As a seasoned researcher and analyst with over a decade of experience in financial markets and a Master’s degree in Aerospace Engineering, I find myself captivated by the potential role of public blockchains, particularly Ethereum, in reshaping the future of financial markets. My journey at S&P Global Ratings has led me to delve deep into the intricacies of digital assets and their implications for rating systems and broader financial market dynamics.
In the coming years, decentralized systems like public blockchains could significantly impact the financial sector, and Ethereum stands out as one of the prime contenders among these platforms to serve as a transactional backbone. It’s crucial for developers to assess risk within the Ethereum network when constructing robust applications designed for financial markets.
The benefits of blockchain and tokenization
Over an extended period, various establishments have delved into the application of blockchain technology and tokenization within financial sectors with the intent to minimize both time and costs. This is achieved by optimizing settlement procedures, leveraging blockchain as a unified data source among all transaction parties, thereby eliminating the necessity for labor-intensive reconciliation tasks across multiple records kept by different participants.
Institutions aspire to simplify the usage of various asset types as collateral for transactions and streamline liquidity management by facilitating intraday transactions. Transforming assets into digital tokens on a blockchain could potentially enhance the experience for most investors, and it may even be feasible to digitize the majority of financial assets. In essence, is it not plausible that in the future, all assets might be tokenized?
Real use cases but small volumes
In conventional financial settings, the primary applications have been digital bonds (these are bonds represented as tokens on a blockchain) and tokenized securities such as tokenized U.S. Treasuries or tokenized money market funds (shares in a fund that owns U.S. Treasuries). We have assigned ratings to digital bonds for various entities, including sovereign nations, local governments, banks, international organizations, and corporations.
Despite established financial institutions like Blackrock launching tokenized money market funds (such as their BUIDL fund), it’s worth noting that the current circulation of digital bonds and tokenized money market funds is significantly smaller compared to those traded in traditional markets. One might wonder, what could be hindering wider acceptance?
Challenges to adoption
Interoperability
The first key challenge is interoperability. Investors need to access the blockchains on which the 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 of these being a “walled garden” set up by a specific institution. This does not support a liquid secondary market for these bonds to trade, hindering wider 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 permissioned blockchains shared between a network of partner institutions;
- Cross-chain communication technologies to allow different private and public chains to interact while mitigating security risks.
On-chain payments
The main hurdle in implementing digital bonds lies in processing the payment transactions on the blockchain. Typically, digital bonds have relied on conventional payment systems instead of blockchain-based payments, thereby minimizing the advantages associated with on-chain issuance and reducing issuer motivation to issue these bonds as well as investor interest in purchasing them. However, in recent times, traditional issuers have started releasing digital bonds that utilize on-chain payments, specifically in Switzerland, where a wholesale digital Swiss Franc issued by the Swiss National Bank is being used for this purpose.
In regions where central bank digital currencies haven’t yet fully materialized, privately issued stablecoins could serve as useful tools to facilitate online transactions in financial markets. As regulatory structures evolve in crucial locations, there will likely be an increased interest among investors to interact with stablecoins and their associated benefits, thereby promoting the use of digital payments on the blockchain.
Legal and regulatory considerations
Institutions proceed with caution due to uncertainties surrounding legal and regulatory issues, particularly concerning privacy, Know Your Customer/Anti-Money Laundering responsibilities, and whether these requirements can be met on a public, permissionless blockchain like Ethereum. However, technological advancements are arising that tackle these challenges at various levels instead of the primary Ethereum transaction layer. For instance, zero-knowledge proof technology offers support for privacy applications, while new token standards (like ERC-3643 for Ethereum) facilitate asset-level permissioning in transactions.
Ethereum’s position in financial markets
In the realm of widely used blockchains, Ethereum is ideally situated to become more popular in a financial sector setting. This is because a significant portion of institutional-oriented stablecoin liquidity is found here. Additionally, it boasts technology that’s been refined and proven through extensive use in its execution and consensus mechanisms. Furthermore, its token standards and decentralized finance markets are well-established and robust.
In truth, certain primary private blockchains employed within financial sectors have been designed to align with Ethereum’s virtual machine. This shared standard is intended to help institutions stay ahead in terms of innovation and attract skilled professionals.
Managing Ethereum’s ecosystem risks
The prosperity of Ethereum within financial markets hinges on institutions grasping and overseeing Ethereum’s potential concentration hazards, alongside the ecosystem’s skill in mitigating these perils. To put it simply, Ethereum relies on agreement from two-thirds of its network validators to approve each new block added to the chain. If more than one-third of these validators are offline simultaneously, blocks cannot be approved. As such, it’s imperative to keep tabs on any concentration risks that might lead to this scenario. In essence:
- No single entity controls a third of validator nodes. The largest staking concentration (29%) is through the Lido decentralized staking protocol: these nodes share exposure to Lido’s smart contract risk but are operated by a multitude of different operators.
- Diversification of client software packages run by validators (consensus and execution clients) mitigates the risk of a network outage resulting from any bug in this software. This is a strength over most public blockchains, which currently each use a single client. Client concentration risk persists, however, 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.
As a crypto investor, I follow the insights of Andrew O’Neill, who serves as the Managing Director and Digital Assets Analytical Lead at S&P Global Ratings. Being at the helm of S&P’s digital assets research, he is instrumental in shedding light on their potential influence on financial markets. Having shifted my focus towards crypto and DeFi-related risks in early 2022, I have dedicated myself to understanding how these emerging trends may impact ratings and broader financial markets. Furthermore, I played a part in developing S&P Global Ratings’ Stablecoin Stability Assessments, which were introduced in November 2023. Prior to my tenure at S&P, I honed my skills as an analyst in Investment Banking, Acquisition, and Leveraged Finance at J.P. Morgan. Armed with a Master’s degree in Aerospace Engineering from the University of Bath and the CFA charter, I bring a unique blend of expertise to the table.
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2024-09-08 14:08