Public vs. private blockchain networks

Tokenization opportunity

Tokenization was first successfully tested during ICO (Initial Coin Offering) mania in 2017 and ‘18. Start-ups used ICOs to raise money by launching a token on Ethereum network and selling it to the public. Different crypto projects raised about USD 12bn during these two years. Currently tokenization is a fancy word to explain regulated ICOs (token with legal rights to the underlying). It has emerged as the most propelling use case of blockchain technology in the financial services. In its most conservative scenario, Boston Consulting Group estimates that 16 trillion of world assets will be tokenized by the end of this decade. Tokenization is a process of creating a digital representation of an asset on a blockchain. Assets can include traditional securities like stocks, bonds, investment funds, private equity; real world assets (RWAs) such as real estate, commodities, art, collectables; or even currencies/money in terms of stablecoins, tokenized bank deposits or CBDCs. Considering the size of cross border payments of USD 190tn, global bond market of USD 128tn, public equity market of around USD 100tn, private markets of USD 12tn, potential for tokenization is enormous.?

I have already written about the importance of Stablecoins for tokenization to really pick up pace. But there is another important question to answer: where are all these tokens going to be booked? Crypto investors are currently speculating on Ethereum, Solana, Avalanche, or any of the newest blockchains like Aptos, Sui or Near. Further, due to scalability issues with Ethereum, several Layer-2-networks emerged such as Polygon, Arbitrum, Optimism or Starknet. At the same time, private or enterprise blockchain networks are not even on the radar of investors. It is not an easy task to pick up the right technology and the right approach.

When designing a blockchain network, developers are facing a significant challenge, called blockchain trilemma. It is a trade-off between three main aspects of the blockchain technology: security, scalability and decentralization. For example, if a blockchain design is prioritizing speed and scalability, it is mostly making sacrifices on decentralization. Therefore, there is currently no single blockchain network fit for every purpose and use case. Bitcoin network is the most decentralized and censorship resistant. With a new blocks every ten minutes, it is slow by design giving all nodes time to align on the status of the ledger. However, due to this reason it is not suitable for micro-payments, which needed to be designed on higher layers and side-chains – like the Lightning network. Some other networks are significantly faster and can handle thousands of transactions per second. However, these are more centralized with one core team responsible if something goes wrong. Accordingly, no single blockchain network can be appropriate for all applications and use cases.

However, let’s take a step back and look at the different types of blockchains and ask the question: private or public, permissioned or permissionless?

Public and private blockchain networks

Typically, blockchains can be public (e.g. Bitcoin or Ethereum) or private, run by a single company or consortium of companies. The classification is based on entities controlling the network and the network's configuration, meaning who has access to the network, can deploy smart contracts, read and submit transactions, and participate within the consensus mechanism.?

Public blockchains are mostly permissionless and publicly accessible without a need to ask anyone for a permission. One can create a new token, transfer such a token to anybody else, validate transactions and generate new blocks. Transactions are broadcast to every node and every node thus keeps a record of transaction history. Public/permissionless blockchains are governed by computer code, which can be freely downloaded from the internet. If technical requirements are respected, no further permissions are required. Public blockchains can also have a layer of permissioning, which restricts access to smart contracts or dealing with specific tokens.?

Alternatively, private blockchains are permissioned, meaning that only authorized entities may participate in the network. The network administrator gives permissions and manages access rights. Such networks usually have a pre-defined set of well-known validators. Some of the most known permissioned blockchains include Hyperledger Fabric, Hyperledger Besu, Quorum and Corda.

Benefits and challenges of public and private networks

Public networks offer numerous benefits. They are randomly distributed around the world, thus decentralized and more stable. The Bitcoin network, for example, does not have a single point of failure, because no single entity controls the majority of the network. Stability come from the reluctance to accept random changes to well-established economic incentives. For example, it is remarkable how the Bitcoin network has reorganized following the “mining ban” in China, where 50 percent of the network’s compute power was switched off overnight and founds its way to more favorable jurisdictions over the course of few months, or how the Ethereum network has managed the transition from proof-of-work to proof-of-stake, without any major interruption.

