Can Ethereum provide a settlement layer for financial markets?

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 settlement layer. Understanding the risks in the Ethereum ecosystem is essential to building robust applications for financial markets.

The Benefits of Blockchain and Tokenization

For years, institutions have been interested in using blockchain and tokenization in financial markets. They want to save time and money by streamlining settlement processes, using blockchain as a single source of truth for trading participants, and reducing the need for time-consuming reconciliations between participant records.

Institutions also hope to make it easier to use more types of assets as collateral for transactions and to manage liquidity more efficiently by enabling intraday trading. Holding assets as tokens on a blockchain should be an improvement over existing 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 main use cases so far in traditional financial markets are digital bonds (issuing a bond as a token on a blockchain) and tokenized Treasuries (or tokenized money market funds, shares of a fund that holds US Treasuries). We have evaluated digital bonds from states, local governments, banks, multilateral institutions and corporations.

We have also seen traditional financial players create tokenized money market funds, such as Blackrock’s BUIDL fund. However, to date, the volumes of digital bonds and tokenized money market funds remain a tiny fraction of the volumes issued in traditional markets. What is holding back the adoption of these products?

The challenges of adoption

Interoperability

The first major challenge is interoperability. Investors need access to the blockchains on which tokenized assets are built, and institutions need to connect their existing systems to these blockchains. Until now, digital bond issuers have primarily used permissioned private blockchains, each of which is a “walled garden” set up by a specific institution. This does not allow for a liquid secondary market for these bonds, which hinders their 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;
• Permissioned private blockchains shared across a network of partner institutions;
• Cross-chain communication technologies that enable different private and public chains to interact while mitigating security risks.

On-chain payments

The second major challenge is the execution of the cash portion of on-chain payments. Most digital bonds have used traditional payment systems rather than on-chain bond payments. This limits the benefits of on-chain issuance, weakening the incentive for issuers to issue and the interest of investors to buy digital bonds. In recent months, however, we have seen the first digital bonds from traditional issuers using on-chain payments in Switzerland, using a wholesale digital Swiss franc issued by the Swiss National Bank specifically for this purpose.

In jurisdictions where central bank digital currencies are still far from crystallizing, privately issued stablecoins can also be tools that support the on-chain cash component of financial market transactions. Emerging regulatory frameworks in key jurisdictions will increase investor appetite for stablecoins and the functionalities they enable, thereby driving the adoption of on-chain payments.

Legal and regulatory considerations

Institutions remain cautious due to legal and regulatory issues, including their privacy, KYC/AML obligations, and the ability to meet these obligations using a permissionless public blockchain like Ethereum. Technical innovations are emerging to address these challenges at multiple levels beyond Ethereum’s core settlement layer. For example, zero-knowledge technology can support privacy applications, while new token standards (such as ERC-3643 for Ethereum) enable transaction authorization at the asset level.

Ethereum’s Position in Financial Markets

Among public blockchains, Ethereum is well positioned for adoption in the context of financial markets. This is where most of the liquidity for institutional-grade stablecoins currently resides. It benefits from a relatively mature and proven technology in its execution and consensus mechanisms, as well as its 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 converging around a common standard, institutions hope to keep pace with innovation and talent.

Managing Risks in the Ethereum Ecosystem

Ethereum’s success as a tool in financial markets will depend on the ability of institutions to understand and monitor Ethereum’s concentration risks, as well as the ecosystem’s ability to manage these risks. Ethereum requires consensus from 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. It is therefore essential to monitor any concentration risks that could cause this. In particular:

• No single entity controls a third of validator nodes. The largest concentration of staking (29%) is via the decentralized staking protocol Lido: these nodes share the risk exposure of Lido’s smart contracts but are operated by a multitude of different operators.
• The diversification of client software run by validators (consensus and execution clients) mitigates the risk of a network outage resulting from a bug in these software. This is an advantage over most public blockchains, which currently use a single client each. The risk of client concentration remains, however, as demonstrated by the network’s only delayed finality event in May 2023.
• Validators are not concentrated with a single cloud provider: the largest exposure hosted by a single provider represents only 16% of validators.

Andrew O’Neill

Andrew O’Neill Andrew is a Managing Director and Head of Digital Asset Analysis at S&P Global Ratings. Andrew leads S&P Global’s research on digital assets and their potential impact on financial markets. He began focusing on cryptocurrencies and defensive finance risks in early 2022, with a focus on understanding their potential impact on ratings and broader financial markets. Andrew also participated in the development of S&P Global Ratings’ Stablecoin Stability Assessments, which were launched in November 2023. He joined S&P in 2009 as a covered bond ratings analyst before playing a role in developing rating methodologies, primarily 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 is a CFA charterholder and holds a Masters in Aerospace Engineering from the University of Bath.