Ethereum as a settlement layer for financial markets: progress & challenges

Transcript

Morning. Hey everyone. Uh my name is Andrew O'Neal. I am a risk guy. No one likes the risk guy. Always asking what might go wrong, worrying about what might go wrong. Uh but I actually believe strongly in the potential for blockchain technology in financial markets and and Ethereum specifically.

And I really think what is important to enable that that adoption is first and foremost educated conversations around risk and how we can work to mitigate those risks in a robust manner. The way in which I participate in that is that I lead digital assets analytics at S&P Global Ratings. We are an old Tradfi institution been around for 150 odd years. We do uh risk assessments on financial securities, bonds and public markets, funds as well as now assessments on stable coins and ratings on tokenized money market funds.

And so what I wanted to start with was a little bit of context as to why I actually think there is significant potential for the adoption of blockchain technology and Ethereum specifically because we we hear a lot about tokenization as if it's like a self fulfilling prophecy that the number must go up but I think there's actually real reason driving this. When we think about this the current technological state of financial markets, we're talking about technology that has broadly not been updated since the 80s.

This is now changing. Markets are being modernized and they're being modernized in a very specific context. We're seeing significant geopolitical shifts where we're moving away from a uniolar US dollar dominated system towards a multipolar world where there are competing nations may wish to have some control over the systems that they use for their trade payments and even where between friends having all of one's gold held at the Federal uh Reserve Bank of New is starting to be something that some European uh nations are questioning.

So the need for open infrastructure that's secure and credibly neutral is obvious. At the same time, we're seeing the rise of AI. We're seeing transition towards new types of energy. And we're also seeing that a lot of the innovation, a lot of the success stories in those areas are coming from private companies. There was a time when a company would take on a certain amount of success and go public. That is now happening a lot later in a company's life cycle.

More companies are staying private for longer and looking to borrow and finance themselves through private credit markets. They are issuing fewer bonds on public markets. They're probably beyond the capacity of what they can get directly through a bank. They are accessing financing that is coming from specialized investment firms through private credit markets. That provides tailored products that suit borrowers very well, that suit very specific investors very well. But it does lead to a risk of markets fragmenting, of borrowers not being able to find someone to refinance with if their original lender is no longer willing to

refinance now. Solving for the unification of liquidity is a problem that crypto markets and DeFi markets specifically have been thinking about for some time. and some of the infrastructure that we're seeing coming out of that could play a key role in that path. But beyond just unifying liquidity, tokenization also promises to accelerate the pace at which value is transferred in markets and that is really a key part of the early adoption cycle.

To explain that, what does that mean? So when we think about transactions in financial markets today, I'm selling you a bond. I'm going to send you that bond through some intermediary using some IT system that uh that's proprietary to them. And you're going to send me a payment from your bank through multiple correspondent banks before it reaches mine. Two separate steps happening at different times on two different systems.

By tokenizing an asset on a blockchain and bringing the cash leg of that transaction onto that same chain, we enable instant atomic settlement. That means lower waiting times, lower costs, lower inefficiencies, reducing counterparty risk exposures during those settlement times. So that's clearly attractive and we've seen assets being tokenized now for years, but we've not really seen this take off yet. And why is that? So in the earlier talks today, you've heard a little bit about the use of private networks and a lot of early adoption of tokenization has happened in those kind of closed

gardens. So one question is how to link up those gardens. Whether that's moving everything to private markets or more likely building tools to link different networks to public networks and to each other. But you also need agreement on the types of tools you can use for a cash leg for an onchain transaction. There are three broad types. One is a digital currency issued by a central bank uh which might work quite well for transactions between banks who are linked to that central bank.

You have tokenized commercial bank money that again can work quite well for transactions between customers of the same bank but potentially not so well suited for more open networks. Privately issued stable coins, if built in a sufficiently robust way, can help to bridge that gap to more open systems and actually unlock some of the benefits of this because the most effective asset tokenization platform brings no commercial benefit to its users if you don't enable the second half of that equation and bring that cash payment on chain. So when we hear about the Genius Act in the US, that is what's really

going on here. Genius Act is the stable coin legislation that has passed the Senate. Next going to the House of Representatives. That is the big unlock having USissued regulated stable coins that institutions can confidently use and trust when bringing financial products on chain. So what's that adoption going to look like? So we see this playing out in three in three phases over um uh over the next 10 years.

First, the lowhanging fruit, the things that are already happening, collateral mobility. Financial institutions borrow and lend against collateral, most often sovereign bonds. Those are the early issuers of digital bonds that we're seeing in the digital bond ratings that we're assigning. We're also seeing the early adoption of tokenized money market funds that I'm going to get to in more detail in a minute.

