The EU: Public blockchains for financial services

Last week, I came across an interesting paper published by the European Union about the potential benefits of public blockchains. You read that right – a sprawling and conservative governing institution is tentatively suggesting that public blockchains be used in regulated markets.

The key idea recognizes that financial onchain development will largely be on private distributed ledgers, but posits that the best connector of these “silos” will be a public blockchain.

Over the past few months, the BIS, the IMF and several other consortia as well as tech solution providers have been talking about the need for either a “unified ledger” (with everyone using the same technology, extremely unlikely) or a connecting layer in the hands of the market regulators. The problem, as the paper’s author points out, is that a centralized connector introduces new risks, whereas a robust, decentralized and transparent public solution can deliver not only greater trust, but potentially also greater utility through its broader scope and flexibility.

Of course, there are risks inherent to public ledgers, but the paper offers an entire section on mitigating policies. There is also still a deep misunderstanding in traditional finance of the properties of public blockchains, with many focusing on advantages that don’t exist. To compound the frustration, many still mistakenly assume that the traditional definition of the term “transaction” applies in the distributed ledger world.

The author lays out in easy-to-understand detail how the main benefit public blockchains deliver, is that of distributed governance. This cannot be replicated either in traditional finance or private blockchains. Programmability, automation and efficiency, characteristics widely associated with distributed ledgers, are not exactly absent in traditional systems. What is absent is distributed governance that is open and transparent. Focusing on this feature highlights the appeal of a public blockchain as finance’s “base layer”.

In this role, a public blockchain will prevent any one entity from dominating the underlying technology to the extent it can influence its function; in theory, this should prevent monopolistic consolidation and promote competition.

What’s more, a permissionless connector will foster interoperability and therefore more technological experimentation. If an entity is not concerned with achieving a large network size, since that can be achieved through a connecting script, it will have greater scope to experiment with features and functionalities. It could also lead to greater “composability”, in which services can test combinations even across private chains.

The author recognizes that public blockchains don’t eliminate all governance issues, and that they could give rise to new ones. One is, of course, regulation; but he points out that, while public blockchains themselves can’t be regulated, entities can. The users of the public blockchain – be they issuers, service providers or investors – could meet compliance requirements at the connecting level.

The document also covers transaction finality (possible on public blockchains), forks (problematic but manageable), programmability (not exclusive to blockchains), privacy (degrees of which can be added as a layer) and whole lot more.

It’s a good paper, thoughtful and easy to read while being both technical and conceptual. This is not surprising given that it was written by Fabian Sch?r, a professor of digital finance at the University of Basel and co-author of a book on bitcoin, blockchain and cryptocurrency. He’s been writing insightful papers on various aspects of the crypto ecosystem since 2015. This year alone, he’s also published research on Ethereum governance, land valuation in the metaverse, and how to regulate DeFi.

He’s a researcher, not a politician, and he is one of those rare individuals with a deep understanding of both traditional finance and the potential of distributed ledgers.

What is surprising is that this was published in the name of the EU’s Directorate?General for Financial Stability, Financial Services and Capital Markets Union. It’s enough to make me feel ever-so-slightly more hopeful that the European regulators can seize the opportunity to re-think markets, drawing on the deep well of intrigued talent, harnessing the momentum of interest from traditional finance, wrangling official support for more experimentation at the private and public level, and eventually filling the need for a common bloc-wide capital markets technology.

True, it’s just a paper that only reflects the views of the author, and the EU has published many of those. But it’s not nothing, either.

(This is an excerpt from my Crypto is Macro Now newsletter, a ~daily publication where I look at the impact of crypto on the macro landscape. If you’re not a subscriber and you’re interested in seeing beyond the crypto impact noise, I hope you’ll consider becoming one!)