Financial infrastructure has always been essential to economic processes. Over the years, advancements from traditional bills of exchange to contemporary mobile banking have relied on technological innovations to enhance efficiency. As technology progresses, financial infrastructure increasingly focuses on immediacy and continuity, aiming for prompt transactions involving money and assets. However, while enhanced computing and communication technologies can minimize friction, significant improvements often require fundamental changes in how financial interactions are structured. Blockchain technology and public cryptocurrency networks offer new frameworks and financial products that challenge conventional financial systems.
### Omni-asset Capability
Most cryptocurrency networks are engineered to manage a diverse array of assets within a unified settlement framework, using tokens to transfer various forms of value. These tokens may possess intrinsic value or be tied to a promise of convertibility, even for assets that exist outside the blockchain. In contrast, traditional settlement systems typically cater to a single asset type, such as Fedwire for large dollar transactions, or a specific category, like the National Securities Clearing Corporation for U.S. equities. There is no inherent technological barrier preventing the settlement of multiple asset types on a single network. However, practical, legal, regulatory, and geopolitical challenges complicate the transition to omni-asset platforms. Incumbents may lack incentives to pursue greater integration, as maintaining fragmentation can be financially beneficial. Consolidating various assets on a single ledger could yield numerous advantages, such as eliminating Herstatt risk and simplifying settlements, while also addressing delays caused by irregular operating hours.
### Higher Speed and Lower Cost
The cryptocurrency sector is advancing towards quicker and more cost-effective settlement options by either enhancing the infrastructure of existing networks or developing modular systems. These systems allow for smaller transactions to occur on layer two solutions, with periodic settlement on primary blockchains like Ethereum. Regardless of the method employed, the ultimate goal is to achieve instantaneous payments at minimal costs, including for stablecoins—digital tokens pegged to fiat currencies. Smart contracts can facilitate a series of transactions that occur almost simultaneously, leading to innovative financial products like ‘flash loans.’ These uncollateralized loans are taken out and repaid within a single transaction, making them useful for short-term activities such as arbitrage. In public blockchain systems, this setup allows for interactions among various financial solutions, fostering deeper integration, a concept known in the industry as composability.
### Disintermediation: Cutting Both Ways
Immediate settlement capabilities reduce the necessity for intermediaries by eliminating the batch processing and delays that intermediaries typically manage while assuming counterparty risks. Fewer intermediaries can lead to quicker settlements, increased transparency, and reduced transaction costs. However, intermediation also offers benefits that extend beyond mere settlement, such as resolving the coincidence problem and creating two-sided markets. It provides essential expertise, efficient credit allocation, and market access for less experienced participants. In decentralized finance (DeFi), smart contracts can pool assets to perform intermediary functions, but this reliance on software can create vulnerabilities. It’s also crucial to recognize that current crypto networks possess significantly less capacity compared to traditional payment systems. One potential solution is the implementation of layer twos, which act as netting layers that offer much of the benefits of intermediaries by enhancing liquidity, privacy, and transaction capacity without introducing new agents.
### Permissioned Blockchains
Permissioned blockchains have the potential to provide greater capacity than public ones. By restricting participation to a select group of known entities, these blockchains can address speed, privacy, and certain regulatory challenges. Initiatives like the Bank for International Settlements’ unified ledger concept and various settlement coins aim to enhance payments and settlements through permissioned architectures, allowing access exclusively to regulated intermediaries. Nevertheless, after a decade of exploration, the effectiveness of any permissioned network remains to be fully realized. One drawback is the necessity to codify critical external factors such as participation, ownership, and control. Furthermore, permissioned systems lack platform neutrality, making it possible for them to be halted or reversed. Critics argue that a blockchain that can be turned off is merely a complex database laden with unnecessary cryptographic features. In contrast, public networks avoid this issue as the rights to tokenized assets are inherently tied to their decentralized nature.
### Mitigating Risks
Public cryptocurrency networks introduce their own set of risks categorized into five areas: legal risks, network governance issues, technological vulnerabilities, illicit activities, and settlement risks. Legal uncertainties, especially in cross-border transactions, can question the enforceability of asset ownership. Governance without a centralized authority poses challenges, as on-chain governance may be susceptible to low participation rates, collusion, or bribery. Alternative governance methods often require off-chain coordination, which can be chaotic, particularly during emergencies. Technologically, decentralized finance solutions are still at risk from coding errors, exploits, and the challenges of linking off-chain data to smart contracts—a dilemma known as the “oracle problem.” However, it is worth noting that major DeFi platforms on Ethereum have remained largely secure, even with substantial user assets. Public crypto networks generally lack error or exception handling, which could compromise their decentralization and neutrality goals. This design may suit native crypto assets like Bitcoin but is less feasible for other digital assets. Most stablecoin issuers have mechanisms to freeze or destroy tokens, a capability that is straightforward to implement due to the off-chain reserves they represent. However, there is no standardized protocol for exercising this power. Pseudonymity complicates compliance with know-your-customer and know-your-counterparty regulations, as data indicates that crypto assets and stablecoins are sometimes used to bypass capital controls and evade sanctions. A fundamental regulatory framework, known as the “travel rule,” is being adopted by more jurisdictions to align virtual asset service providers with traditional anti-money laundering and counter-terrorism regulations. Nonetheless, practical implementation and effectiveness issues remain, especially for transactions involving non-custodial wallets. Different blockchains may not share identical standards for final settlement, which can lead to operational discrepancies and settlement risks. Future developments in DeFi networks must confront these complexities while regulators need to establish effective oversight without disrupting the essential functioning of crypto networks as financial infrastructures. The risks inherent in these systems also exist in traditional finance, where they are typically mitigated through experience, investment, and regulation.