Second, the permissionless nature of public networks is a catalyst for innovation, especially with regards to the Ethereum network which saw the emergence of groundbreaking projects, as programmers around the world freely deployed applications on the network. Since all applications are running on the same network allowing interoperability, they are seamlessly composable (a feature known as “money lego”). Imagine being able, in traditional finance, to deposit cash into a long-term saving account with one bank and at the same time use that deposit as collateral to borrow short-term cash from other bank, while accruing interest.?

Companies face several challenges to use public permissionless blockchains. First, they do not fully control governance and consensus. When sharing a network with other parties, companies are subject to the same rules and there are number of parameters that they would need to agree on. Any change to the blockchain requires broader consensus by the majority of participants. Therefore, it takes a big leap to move away from centrally managed databases to distributed public networks. Second, it also impacts their proactiveness in complying with regulation. Centralized private networks are much easier to customize and change policies as required. Thirdly, someone might use the network or any application for things that are not anticipated. Somebody might find a bug and exploit it. This is not a theoretical concern. This happens repeatedly on public networks.

The fourth challenge is related to privacy. Public networks are fully transparent meaning that anyone can open a blockchain explorer and monitor execution of transactions, wallet holdings, and balances. Some public entities even disclosed that they are associated with a specific wallet to encourage transparency and auditability. Although regulators, law enforcement agencies and general public would certainly welcome more transparent financial markets, banks and other intermediaries are currently obligated to respect banking secrecy and offer strong privacy to their customers.

Further, public permissionless blockchains are mostly pseudonymous, meaning that participants are not disclosing their real-world identity (only a public address with its full transaction history is disclosed). Accordingly, when using public networks, regulated financial institutions are required to use an additional “permissioning” layer, which allows only identified (KYC-ed or whitelisted) participants to access and interact with their token or application. Numerous initiatives around the world are trying to solve this challenge by introducing a digital identity (some initiatives include an EU Digital Identity Wallet, from which open code has recently been published on GitHub; Linux’s Open Wallet Foundation etc.).

Finally, private networks are less decentralized requiring less synchronization across distributed nodes, thus enabling faster and more scalable networks compared to public alternatives.?

History lessons and emergence of the internet

Major underlying protocols that power the Internet are open and permissionless, like TCP/IP (Transmission Control Protocol and the Internet Protocol), HTTP (Hypertext Transfer Protocol), SMTP (Simple Mail Transfer Protocol), RTP (Real-time Transport Protocol) and FTP (File Transfer Protocol). They are open technical specifications, like human languages; anyone is free to learn them, write anything in that language and share it.?

When Tim Berners Lee had the idea of sending virtual pages filled with styled text, images, and interactive links over TCP/IP (i.e. when he invented the Word Wide Web), there was no central authority he needed to approve the project. He could write the HTTP standards and protocols for displaying websites and anyone with a TCP/IP capable server or client could run freely available HTTP-based software (web-browsers and web-servers) to read or publish these new rich web pages.

However, the internet is still permissioned on different levels. Firstly, Internet Service Providers (ISP) serves you a connection/access to the internet. Each device gets a pseudonymous IP address to be able to connect to the internet. Accordingly, ISPs are able to connect your real identity with your IP address and determine the exact location of each IP address. Secondly, ISPs and your device need to trust a DNS (Domain Name System) provider like Google to translate your search request into an IP address of a server where the requested content is stored. Additionally, all secured internet traffic happens with the use of digital certificates issued by Certificate Authority providers, which require trust from operating system vendors and their browsers, thus not permissionless. As a result, it can be said that the Internet is a public network with permissioning of some key resources.

Before the internet received adoption and scale, computers were first connected within private networks of universities, companies and the military. Companies, for example, wanted to connect their offices and databases into one internal network – an ‘intranet’. What they had created were silos of different private networks. Only once the TCP/IP protocol emerged, did the internet start to scale connectivity. Today, private and public blockchain networks operate in silos as well. They are not interoperable at internet scale. Different blockchains do not talk to each other. You cannot transfer bitcoin to the Ethereum network to deploy it within a smart contract. In that regard, blockchain technology development is still pre-TCP/IP when compared to internet development.

