Traditionally, financial market participants exchange electronic messages to coordinate financial transactions, and each institution updates its own books and records based on these messages. The final record, against which the accuracy of each institutions’ own records is assessed, is maintained by a central party. The integrity of the system is based on trust in that central party.
Public, permissionless blockchains are upending that order. Blockchain was initially created to provide a means of transferring value peer-to-peer, with integrity maintained by participants, rather than trusted intermediaries. This was intended to create a transaction network outside the control of nation states that is resistant to censorship.
This is clearly a radical proposition, and one that would not be likely to find much favour with incumbent intermediaries and governments. The challenge of drawing a regulatory perimeter around a public blockchain, where anyone can become a validator and anyone can propose transactions, requires a profound rethinking of how supervision of financial markets works.
Permissioning: a compromise too far?
Private blockchains have emerged as an attempt to create a less radical version of distributed ledger technology. Permissioned blockchains, which restrict participation to an agreed list, seem to offer an opportunity to enjoy the benefits of blockchain architecture without introducing the challenges that public, permissionless infrastructures entail.
If blockchain technology is so promising, and if its development is primarily held back by regulatory challenges, and if private blockchains with limited participants seem to create an environment more easily supervised by traditional methods, then it follows that private blockchains should have taken off.
But adoption remains patchy at best, and this technology is not exactly new. Private blockchains have been floating around the edges of the ecosystem for upwards of 10 years.
Official institutions are pursuing projects built on the concept in various guises. Project Agorá, an example of the Bank for International Settlements’ unified ledger concept, and the Regulated Liability Network are notable examples, while SIX Digital Exchange, a Swiss blockchain-based exchange and central securities depository, is one of the few to have advanced beyond proof-of-concept stage.
While these projects have undeniable support from some incumbents, the benefits promised by public blockchain are apparently enticing enough to win admirers even in the communities it was designed to shut out.
Public sector support
Ulrich Bindseil, director general of market infrastructures and payments at the European Central Bank, and a confirmed sceptic of bitcoin and cryptoassets, nevertheless has written of the promise of public blockchains to deliver immediacy, omniasset capability, programmability and disintermediation, while pointing out the limitations of permissioned blockchains.
In a report for the European Commission entitled Enhancing Financial Services with Permissionless Blockchains, Fabian Schär, professor of DLT and fintech at the University of Basel, said that: ‘The success of [decentralised finance]… led many organisations to recognise that this technology’s true potential is realised only when the blockchain functions as a broadly shared ledger.’ Schar highlights that the key advantage of public, permissionless blockchains is their neutrality, since decentralised governance creates an ‘open, neutral, and competitive base layer… a network without gatekeepers, [that] mitigates rent extraction opportunities and allow[s] anyone to validate that the transactions have been executed correctly’.
And, of course, there is the Donald Trump administration’s full-throated endorsement of cryptoassets, although that comes packaged with talk of a bitcoin reserve that seems designed to enrich bitcoin holders and the issuance of meme coins that seem designed to enrich Trump personally.
What makes public blockchains special?
It is important to examine the qualities that make public blockchains different and preferable to permissioned versions. The first issue is governance. Permissioned blockchains by definition give certain institutions the authority to determine who can participate in validating transactions on the network. This is a position of immense power determining the governance arrangements for who can control what can become a thorny issue. The existence of privileged participants can hurt competition and entrench incumbents.
The second but related issue is neutrality. Private blockchains can be shut down and the transactions that take place on it can be reverted. In some cases, this can be a desirable functionality, but some feel it compromises the integrity of the blockchain.
Third, public blockchains come with a robust developer community and base of participants. They are built on open source, standardised architecture. Standing up new private chains for new products means having to recapture the resilience benefits of a network every time.
Fourth, there is composability. The siloed nature of traditional finance means that interactions between different types of assets and the systems that hold them and govern their transactions are limited. In decentralised finance, the shared base layer enables a much more comprehensive integration of various functions from different participants.
Finally, we have atomicity: ensuring that a transaction cannot be executed unless all components of it can be completed. Long and mismatched settlement windows in some traditional financial markets means that market participants must rely on intermediaries like central counterparties, CSDs or escrow arrangements in order to mitigate settlement risk. This risk requires collateral, which ties up valuable liquidity. With a single base layer, settlement can take place on demand on an atomic basis. When multiple ledgers are involved in a transaction, this requires solutions like synchronisation triggers and hashed timelock contracts.
Not ignoring the risks
Regulators are understandably wary of public blockchains and their integration. There is a tendency to compare public blockchain protocols to an imaginary standard of perfection, rather than the flawed but functional status quo. This is understandable. Even if the status quo is imperfect, it tends to be flawed in ways we understand and can position ourselves to mitigate. A new system can be flawed in new and exciting ways.
But regulators need to create an opportunity to properly assess those risks and mitigate them. Many of the issues once conceived of as potentially fatal risks to using public blockchains can be mitigated through use of layer two solutions. One important example of this is that, while anyone can become a validator on a public blockchain, layer twos can place limitations on who can hold tokenised assets, allowing public blockchain transaction networks to implement know-your-customer and anti-money laundering checks and comply with sanctions.
Similarly, while public blockchains are famed for the fact that their transactions are visible to the public, this can also be mitigated through privacy-enhancing layer two solutions. The Basel Committee on Banking Supervision’s prudential rules on cryptoasset exposure appear, at present, to treat public blockchains as markedly more risky than private blockchains.
When these rules come into force in January 2026, it will spell the end for banks’ work on tokenising securities on public blockchains. Perhaps investigation will show that this is the correct position but, given the possible benefits and the level of support from official sector policy-makers as well as those in traditional banking, the industry is owed a thorough and clear exploration of the risks.
Lewis McLellan is Editor of the Digital Monetary Institute, OMFIF.
This article featured in the March 2025 edition of the DMI Journal.
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