Permissionless Consensus for Robust Institutional Onchain Finance

Introduction

Institutional asset managers evaluating onchain finance face a fundamental architectural decision: deploy capital on infrastructure with permissionless validator participation, like Ethereum, or migrate to networks with permissioned validator sets that promise regulatory compliance through administrative controls at the consensus layer. This analysis argues that permissionless validator participation at the consensus layer is structurally superior and necessary for institutional-grade security, while permissioning belongs at higher layers of the stack.

This distinction is critical because institutional onchain finance may legitimately require:

• Whitelisted assets and investment universes;
• KYC/AML-gated user access;
• Jurisdictional and regulatory constraints;
• Compliance-driven smart contract controls.

However, these requirements should not be implemented at the consensus and validation layer.

Permissioned validator sets rely on legal enforcement, governance committees, and administrative controls to maintain validator participation and network security. Permissionless validator participation relies on protocol-enforced incentives that create endogenous stabilization mechanisms. This distinction matters for institutional finance because:

1. Operational risk: Networks relying on permissioned validators depend on continuous administrative oversight, compliance enforcement, and governance interventions. These additional operational dependencies introduce potential points of failure and reduce overall system resilience.
2. Security risk: Validator sets restricted by permissioning lack the protocol-aligned economic incentives that stabilize open networks during periods of market stress. This makes them more susceptible to coordinated validator exits, governance manipulation, or other systemic threats.

This analysis demonstrates that Ethereum's Proof-of-Stake protocol delivers greater resilience to exogenous shocks than permissioned networks through two interconnected mechanisms: (i) endogenous reward adjustment that stabilizes validator participation, and (ii) a feedback loop between Ethereum as operational infrastructure and staked ETH as a financial instrument, in which growing onchain capital reinforces network security. In permissioned consensus models, these stabilizing forces weaken, become discretionary, or may fail entirely, resulting in a structurally less robust infrastructure.

We argue that implementing compliance, privacy, and operational controls at the application layer on Ethereum is more resilient than migrating institutional activity to networks with permissioned validators. This approach preserves the security and robustness of permissionless consensus while meeting institutional requirements for security, capital efficiency and regulatory compliance.

A Layered Model: Where Permissioning Belongs

The Stack Architecture

Blockchain infrastructure can be understood through a layered model:

1. Consensus/Validation Layer: The protocol layer that determines transaction ordering, finality, and network security through validator participation.
2. Application Layer: The product layer where institutional requirements for compliance, access control, and asset restrictions can be implemented.

Why Permissionless Validators Are Necessary

The endogenous security mechanisms that stabilize Ethereum's Proof-of-Stake protocol require open validator participation. When validator sets are permissioned:

• Endogenous reward adjustment breaks down: Permissioned validator sets cannot leverage the negative feedback loop where decreased stake increases per-validator rewards, because validator entry is controlled administratively rather than economically.
• Infrastructure-financial instrument feedback is weakened: The economic incentives that drive additional staking when onchain capital increases are reduced when validator participation is gated by administrative approval rather than economic self-interest.
• Security guarantees shift from protocol-enforced to trust-based: Instead of cryptoeconomic guarantees enforced by protocol mechanisms, permissioned validator sets rely on trust in governance entities, legal contracts, and administrative controls.

This analysis focuses on why permissionless validator participation at the consensus layer is necessary, while acknowledging that permissioning at the application layer is appropriate and often required for institutional finance.

The Security Economics of Permissionless Validator Participation

Validator Participation and Price Volatility

Recent analyses by central banks and regulators have emphasized a potential link between crypto-asset price volatility and infrastructure risk in permissionless blockchains [Biancotti (2025)]. The proposed mechanism typically asserts that high volatility or sharp price declines reduce validator revenues, inducing validator exit and thereby impairing transaction settlement and increasing exposure to adversarial attacks.

This mechanism rests on two implicit assumptions: (i) validator participation is highly sensitive to short-run price movements, and (ii) validator rewards are exogenously fixed in token units and do not adjust to participation. Neither assumption holds for Ethereum's Proof-of-Stake protocol.

Empirical evidence demonstrates that validator participation is largely insensitive to short-term ETH price volatility. Since its launch, Ethereum has exhibited a high degree of operational continuity. Despite episodes of extreme price volatility, sharp drawdowns, and major protocol transitions, the network has maintained continuous block production and transaction settlement, with no prolonged, system-wide outages attributable to validator exit or incentive failure.

Periods of elevated price volatility have not coincided with observable disruptions to liveness or finality. This historical robustness suggests that validator participation is sufficiently resilient to market fluctuations and that the protocol's design effectively insulates core infrastructure from short-run price dynamics.

Endogenous Reward Adjustment as a Stabilizing Mechanism

Ethereum's issuance schedule implies that the protocol-defined reward per validator decreases as the total staked ETH increases.

This relationship creates a negative feedback loop: when total stake decreases, per-validator rewards increase, incentivizing validators to join or remain online. Conversely, when total stake increases, rewards decrease, preventing overcollateralization.

Two separate mechanisms affect validator earnings:

1. Stochastic proposer selection: Each validator is randomly selected as a block proposer with probability approximately inversely proportional to the number of active validators. A decrease in the number of validators increases the expected share of proposer rewards for each individual validator.
2. Protocol-defined reward curve: Independently of proposer selection probabilities, Ethereum's Proof-of-Stake protocol defines validator rewards as a decreasing function of total staked ETH. When total stake decreases, the per-validator reward rises according to the consensus-layer reward and penalty mechanism. This deterministic adjustment creates a negative feedback loop that stabilizes total participation: higher rewards incentivize validators to join or remain online when stake is low, while lower rewards discourage excessive staking when the network is overcollateralized [Ethereum Foundation (2023)].

