The European Union has published a report exploring the potential for permissionless blockchain in traditional finance (TradFi). It argues that permissionless blockchains should at least be considered as options for TradFi and financial market infrastructures. However, adoption should happen in a cautious manner.
Fabian Schär of the University of Basel is the paper’s author. He wrote one of the most cited early papers on Decentralized Finance (DeFi). While Mr Schär is a proponent of permissionless blockchains and DeFi, the paper is nonetheless objective and thorough.
It argues that permissionless blockchains can be more neutral than private ones, and in turn encourage competition. Unfettered access enabled by public blockchains contrasts with the siloed permissioned blockchains that are proliferating. While public blockchains have drawbacks, there are many widely known workarounds to their challenges, particularly by adding permissions at the smart contract level.
Mr Schär proposes that permissionless blockchains can provide an interoperability layer for layer 2 blockchains, including regulated ones. When smart contracts are on a single chain, they are capable of being composable into more complex functionality. Composability is possible across multiple blockchains but is weaker and messy. We’d note the point about composability is sometimes a blind spot in the TradFi space. Our recent report on DLT payments highlights that some application designs overlook composability and how to address that.
The EU paper doesn’t gloss over the drawbacks of public blockchains, such as scalability, privacy, finality and governance. It delves into each topic, as well as the contentious issue of maximal extractable value (MEV) in which block proposers sometimes reorder transactions at the expense of blockchain users, a type of front running. Mr Schär describes each challenge and the pros and cons of the various workarounds.
Why permissionless blockchains are so topical in TradFi
Clearly asset managers are attracted to the potential of permissionless chains with the likes of BlackRock and Frankin Templeton launching on-chain funds.
From a policy perspective, the paper is timely for three reasons:
In the latter case, one example is Singapore’s global layer one (GL1), a public, permissioned and regulated blockchain, which looks similar to a permissionless blockchain.
The EU DLT Pilot Regime
In early 2023 the EU DLT Pilot Regime came into force, which relaxes some regulations relating to central securities depositories. Most importantly it allows the use of permissionless blockchains. We’ve previously written about DLT Pilot Regime candidate 21x, which plans to operate a trading and settlement infrastructure on a permissionless blockchain. Many of the workarounds mentioned in the EU paper will be put into action by 21x and other DLT Pilot Regime participants.
For example, 21x participants are restricted to known entities and it uses a central limit order book. Hence, market surveillance will result in the identification of MEV activities and the seizure of a frontrunner’s on-exchange assets. If there’s an issue with the blockchain infrastructure then the assets can be moved to a different blockchain.
Another reason why the paper is timely is the ongoing debate by the Basel Committee on Banking Supervision, which recently imposed tighter rules for permissionless blockchains, particularly for tokenized assets that are likely to take many of the precautions mentioned in this paper. This encourages the banks to only engage with permissioned blockchains and creates a divide between them and asset managers who don’t face the same restrictions. The Basel Committee also published a paper addressing potential workarounds, but the EU paper is more technical and goes further.
For anyone wishing to really understand the ins and outs of permissionless blockchains in the context of TradFi, this paper is a must read.
