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Public permissionless blockchains offer groundbreaking advantages like transparency, composability, and decentralization, making them strong candidates for becoming the foundation of future financial infrastructure.
While these networks have the potential to transform finance by fostering open and inclusive platforms, they also face significant technical, operational, and governance challenges that must be addressed before they can fully serve as financial infrastructure, according to a new report by the European Commission (EC).
The paper, released in November 2024, examines the potential of public permissionless blockchains to enhance traditional financial services, highlighting key advantages of utilizing an open, decentralized base layer.
Main properties and differences
Permissionless blockchains, also known as trustless or public blockchains, are decentralized networks that allow anyone to participate without requiring prior authorization or permissions. These blockchains enable any users to read, write, and validate transactions, with examples including Bitcoin and Ethereum. On these networks, participants interact pseudonymously and all transactions are recorded on an immutable ledger, fostering trust through cryptographic proofs rather than intermediaries.
According to the EC report, financial market infrastructure (FMI) and blockchains share a core similarity: both are built on databases that record the transfer, creation and redemption of assets. However, there are significant differences.
First, in traditional finance, transactions are synchronized across multiple ledgers maintained by different entities, requiring verification at every step. Blockchains, on the other hand, use decentralized protocols to handle peer-to-peer transactions, execute them through virtual machines, and achieve consensus on the ledger’s state.
Another difference is composability. In traditional finance, composability exists only in a limited capacity due to the variety of isolated systems and their parametrization, which result in numerous mostly incompatible ledgers. Decentralized finance (DeFi), on the other hand, uses a more flexible “Lego pieces approach”, the report says, where smart contract-based financial protocols and assets can be reused within other protocols to create innovative solutions.
Another feature highlighted in the report is atomicity, which refers to the inseparability of multiple transaction steps. In traditional finance, transactions often rely on intermediaries, such as central counterparties, central securities depositories, or other escrow agents and platform providers, to ensure that conditions are met. While these intermediaries play an essential role in managing risks, they also introduce additional costs.
In the context of blockchains, solutions such as multi-ledger trigger systems and hashed timelock contract setups have emerged over the past years to enable cross-chain interoperability. These systems allow for seamless interactions between different blockchains, breaking the silos that typically isolate them and removing the need of intermediaries.
Finally, governance is the primary property where public permissionless blockchains differ substantially from permissioned systems like centralized ledgers operated by FMIs. By design, any permissioned system requires gatekeepers who control access and validation, creating centralized authority. In contrast, public permissionless blockchains create a neutral platform that belongs to everyone, without requiring a predefined set of gatekeepers with special privileges. This decentralized governance fosters flexibility, enabling centralized services to be built on top of a decentralized foundation, the report says.
Challenges to address
Despite these benefits, several challenges must be addressed for permissionless blockchains to be fit for financial infrastructure.
First, permissionless blockchains often struggle to handle the high transaction throughput required for global financial systems. However, simply increasing block size of creation frequency won’t solve these issues as it demands more powerful hardware and better network connections, ultimately reducing accessibility, creating barriers to entry and undermining decentralization.
Balancing transparency with user privacy is another challenge. Public permissionless blockchains inherently expose transaction details, which may not be suitable for all financial applications that require confidentiality and which may be detrimental to institutional adoption. Furthermore, real-time updates on monetary outflows could promote bank-run equivalent scenarios and pose a risk to financial stability.
Transaction finality is another critical concept in blockchain settlement, particularly in financial services. Finality means a transaction cannot be reversed or altered without changing the blockchain’s consensus rules.
Finally, the decentralized nature of permissionless blockchains raises governance issues, including how decisions are made regarding protocol changes and how to handle disputes among users. Establishing effective governance mechanisms will be essential for the long-term viability of these systems in the financial services industry.
In Switzerland, the central bank has been actively exploring how tokenization and distributed ledger technology (DLT) can play a key role in creating an “efficient, reliable and secure ecosystem” that’s geared towards “the future of cashless payments in Switzerland.”
The Swiss National Bank (SNB) has conducted studies on how central bank digital currency (CBDC) can be integrated into a regulated token environment. It’s also been exploring how DLT can enhance payment systems, particularly by simplifying transaction processes and eliminating costly reconciliation across various systems.
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