View on the market

Blockchain technology is evolving pretty fast. Currently there are around 2.5M different crypto tokens representing experimentations with various blockchain use cases. However, large number of these tokens will not survive and see adoption. Therefore, when following the timeline of the internet development, the blockchain industry is still in a period prior to burst of the dot-com bubble. But what will pop the bubble? I think it will be regulation and utilization of some blockchain networks, which would leave other blockchains behind.

Tokenization use cases require blockchain that supports smart contracts. Competition in this segment is huge, where newer, faster, and better blockchains are constantly emerging. Currently there are around 30 smart contracts platforms within the top 100 tokens and not all of them are useful. By looking at the Ethereum network, there are around 1200 relevant tokens existing on the network (ERC-20 tokens). Around 50 coins have market cap above USD 1bn. By comparison, there are more than 50 thousand instruments listed on the Nasdaq exchange. Within Nasdaq listed stocks only, 2614 have a market cap above USD 1bn (without counting other financial instruments). Other public blockchains are even smaller than Ethereum. Solana, for example, has only 13 coins with a market cap above USD 1bn, and Avalanche currently has none. Thus, it can be concluded that public blockchain are yet to see a wider adoption.

On the other side, public blockchains are also getting competition from regulated private blockchains, which are accelerating development and not receiving appropriate attention. J.P. Morgan is operating Onyx, which is built on Consensys’s Quorum. At its core is the JPM coin (digital representation of cash deposits) allowing clearing and settlement of transactions around the clock. It is already processing USD 1bn of transactions daily. Siemens is their first client to use programmable payments, allowing automation of their treasury (e.g. to top-up accounts in case of shortfalls, respond to margin calls) and thus optimize working capital. Applications built on top of Onyx are a Digital Financing app, which uses tokenized cash and collateral for Repo transactions allowing instant settlement and automated interest accrual, as well as a Tokenized Collateral Network (TCN) enabling investors to utilize assets as collateral. BlackRock and Barclays have already tested TCN when BlackRock tokenized shares in their money market fund and pledged them as collateral with Barclays for a derivatives contract.?

SIX Group has launched SIX Digital Exchange (SDX) in Q4 2021. SIX Group has a unique position because it operates within the Swiss payments system (RTGS SIC), the main stock exchange, Central Counterparty and national Central Securities Depository, thus both payment and securities clearing and settlement system. Their blockchain platform is based on Corda blockchain and it enables automation of the entire life cycle of securities/ digital assets – through issuance, trading, settlement, and custody. SDX aims to offer access to digital bonds, private and public equity that are settled against tokenized CHF and EUR on-chain. In Nov ’22, UBS used SDX to issue the largest ever digital bond of CHF 375M, which was also dually listed on the SIX exchange. In Feb ’24, the City of Saint Gallen was the fourth Swiss municipality to issue a digital bond on SDX, in the amount of CHF 100M. Previously, the Canton of Zurich, city of Basel and Lugano issued four bonds of around CHF 100M each. Uniquely, these transactions are the first ever use of Wholesale Central Bank Digital Currency (wCBDC) for the settlement of digital bonds. SDX is also participating in several Sandbox projects with the Swiss National Bank and the Bank of International Settlement to use SNB’s issued digital Swiss franc.

HSBC is running a private, permissioned blockchain ‘Orion’, which was tested by Hong Kong Monetary Authority (HKMA) to issue a USD 770 million-equivalent multi-currency digitally green bond on behalf of the Hong Kong government as well as EIB to issue GBP 50m blockchain bond. Other financial institutions are active as well and have built their own solutions covering specific use cases for tokenization, trade finance etc.?

