consensus and execution mechanisms is relatively mature, and it also has token standards. 

Some of the most popular private blockchains in financial markets are compatible with Ethereum’s virtual machine. Institutions hope to stay on top of innovation by convergent around a standard.

Manage Ethereum’s risks

Ethereum’s potential as an instrument in the financial market will be determined by institutions’ abilities to monitor and understand Ethereum’s risks of concentration, as well their ability to manage them. Ethereum needs the agreement of at least two thirds of its validators in order to add a new block to the chain. Blocks cannot be completed if more than one third of validators go offline simultaneously. This is why it’s important to keep an eye on any potential concentration risks. Specifically:

• The validator nodes of a given entity are distributed across a wide range. The largest The Lido protocol for decentralized staking is responsible for staking (29%): These nodes all share the same exposure to Lido smart contract risks, yet are controlled by different operators.
• A diversification of the client software that validators run (consensus clients and executions clients) reduces any risk of network failures due to bugs in these software. The majority of blockchains use just one client. The risk of client concentration persists however as shown by the only event that was delayed in 2023.
• Validators do not concentrate through one cloud provider. The largest exposure is hosted by only one provider. only 16 % of the validators.