And in terms of stable coin payment, the use case of stable coins for crossber payments, removing all of the friction and cost that exists in today's payment systems, I should say yesterday's payment systems is a really straightforward unlock and first use cases for people using uh stable coins. Now, when we start to see companies using more stable coins for payment, they will then have a need to borrow on chain.

And this is where we start to see the use cases for tokenization expand beyond the very safe and boring uh short-term government obligationbacked transactions we're seeing today. And indeed we we're seeing early use cases of uh of this phase 2. Uh so when I put 2027 there maybe I was a bit cautious. Uh but I I I think there will still be it will take a little bit more effort for this to actually scale. Uh I know uh Paul from Morpho is uh is speaking after me. Um and uh there were some interesting developments on the the morpher protocol earlier earlier this year when they worked with Apollo to make uh the a tokenized Apollo private credit fund uh available for for

borrowing uh for investors in that fund. And that's just an example of how for more complex financial instruments uh the um some of the infrastructure of DeFi can actually be used to generate some pretty interesting products from an institutional investor perspective. But we're also going to see the evolution of tokenization as more and more things are coming on chain converge with or converge and intersect I should say with with other technological developments and in particular the rise of AI and how it applies in asset management. So on the investor side of capital markets because as more and more assets are tokenized asset managers will be

building their portfolios on blockchain rails. They will be rebalancing their portfolios using smart contracts. They will be individualizing portfolios for investors using AI agents and using again smart contracts for rebalancing and enabling easier access to alternative asset classes for smaller investors who today aren't able perhaps to access some of the opportunities we're seeing in um uh in in in private companies that are leading some of the growth trends of today's markets.

But I want to focus today on phase one, what we're seeing today. So when I when I spoke at the etc last year, I talked about tokenized money market funds at uh as as being the story of the time. I think 12 12 months on it is still very much uh the main story that we've been seeing on the um on the rating side, but is still very early. And I would say we'll be very early so long as we're still looking at a y-axis here with the letter B rather than the letter T. But still, we've seen 7x growth in the last uh in the last 12 months and some pretty interesting trends within that.

What do these funds enable? Basically, they're backed by boring government bonds. They enable investors to move in and out of those funds quickly on chain using stable coins. So who are the investors? Who's actually buying this? The early investors are actually mainly DeFi protocols and particularly if we look at uh the pickup here in um uh in March and April this year that is primarily driven by uh the Sky Protocol uh formerly known as Maker Dow investing a significant chunk of their balance sheet about I think by now about $ 1.5 billion in these tokenized money market funds. So why are they doing that? If you're familiar with Sky or Maker DAO,

they issue the USDS D stable coin. Part of the mechanism for maintaining the stability of that coin relative to the dollar is that they provide liquidity to to swap UDS for USDC. So holders of USDS can move in and out of um uh of the Sky protocol uh and into USDC. And so what they need to do is provide sufficient liquidity to support that mechanism. They hold some USDC, but they also need to generate yield on the assets that they're holding. So they need safe investment products that they can move out of quickly. Until very recently, they were doing this by investing in T

bills that they held offchain, which indeed are a liquid instrument, but certainly not something that can move at crypto speeds. That's the promise that tokenized funds bring. So, here we're looking at the liquidity mechanism of the Sky Protocol uh comparing the USDC in their PEG stability module. So USDC that they're holding as uh liquidity to support swapping uh for USDS and their exposure to tokenized money market funds. And the really cool thing that this has enabled is that they're able to completely automate the uh management of this liquidity position.

They set their USDC to be within a target range of 20 to 30% of total assets. If they fall below 20%, smart contract sells some T sells some um tokenized money market funds raises USDC. If they're in excess of their 30% threshold, they use the excess to buy some more money market funds. Only having that onchain allows it to be automated, allows it to happen in real time at crypto speeds. Now, this is pretty cool for a DeFi protocol. It is pretty niche in terms of overall volume.

But actually this promises some very interesting applications in much more general corporate treasury management as well as in the liquidity profiles of various types of financial instruments such as securitizations. So this kind of thing gets me really excited. The ability to track this stuff on a dashboard uh is something that as a risk analyst gets me really excited too. um but just an insight into how these funds are being used today. But I started by saying that we really need to have educated conversations about risk. So I wanted to spend some time going through the risk considerations that we see when these um these traditional products are coming on chain.

So starting on the right over here, we've got a couple of investors want to buy this tokenized money market fund. They may be investing on different chains. They may be using different stable coins. They are interacting with a mint and redeem contract on the relevant chain, usually with uh some kind of permissioning enabled to ensure the fund manager meets their KYC obligations. So, they're investing in the fund in stable coins.

The fund manager will use an on andoff ramp provider to swap that for off-chain US dollars and then buy the offchain uh the offchain t bills. When the investor wants to redeem the whole thing happens in reverse the fund manager pay sells the t bills pays the dollars and to to the on-ramp provider and the stable coins flow out to the investor. So, we've got three main categories of risk here.

