Public blockchains will shape financial markets, and Ethereum is well-positioned to serve as a settlement layer. Building powerful financial market apps requires understanding Ethereum ecosystem risk.
Financial institutions have investigated blockchain and tokenization for years. They streamline settlement procedures, use blockchain as a single source of truth, and reduce reconciliation efforts among participants' records to save time and money.
Institutions also seek to enable intraday transactions to make additional asset types simpler to use as collateral and improve liquidity management. Most investors should benefit from tokenizing financial assets on a blockchain. Shouldn't all assets be tokenized eventually?
Electronic bonds and tokenized Treasuries are the main applications of blockchain technology in conventional financial markets. Our digital bond ratings include sovereign, local, bank, multilateral, and corporate bonds.
Traditional financial institutions like Blackrock have launched tokenized money market funds like BUIDL. Digital bonds and tokenized money market funds still make up a small portion of conventional market activity. What hinders adoption?
The first issue is compatibility. Institutions must link their old systems to tokenized asset blockchains, and investors must access them. Digital bond issuers have mostly employed private permissioned blockchains, which are institutional “walled gardens”. This prevents a liquid secondary market for these bonds, limiting uptake. Different approaches to these issues are developing, including:
Public blockchains. Public blockchains like Ethereum and Polygon have issued digital bonds in recent months. Blackrock released BUIDL on Ethereum.
Private permissioned blockchains shared by partner institutions;
Private and public chains may connect securely via cross-chain communication technology.
Executing cash payments on-chain is the second difficulty. Many digital bonds employ regular payment channels instead of on-chain bond payments. This reduces the advantages of issuing on-chain, discouraging issuers and investors from purchasing digital bonds. New digital bonds from conventional issuers employing on-chain payments in Switzerland have been issued in recent months using a wholesale digital Swiss Franc issued by the Swiss National Bank.
Private stablecoins may allow on-chain cash transactions in places where central bank digital currencies are still developing. Emerging legislative frameworks in important countries will increase investors' interest in stablecoins and their characteristics, promoting on-chain payments.
Legal and regulatory concerns about privacy, KYC/AML, and meeting these requirements on a public permissionless blockchain like Ethereum keep institutions hesitant. Technical improvements are addressing these issues at layers other than the Ethereum settlement layer. Zero-knowledge-proof technology supports privacy applications, while new token standards like ERC-3643 for Ethereum provide asset-level transaction permissioning.
Ethereum is well-positioned for financial industry adoption among public blockchains. It holds most institutional-focused stablecoin liquidity. In its execution, consensus, token standards, and decentralized financial markets, it uses mature and proven technology.
Some of the primary private blockchains used in financial markets are Ethereum-compatible. Institutions strive to stay up with innovation and talent by standardizing.
Institutions' and the ecosystem's capacity to comprehend and manage Ethereum's concentration concerns will determine its financial market success. Ethereum needs two-thirds of validators to approve each new block. Blocks cannot be completed with more than one-third of validators unavailable. Thus, concentration risks that might induce this must be monitored. In particular:
Nobody owns a third of validator nodes. The Lido decentralized staking protocol has the highest staking concentration (29%): these nodes share Lido's smart contract risk yet are run by several operators.
Diversifying validator client software packages (consensus and execution clients) reduces the danger of a network outage due to a defect. This is an advantage over most public blockchains, which have one client. Client concentration risk remains, as seen in the network's lone delayed finality event in May 2023.
At most, 16% of validators are hosted by a single cloud provider.
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