Together, these mechanisms imply that a validator's expected earnings increase when total stake falls, creating a protocol-enforced economic stabilization designed to maintain network security.

Critical requirement: These mechanisms only function when validator participation is open and permissionless. Under a permissioned validator set, validator entry is controlled administratively rather than economically. When total stake decreases, the protocol cannot automatically incentivize new validators to join because validator selection is gated by governance approval, regulatory compliance, or administrative processes. The endogenous stabilization mechanism breaks down, and security guarantees shift from protocol-enforced to trust-based.

The Infrastructure-Financial Instrument Feedback Loop

Ethereum functions simultaneously as operational infrastructure and a financial instrument. This dual nature creates a further stabilizing feedback loop.

Tokenized real-world assets (RWAs) deployed onchain, currently totaling $13.93B [RWA Stats (2024)], highlight the growing role of public blockchains as secure, operational infrastructure. As more capital is deployed onchain, more transactions and operations are executed, consuming gas denominated in ETH. This generates utility demand for ETH, acquiring commodity-like properties.

This creates a further stabilizing feedback mechanism:

1. Infrastructure-financial instrument feedback loop: When total staked ETH decreases, the security of onchain infrastructure is reduced, increasing shortfall risk for capital deployed in RWAs. Asset allocators who have deployed capital onchain are not neutral in the face of increased APY (which is fully causally linked with increased expected shortfall in the tokenized securities). This creates incentives for these actors to increase staking, either directly or by supporting infrastructure security.
2. Commodity demand reinforcement: As more capital is deployed onchain, gas usage rises, creating additional demand for ETH to conduct operations. This commodity-like function further stabilizes ETH value and incentivizes continued participation in network operations.

Ethereum simultaneously functions as infrastructure, a financial instrument, and a commodity, while staked ETH provides a low-correlation, yield-enhancing allocation for portfolio managers seeking improved risk-adjusted returns [Hoffman, 2019]. This integrated system ensures that capital naturally oscillates between assets, supporting both network stability and economic value.

Critical requirement: This feedback loop only functions when validator participation is open and permissionless. Under a permissioned validator set, the economic incentives that drive additional staking when onchain capital increases are weakened because validator entry is gated by administrative approval. Asset allocators cannot freely respond to infrastructure security needs by staking, because validator selection is controlled by governance rather than economic self-interest.

The empirical record confirms these theoretical predictions: Ethereum has maintained continuous operation through extreme market volatility and regulatory uncertainty, demonstrating that protocol-enforced security enabled by permissionless validator participation provides superior robustness for institutional finance.

Protocol-Enforced vs. Administrative Guarantees at the Consensus Layer

The critical distinction lies in the enforcement mechanism for security guarantees at the consensus layer:

• Permissionless validator participation: Security is enforced by protocol-level incentives. Validator participation is stabilized by endogenous adjustments. These mechanisms operate automatically, without requiring administrative intervention or legal enforcement.
• Permissioned validator sets: Security relies on legal contracts, governance committees, and administrative controls at the consensus layer. Validator participation depends on contractual obligations, regulatory compliance, and governance decisions. These mechanisms introduce single points of failure, regulatory exposure, and operational dependencies at the most critical layer of the stack.

For institutional finance, protocol-enforced guarantees at the consensus layer provide superior robustness because they operate independently of administrative systems and more efficiently than legal ones. During periods of market stress, regulatory uncertainty, or governance disputes, protocol-level incentives continue to stabilize validator participation and network security.

This does not preclude permissioning at higher layers: Application-level access controls, asset whitelisting, and compliance-driven restrictions can be implemented through smart contracts and application logic without compromising the security benefits of permissionless validator participation.

Analogously, we argue for bringing privacy to Ethereum via cryptographic and protocol-level mechanisms with no need to migrate institutional activity. In fact, Ethereum can achieve privacy through cryptographic mechanisms at the application and execution layers, while maintaining permissionless validator participation at the consensus layer.

Key implications for institutional finance

• Compliance requirements (KYC/AML, asset whitelisting, jurisdictional constraints) can be implemented at the application and access layers through smart contracts and access controls, without compromising consensus-layer security mechanisms.
• Privacy requirements can be satisfied through cryptographic mechanisms at the application layer rather than administrative controls at the consensus layer, preserving the security benefits of permissionless validator participation.
• Native onchain funds can benefit from superior operational efficiency and capital alignment compared to off-chain analogues.

Orion Finance Research

References

Biancotti, Claudia (2025). What if Ether Goes to Zero? How Market Risk Becomes Infrastructure Risk in Crypto. Bank of Italy, Mercati, Infrastrutture e Sistemi di Pagamento, No. 74. Available at SSRN: https://ssrn.com/abstract=5270949

Ethereum Foundation (2023). Rewards and penalties in Ethereum proof-of-stake. https://ethereum.org/developers/docs/consensus-mechanisms/pos/rewards-and-penalties/

Hoffman, David (2019). Ether: The Triple Point Asset. Bankless. https://www.bankless.com/ether-a-new-model-for-money

RWA Stats (2024). Real-world assets on Ethereum. https://app.rwa.xyz/networks/ethereum/