First, stable coin risks. One of the most important things to note is that all these instruments are still going to be denominated in dollars. There's no such thing really as a fund that's denominated in say USDC. Stable coins are a tool for making payments on a dollar denominated asset. So the way in which these funds are structured is that indeed investors can choose for example USDC as their preferred means of payment but the amount that's owed to them is calculated in dollars. The fund itself is not holding on to any stable coin. Uh it is taking moving that offchain and and

buying T bills. That may change one day if the um uh if uh the US issues their bonds on chain, but for now that's the mechanics. So then you've got the risk of this on an off-ramp provider. Are they are they exposing the fund to any uh price sensitivity? Is there any risk or exposure to that um to the risk of that counterparty going insolvent? Step two, the flow of information between the onchain and off-chain environments. So when an investor puts $100 into the smart contract, how how many shares should they get? If they want to redeem $50 or 50 shares,

how many how many dollars should they get back based on the valuation of the fund? How does that valuation information flow from the fund manager into the smart contract? Is that an oracle risk? Is there a centralized party operating the tokenization platform? Again, this is a case- by case analysis and understanding the dependencies that are involved and what can happen if say there is a interruption in a data feed. And last but certainly not least, we think about cyber risk. We think about the operational resilience of the setup.

We look at the division of roles. um to um address the risk of any particular role being concentrate being um compromised. We look at the security around the wallets that access these smart contracts that can modify these smart contracts. And perhaps most importantly, we look at the underlying chain that is being used uh to support these transactions and how interruptions with that chain would be considered under the documentation of the security that we're writing because this is what it all comes back to. It is you will never get to a situation where you can eliminate

all risk. The question is understanding what are the risks and how can we contemplate different risk scenarios and how a long-term transaction will uh operate in those scenarios. So let's focus on Ethereum and what we need to think about when we're thinking about risk and the use of Ethereum. If we're thinking about an interruption in the chain, if we're thinking about the inability to actually finalize a transaction on Ethereum mainet, a key consideration is

could there be a sufficient number of validators that are offline at once that could prevent the ability to reach consensus and reach finality on chain. that number one third, start thinking about different thresholds a bit higher than one third. Um or much more serious things might happen. But already if you have a third of validators compromised, you're in a situation where until that's resolved, you cannot achieve consensus. So that's already the first concept to look at. We look at the concentration of stake, who's running validators. This is actually a picture that's improved since last year. Um,

concentrations in Lido and um, and Coinbase in particular have decreased. Now, spend a whole talk talking about whether you should really think about LIDO as a single exposure. Probably shouldn't, but there is still a commonality of um, at least smart contract risk that needs to be uh, needs to be considered there. And then we look at clients, execution clients, consensus clients that the validate validators are operating. What happens if there's a bug in one? Go back to May 2023. This was one of the very rare um interruptions in um uh in Ethereum achieving finality because of a client bug. Now this lasted

a few hours but the reason that it's a problem is that if you have the same number of or sorry if you have a large number of validators that are using a client that happens to have a bug in it then you are exposed to the even if you have diversification of the underlying validators you have the risk that they're all off a line at once because they're using the same software. Now you can look at decentralization in many ways but it's key to understand that from Ethereum mainet perspective decentralization is the way in which risks get mitigated and institutions looking to use Ethereum mainet need to understand how to monitor that need to have a plan for what what to do

if someday consensus client concentration reaches 100% again or 75% % of validators are being run by the same company. These are risks to monitor. They're not risks that can be excluded. But for many use cases, Ethereum mainet may not be the most optimal solution. Whether that's for throughput, for privacy solutions that uh that Paul was talking about just before, L2s may provide a better fit for some use cases.

And when we're looking at risk in L2s, it's not really about decentralization because L2s by design are a more centralized construct than L1's. You may be familiar with the L2 beat platform and they're their risk pie charts uh that can compare different L2s. If not, check it out. Um, this is just a way to start thinking about the different risks that we see in L2s because what are we thinking about?

Ultimately, the L2 to a point benefits from the security of Ethereum mainet. Transactions are being sequenced on the L2 and and sent by a proposer back to Ethereum mainet. there's a validation of the state of that network. The data of the network is made available. How? The key question that we're looking to address here is if there's a central entity performing a key role in this setup, a centralized sequencer, a centralized proposer. the centralized sequencer, centralized proposer being the same entity, a core development team of you know five

people who might have another brilliant idea and go off and uh and do something else. How do users of the chain manage to continue its operation if that central dependency becomes a risk? If that entity is no longer able for whatever reason to perform the role that they're doing. So are we comfortable that the state of the network is valid? Are we comfortable that people can or users of the platform can permissionlessly operate the sequencing can permissionlessly bring transactions back to the L1.

