Risks Faced by Banks Transacting on Permissionless Blockchains

The recent paper published by the Basel Committee on Banking Supervision, part of the Bank for International Settlements (BIS), outlines a multitude of risks that banks encounter when engaging with permissionless blockchains. As the financial industry increasingly explores blockchain technology, understanding these risks becomes paramount to ensuring stability and compliance within the banking system.

Key Risks Identified

• Money Laundering and Terrorism Financing: The anonymity associated with many cryptocurrencies poses significant challenges for banks in their efforts to comply with anti-money laundering (AML) and combatting the financing of terrorism (CFT) regulations. Transactions can be obscured, making it difficult for banks to trace the origins of funds.
• Operational and Security Risks: The reliance on decentralized networks introduces vulnerabilities related to operational processes and security protocols. Banks must develop robust systems to detect and respond to potential breaches or failures within these networks.
• Governance Issues: The decentralized nature of blockchains can lead to governance challenges, particularly when it comes to decision-making processes. Banks must navigate how to effectively engage with these governance structures to protect their interests.
• Legal and Compliance Challenges: The legal landscape surrounding cryptocurrencies and blockchain technology is constantly evolving. Banks must stay informed about new regulations and ensure that they remain compliant, which can be a daunting task in a rapidly changing environment.
• Settlement Finality: The uncertainty surrounding transaction finality on permissionless blockchains presents risks to banks in terms of ensuring that transactions cannot be reversed or altered once confirmed, which is critical for financial stability.

According to the Basel Committee’s findings, the reliance on unknown third parties in blockchain networks complicates due diligence efforts. This lack of transparency makes it challenging for banks to implement effective oversight strategies. Consequently, banks may need to develop new risk management frameworks specifically tailored to address the unique challenges posed by blockchain technology. This process is ongoing, and existing risk mitigation practices are still in various stages of development and testing.

Political and Regulatory Uncertainties

Another significant concern highlighted in the paper is the exposure of banks to political and regulatory uncertainties. Changes in legislation can rapidly alter the operational landscape for permissionless blockchains. For instance, if a government were to impose restrictions on validator behavior or implement a ban on certain cryptocurrencies, it could lead to operational instability within those blockchains. Such changes may temporarily reduce the computational power or the amount of staked native tokens available to secure the blockchain, subsequently increasing the risk of a 51% attack. This type of attack occurs when a group of validators coordinates to take control of more than 50% of the validation nodes, undermining the integrity of the blockchain.

Technological Developments and Solutions

The paper also discusses the evolving landscape of technology aimed at addressing some of the identified risks, particularly in the realm of privacy. Innovations such as zero-knowledge proofs are highlighted as potential solutions that could enhance privacy without compromising transparency and accountability. Zero-knowledge proofs allow one party to prove to another that a given statement is true without revealing any additional information. This technology could be pivotal in enabling banks to engage with permissionless blockchains while maintaining compliance with regulatory requirements.

Future Considerations

In addition to the outlined risks, the Basel Committee has mandated that banks implement a disclosure framework for their exposure to cryptocurrencies by the start of 2026. This framework aims to increase transparency and allow stakeholders to better understand the extent of banks’ involvement with digital assets. As the landscape of blockchain technology continues to evolve, ongoing dialogue among regulators, banks, and technology developers will be crucial in navigating the complexities and risks associated with permissionless blockchains.

In conclusion, while permissionless blockchains offer exciting opportunities for innovation and efficiency within the banking sector, they also present a range of risks that must be carefully managed. By developing comprehensive strategies to address these challenges, banks can position themselves to leverage the benefits of blockchain technology while safeguarding their operations and customers.