Financial processes have always been tied to infrastructure. From bills of exchange to mobile banking, economic participants have relied on technology to innovate over time to achieve greater efficiency. As technology improves, financial infrastructure tends towards continuity and immediacy, achieving the desired outcome – typically the transfer of money and assets right away.
Higher computing power and modern communication power can only do so much to remove friction. At a certain point, combining it with changes to the core architecture of financial interaction can make a difference. Blockchain technology and public crypto networks can enable time structures and novel financial products that are difficult to imagine in traditional financial architecture.
Omni-asset capability
Most crypto networks are designed to handle an infinite variety of assets within a single settlement system by transferring arbitrary stores of value called tokens. These tokens can have native value or be anchored by a convertibility promise, including for an asset that lives off chain.
Most traditional settlement systems are only used for a single asset (Fedwire for wholesale dollar payments), a category of similar assets (National Securities Clearing Corporation for US equities) or a pair of asset types (T2S for securities and euro payments). There is, however, no universal technological reason for the settlement of different assets to take place on different networks.
On the other hand, there are practical, legal, regulatory and even geopolitical reasons that make the move to omni-asset platforms challenging. Sometimes, incentives for incumbents to desire greater integration may be missing, since fragmentation may support profit margins.
Bringing multiple assets onto the same ledger can offer a slew of further benefits, including the elimination of Herstatt risk and a simplification of settlement, or removing delays based on limited or mismatched operating hours.
Higher speed and lower cost
The crypto industry is evolving to offer faster and cheaper settlement, either by improving the infrastructure of a single network or by creating a modular system where lower-value transfers happen on layer two solutions that settle periodically on a chain like ethereum.
Regardless of the approach, there is a likely end state where payments can become instant, continuous and with a very low cost – including for stablecoins, or tokens tied to fiat currency. Payments controlled by smart contracts can execute a number of sequential transactions, effectively simultaneously. With this kind of infrastructure, products like ‘flash loans’ can be offered. Flash loans are uncollateralised loans that are taken out and repaid in the same transaction and can be useful for short-term activities like arbitrage. Borrowers submit a list of activities to conduct with borrowed funds, ending in repayment, so the loan is only issued if repayment is certain.
In a public blockchain architecture, this can enable interactions between different financial solutions, allowing a more profound degree of integration, known in the industry as composability.
Disintermediation: cutting both ways
Providing immediate settlement counters some of the need for intermediaries by removing the batch processing and settlement delays that require offsetting by intermediaries that shoulder the counterparty risk such settlement models entail. Fewer intermediaries could mean faster settlement time, greater transparency and lower transaction costs.
However, intermediation provides benefits beyond settlement. In particular, it solves the coincidence problem, making two-sided markets. It also provides expertise, efficient allocation of credit and market access for less sophisticated participants. In decentralised finance, assets can be pooled via smart contracts in order to fulfil this role without an intermediary, but relying on software for this role does create a vulnerable honeypot.
It is also important to note that crypto networks today have several orders of magnitude less capacity than traditional payment systems. One possible solution for addressing this is the creation of layer twos, which effectively create a netting layer, providing much of the functionality of intermediaries, improving liquidity, privacy and transaction capacity without creating a new agent.
Permissioned blockchains
Permissioned blockchains can also offer greater capacity than their public counterparts. Limiting participation to a small group of known entities can overcome challenges of speed and privacy, as well as some regulatory hurdles. The Bank for International Settlements’ unified ledger concept, as well as the Utility Settlement Coin, the Regulated Liability Network and Global Layer 1, aims to improve payments and settlement using permissioned architecture, granting access only to regulated intermediaries.
But despite a decade of exploration, it remains to be seen if any permissioned network could live up to its promise. One drawback of any permissioned ledger is the need to codify important external considerations such as participation, ownership and control. Another drawback (and in some situations advantage) is the lack of platform neutrality. A permissioned system could always be halted, reversed or shut down.
It might be argued that a blockchain that can be turned off or reverted is little more than a complicated database with a lot of cryptographic bloat it does not need. Public networks don’t have this problem. The property rights of tokenised assets on a public network are directly tied to the fact that nobody is in charge.
Mitigating risks
Public crypto networks bring their own risks, which fall into five categories: legal risks, network governance, technology risk, illicit activity and settlement risk.
Legal risks can arise in particular in cases of cross-border transactions when it is unclear that asset holders have an enforceable legal basis to own the assets they hold. Governance of a network without executive authority is challenging. On-chain governance token-based voting is vulnerable to low turnout, collusion and bribery. Other solutions require off-chain coordination, which can be chaotic, particularly in emergencies.
Technologically, DeFi solutions remain vulnerable to code bugs, exploits and robust linking of off-chain data to smart contracts, known colloquially as the ‘oracle problem’. However, it is worth acknowledging that the largest DeFi solutions on ethereum have not experienced a major breach in years, despite having tens of billions of dollars in user assets.
Public crypto networks don’t offer any kind of error or exception handling – doing so would violate the desire for decentralisation and neutrality. This design might be desirable for native cryptoassets like bitcoin, but unrealistic for other digital assets. Most stablecoin issuers already have mechanisms to freeze, confiscate or destroy tokens – the fact that tokens only represent a claim on an off-chain reserve make this ability easy to implement. But there is no set standard on how this power should be exercised.
Pseudonymity poses a challenge to know-your-customer and know-your-counterparty laws. Data suggest that cryptoassets and stablecoins are used in the circumvention of capital controls and in sanctions evasion.
A key pillar of regulation would be the ‘travel rule’, which is being implemented by a growing number of jurisdictions and which applies to virtual asset service providers engaged in virtual asset transfers. It aims to bring the crypto industry in line with the traditional financial industry’s anti-money laundering and countering the financing of terrorism rules. However, there are questions about the practical implementation and effectiveness of the travel rule. Moreover, payments between two non-custodial wallets are not directly covered by it.
Not all blockchains use the same standards for final settlement, and therefore operational transfer and final settlement may not coincide, which may lead to settlement risk.
The further evolution of DeFi networks will need to address these challenges, and authorities need to develop effective supervision without disrupting the effective functioning of crypto networks as financial market infrastructures. The underlying risks are also present in the traditional financial industry, but have normally been mitigated through experience, investments and regulation.
Ulrich Bindseil is Director General of Market Infrastructure and Payments at the European Central Bank. Omid Malekan is Adjunct Professor at Columbia Business School.
This is an edited version of ‘Public crypto networks as financial market infrastructures’. It also featured in the March 2025 edition of the DMI Journal.
