As the use of public blockchains in financial transactions continues to grow, it is crucial to address the settlement risks associated with these decentralised systems. Traditional financial markets benefit from the assurance of central bank money and government-backed insurance schemes, which provide a sense of security and trust. However, some believe that public blockchains lack these safety nets, leading to uncertainty and potential principal risk for market participants. Understanding and mitigating these risks is essential for the future of decentralised finance (DeFi) and the broader adoption of blockchain technology.
Leading Web3 venture capital, Paradigm, has issued a report written by Natasha Vasan which dives into the intricacies of settlement risks in hybrid transactions—those involving both public and private blockchains or a mix of on-chain and off-chain components. The paper explores various technical, legal, and market-based solutions to enhance settlement finality and reduce risks, making DeFi a more reliable and attractive option for financial institutions and individual traders alike.
Key takeaways from the report:
Understanding Settlement Risks: Despite immutability being one of the selling points of blockchain technology, public blockchains like Ethereum do not guarantee that transactions are final and irreversible as central banks do in traditional finance. This means there is a risk that transactions could be undone or disputed, especially if someone gains control of the network (although it is worth noting that this is unlikely for a mainstream blockchain such as Ethereum). Without a central authority to ensure transaction finality, the report states this creates uncertainty and potential financial risk for users. Unlike traditional financial systems, where government guarantees and insurance schemes protect consumers within the system, DeFi operates without these safety nets. This increases the need for proper risk management strategies.
Decentralised Settlement Insurance: Implementing decentralised settlement insurance could provide a safety net for users. This mechanism would use incidental funds that are burnt by blockchains as part of its mechanism of action (i.e., slashed funds) to compensate victims of settlement issues or disruptions. This proposed insurance system could operate similarly to traditional depository insurance but would be managed through decentralised governance mechanisms, adding extra layers of security and trust to the particular blockchain ecosystem.
Central Counterparty for Hybrid Transactions: Exploring the creation of "decentralised central counterparties" (CCPs) can help mitigate credit risks in hybrid transactions. These CCPs could pool resources and risk exposure, functioning similarly to traditional financial institutions like the Depository Trust Company (DTC). A decentralised CCP could manage settlement risks and provide compensation for victims of transaction issues, thereby reducing the principal risk for users and enhancing the reliability of hybrid transactions (i.e., part blockchain and part tradfi transactions).
Standardised Legal Contracts: Adopting standardised contractual frameworks, akin to the ISDA Master Agreement for OTC derivatives, could provide consistency and legal certainty for hybrid transactions. These contracts would define the moment of settlement finality, specify remedies in the case of settlement disruptions, and integrate contract logic into self-executing smart contracts, thereby reducing the risks associated with hybrid transactions and promoting greater trust and adoption in DeFi.
Public-Private Blockchain Communication: Developing solutions to enable seamless communication between public and private blockchains is essential as we move towards an increasingly tokenised future. This includes addressing the unique risks associated with transactions involving regulated financial institutions or national governments. Collaborative efforts, such as the SWIFT and Chainlink Cross-Chain Interoperability Protocol (CCIP) project, are exploring ways to ensure regulatory compliance and settlement finality in public-private blockchain communications.
Legal Interventions and Industry Self-Regulation: External legal interventions may be necessary to ensure institutional adoption and to promote trust in public blockchains as a settlement option for financial transactions. Defining a legally recognised moment of settlement finality and providing a legal basis for recourse in case of disruptions is a useful starting point. Through the development of baseline standards and best practices, industry self-regulation can complement legal mandates and enhance interoperability and trust across different blockchains.
Managing Operational Risks: Addressing operational risks, such as settlement delays due to network congestion or inflated gas fees is crucial for the smooth execution of hybrid transactions. Placing certain legal requirements on off-chain agents involved in hybrid transactions, such as ensuring timely conclusion of transfers on public blockchains, can help mitigate these risks and enhance the overall efficiency and reliability of DeFi.
As the use of blockchain technology in financial markets increases, Paradigm's report highlights the importance of understanding the underlying technology and the ability to craft unique solutions to address market risks. Adopting strategies to address these risks will be important as mainstream institutions increasingly enter these markets and expect a level of assurance on par with traditional markets. Proactively addressing critical settlement risks may be the difference in ushering in the future of markets.
Written by Luke Higgins and Steven Pettigrove