The example here of base there's one uh one weakness highlighted by by L2B which is just around the um ability to exit if there is an an upcoming upgrade. So, a window of time during which users can uh can upgrade. But that's that's an important concept as well. The the idea that you're using a smart contract through this L2 that can be changed by someone that someone has the keys to. So, how do you get out if it's going in a direction you don't agree with? Now, there are two types of ways in which the validation of these networks is achieved. either through optimistic setups or zero knowledge setups. The

optimistic setups are I will say from a very non-technical background simpler. Zero knowledge is very advanced cryptography and is harder work. So to date most of the adoption has happened uh on the optimistic side but progress is ongoing on the zero knowledge side and that may be where we see adoption from institutions or companies who are more concerned with privacy. Um you know I showed you the Sky Protocol's full liquidity picture um a few minutes ago.

I don't think a bank would be particularly appreciative of me standing here and showing you a live picture of their um uh of their liquidity position. Paul was talking about how companies need to protect the information about their supply chain, about their financial position, the prices they're paying. So transparency can be good. It's not necessarily suited for every use case. So we've seen banks announce that they're working on L2s. We've seen JP Morgan deploy their new tokenized deposit product JPMD on base because these L2s provide some of the openness of crypto. They provide most of the

security of the Ethereum network and they also come with centralization that can be identified and mitigated. Now, I don't know what JP Morgan's plan is if there's an issue with Bass, but it's recreating a situation that is more comparable to the existing world where you can never exclude operational risk. You can never exclude the risk of a system going down, but you can write contracts that define who is responsible for remediating a situation that hasn't worked out. Those contracts are underpinned by a legal system and that is the context in which

institutions operate and institutions will seek to adopt these tools. So it's not all Ethereum. Other platforms are emerging that might be more permissioned, might be more centralized, may still meet the needs of financial institutions. It's very early days for all of them. Ethereum has a significant head start in terms of the liquidity that's available there today. But what's really going to drive adoption and really help Ethereum adoption in my view is honest informed conversations about risk and about how

risk can be captured within the context of a financial market transaction. So with that, happy to take any questions [Applause] or insults. Last last year someone had an insult. Um yeah, I think we've got one here.

Hi, thank you for the presentation. Actually, I just saw the the last couple of minutes of it, but I'm interesting uh interested in learning what do you think about you mentioned Ethereum already have some traction having a lot of liquidity on there, lots of real world assets tokenized. Um, do you think for institutions Ethereum looks much more safer than other like alternative blockchain networks when it comes to tech operational risks or just risks in general like for example Solana or some of the yeah the the new wave of Ethereum killers?

I'm not sure I like the term Ethereum killers. I think when we when we looked at the I guess the funds that we've rated, we've seen them issued on more than one chain. uh but with Ethereum being at least the largest initial area where where activity has happened. So I think institutions will look to meet investors where they are, they're not going to be ideological about that. At the same time, you have to know that a lot of the private networks that institutions built were built to be EVM compatible. That wasn't by accident.

When you're when you're thinking about operating systems in in an institution, you don't want necessarily to develop something that's entirely proprietary, that's based on some coding language that you've got one clever employee who created himself. You want to you you want to be able to dip into the talent that's out there. You want to have a wide range of available developers, for example, who are um well-versed in the technology and and so able to come in and bring improvements to your to to to your institution or even just replace the person you have who's who's left.

That becomes a lot harder to do if you're doing something that's highly specialized and based, you know, based based on your own technology. That is why a lot of the early adoption I think as of last year was about half um of the um the use cases done on private networks were actually done on EVM compatible networks. Hey, thank you so much for the talk. This was great. wondering are you planning on providing some ratings for different assets and how are you currently supporting institutions in making better informed decisions? Thank you.

Sure. So we so we we rate tokenized money market funds and digital bonds. They're the first kind of traditional things that um that we've rated um on chain. So for in terms of digital bonds uh we have I think about 20 uh issuances outstanding. most of them uh from government issuers. We have two ratings on tokenized money market funds and then we also publish ratings on uh sorry not ratings stability assessments on uh stable coins. So we published reports on 12 of the largest stable coins mostly US dollar pegged uh but um uh but also a couple of of euro ones and both centralized and and decentralized.

That's why we're quite interested in the monitoring of uh the Sky protocol in particular um as as we we publish an assessment on its um its stable coin uh USDS die. So that's the beginning and then you we're part of project guardian which is a kind group of um of institutions led by the monetary authority of Singapore that's looking to um uh you know establish global standards for the use of blockchain technology in financial markets. Uh so there's a report published from that at the end of last year and u and I'm sure more to come.

Think we had one over here. Oh no. Oh sorry. Um no more time for questions I'm told. So thank you very much and enjoy the rest of your day. [Music] [Music]