Regulated consortium blockchain networks are launching as well. Singapore based interbank payment system Partior was founded in 2020 by JP Morgan, DBS Bank and Temasek. In Nov 2022, Standard Chartered led the Series A fundraising, and involvement of Deutsche Bank as well as Japanese Sumitomo Mitsui Financial Group has been rumored. In Dec ’23, JP Morgan went live on Partior after receiving approval from the United States’ Office of the Comptroller of the Currency (OCC). Partior is offering global clearing and settlement of payments and FX among participating banks. Other innovative use cases are being explored as well. In the UK, Fnality payment system went live in December ’23 with the initial participation of Lloyds Banking Group, Banco Santander and UBS. Fnality has already been designated as a systemically important payment system in the UK. It enables banks to settle transactions with each other on blockchains using tokenized money in the form of synthetic wCBDC by using Fnality’s omnibus account with the Bank of England.? Fnality has global ambitions and is also expected to launch EUR and USD settlement. The Regulated Liability Network (RLN) is another cross-border initiative, which conducted two proofs of concept (PoC).? In Nov ‘22, the New York Fed, Mastercard, City and Wells Fargo, among others, tested interplay of wCBDCs and commercial bank deposit tokens on the same platform. UK PoC took place in ’23 and tested retail CBDC (rCBDC) with the involvement of HSBC, Barclays, Lloyds, Santander and Visa.??

Financial institutions are also testing public blockchains, and some have already built marketable products based on public networks. For example, Societe Generale’s Forge has issued a stablecoin on the Ethereum blockchain and listed it on crypto exchange Bitstamp. It runs a bond tokenization and money market platform based on Tezos and Ethereum blockhains. The European Investment Bank has used their platform to issue a EUR 100m blockchain bond on the Ethereum network. Another example is project Guardian, where the Monetary Authority of Singapore (MSA) under the framework of Bank for International Settlements (BIS) has mandated a number of global banks to explore public blockchains for tokenization and DeFi.? For example, JP Morgan, together with Apollo, tested interoperability between Onyx, a permissioned subnet on Avalanche and Cosmos based Provenance blockchain. Overall, 17 financial institutions are testing public infrastructure under project Guardian, and their PoCs are mostly utilizing the Ethereum and Avalanche networks.

In summary there is a lot going on and regulated financial institutions are in parallel building their own infrastructure as well as testing public infrastructure too. However, all these initiatives are still lacking scale. They mostly involve few test cases or still lack significant volumes. Additionally, initiatives have taken place in silos and mostly without access to central bank money.

Blockdeamon has done a survey asking 92 firms which protocol they are using for tokenization. It is not surprising to see that private networks like Hyperledger Besu and Private Ethereum are leading the pack. Private Ethereum means that companies are copying the open-source code and adjusting it for their in-house use and selecting their own validators. Such setups most likely do not use Ether token (ETH) to incentivize validators.

Conclusion

We cannot say with certainty which blockchain network is going to win in the long run. It is still early to even guess whether it will be public or private blockchain that becomes the preference for the tokenization and other use cases. However, at this stage it is quite clear that it would not be one single blockchain, but likely several.?

HKMA and other representatives from the financial services industry are not ruling out the use of the public infrastructure. They are pushing back on the BIS, which sees high risk in public blockchains and might consider applying unfavorable balance sheet treatment for tokenized assets on public blockchains. In addition, BIS has recently come up with the concept of the Unified Ledger, the idea that multiple blockchains, each with a specific use case, might coexist, – e.g., security settlement, trade finance, NFTs, AI etc. These blockchains should be interlinked by application programming interfaces (API layer) to ensure interoperability. Thus, unified ledger would create a network of blockchain networks, most likely involving public as well as private networks.

Only once there is a considerable volume onboarded on the smart contacts platforms, will we see where the volume gravitates to and which blockchains are gaining network effect. If we look at the internet, there should be no more than 10-15 main protocols. What will happen with all the others? They will be forgotten, like many other tokens that fell out of fashion. Historic snapshots from the CoinMarketCap are always a good reminder of how quickly technology trends may change. Just make sure that you do not end up holding the bag.