Authored by: Scott Canning, CFA and Erik A. Swords
Amid perpetual news flow, the price swings of blockchain technology's most visible proving ground— cryptoassets—can be misleading to investors. This persistent noise has the undue effect of overwhelming rational analysis and the longer-term perspective required to fully appreciate the technology's potential. During a recent trip to New York City's "Blockchain Week," we saw the mania—a meld of fast money and philosophical drama. We also identified some signals—developmental maturation, firming use cases and growing institutional interest in cryptoassets. With numerous pitfalls, navigating this nebulous environment can be perilous. Here, we attempt to provide some clarity.
Signals in the noise
Within the developer community, a philosophical divide is deepening between two schools of thought regarding the technology's potential applicability. The first school views distributed ledger technology as the ideal tool for disintermediating any network where centralized trust providers are perceived as extracting excessive value. The second view is the steadfast "maximalist" whose proponents contend that the only proven and likely useful application of the technology is Bitcoin. Admittedly, we appreciate the purist's view of "blockchain technology" as an open-sourced, permissionless protocol, like the Bitcoin network, but our research suggests that, while a rigid definition is very effective in marketing cryptoassets, it pre-maturely ignores an undefinable spectrum of innovation in distributed ledger technology.
We think each use-case objective of a distributed ledger will shape the implementations architecture to highlight or balance three key trade-offs: speed, security and scale. Accordingly, our longer-term view falls somewhere in the middle of this philosophical debate and our outlook will continue to take shape as hype wanes, proof-points are increasingly realized, and as return on investment becomes prioritized.
In our conversations with experts, emphasis on blockchain governance and cross-chain interoperability is growing, indicating that a subset within the broader developer community is proactively taking the long view.
- Governance: Blockchain implementations are known for their inherent immutability, a distinguishing feature relative to traditional ledgers and databases. While many thought the distributed consensus mechanism was enough to create an on-chain "judicial system," that view quickly changed when a security vulnerability in Ethereum smart contract code was found, and funds were stolen. Subsequent to the theft, lead developers intentionally split the network to restore the ownership of stolen assets. The ensuing debate over the handling of this malicious hacking brought governance, essentially a structured system for network voting, to the forefront of architecture development. The read-through for enterprises collaborating with direct competitors, suppliers and buyers is that their blockchain implementations will require robust governance frameworks at the outset. Related negotiations may therefore moderate the pace of enterprise adoption of distributed, shared ledgers.
- Interoperability: We heard diverse participants discussing cross-chain porting and functionality. For example, if two different financial institution consortiums tokenize debt on separate, non-standardized syndicated loan chains, and investors are unable to transfer assets cross-chain, there is an immediate risk of reduced liquidity and subsequently, lower incentive for borrowers and lenders to participate. Chains that provide "internet of blockchain" solutions will therefore be key players between consortiums and, notably there is talk of permissionless chains becoming that conduit.
Blockchain in financial services
Scale financial institution distributed ledger adoption for mission-critical infrastructure will most likely occur in verticals and businesses that see the technology as an existential threat (e.g., international remittance and infrastructure supporting assets that have excessive clearing times) and in "contained" environments, where operators have a well-established user base and cost benefits are clear to all participants.
Cryptocurrency exchanges within the US are experiencing a wave of activity including industry consolidation, the rolling out of new professional-grade services, and new competition from legacy Wall Street firms, all in anticipation of increased interest from institutional investors. With new custody, derivative, and liquidity solutions now available, we see the lack of regulatory visibility as the most near-term hurdle to greater investment in the space.
Over the last 6 to 12 months, it has become increasingly apparent that there is a rising interest among institutional investors to gain exposure to emerging opportunities in distributed ledger technology. We remain focused on the longer-term perspective. At the same time, we continue to monitor the most effective use cases and leading innovators within this exciting frontier. Filtering the hype surrounding its various applications is critically important when assessing its viability going forward.