The Blockchain Revolution

February 26th, 2018

“If we all worked on the assumption that what is accepted as true is really true, there would be little hope of advance.”— Orville Wright

  • Bitcoin is one of many “cryptocurrencies”—a new class of currencies created, held and exchanged electronically through a decentralized process.
  • Cryptocurrencies, such as Bitcoin are currently unregulated and lack the stability of other mediums of exchange and operate without many of the safeguards that govern more traditional exchanges.
  • While Bitcoin is revolutionary, the real breakthrough is blockchain—the distributed ledger database technology that was the byproduct of Bitcoin’s creation.
  • Given the nascent stage of blockchain technology, new technologies could emerge and render the leaders of today obsolete, making owning Bitcoin, other cryptocurrencies and even blockchain-oriented business highly speculative. 

Bitcoin’s Beginnings

Originally described in a 2008 whitepaper by an unknown author operating under the pseudonym Satoshi Nakamoto, Bitcoin is a digital currency born out of distrust for the financial system. In fact, the first Bitcoin was created on the eve of the second bank bailout during the 2009 financial crisis. The supply was intentionally limited in order to keep Bitcoin relatively untethered from what was perceived as the ever-growing creation of money by the U.S. Federal Reserve. As a result, many owners of Bitcoin and other cryptocurrencies have viewed these investments as an alternative store of value, much the way gold and other precious metals have long been treated.

EXHIBIT 1: Bitcoin Characteristics

In addition, the promise of low fees, ease of transaction and anonymity further support Bitcoin’s value proposition. Bitcoins are exchanged electronically, utilizing a decentralized, encrypted verification process called blockchain, which hides the identity of the transacting parties through the use of a public address, and eliminates middlemen such as federally regulated banks and financial transaction processors.

EXHIBIT 2: Bitcoin Timeline

Source: Coindesk

Copy-Cat Crypto-Coins

Alongside Bitcoin’s rise, hundreds of different cryptocurrencies have also emerged, each with different purposes and some with different features. Some of these new cryptocurrencies, like Ripple and Ethereum, have attracted considerable attention for their faster transaction speed. In fact, some of these newer alternative cryptocurrencies have been catching up to Bitcoin’s market cap, as indicated in the chart below. The introduction and rise in popularity of these newer coins not only show the ongoing evolution of this space, but also hint at the fragility of Bitcoin’s first-mover advantage.

EXHIBIT 3: Growth of Cryptocurrencies

Source: Coinmarketcap

Cryptocurrencies In Context

As of February 14th, 2018, there were 16.8 million bitcoins worth approximately $158 billion in circulation. Including the hundreds of other new coin offerings attempting to piggyback on Bitcoin’s success, the cryptocurrency market had grown to nearly $456 billion. By comparison, there are $1.5 trillion U.S. dollars in circulation.1 Further, most traditional financial markets, including stocks ($67 trillion), bonds ($85 trillion) and even gold ($8 trillion) dwarf the total value of cryptocurrencies, though the latter have been gaining substantial ground due to their appreciation in value.

EXHIBIT 4: Cryptocurrencies in Context of Total Value

Source: CoinTelegraph

While decentralization is key to the creation of cryptocurrency, the lack of trusted intermediaries or a central governing authority makes some institutional investors leery of the safety of cryptocurrencies as a medium of exchange. This is further exaggerated by their price volatility, which undermines the economics of transactions conducted in cryptocurrencies.

Many cryptocurrency exchanges have shown vulnerability to hacking. Since 2014, roughly 2-3% of all cryptocurrency in circulation has been stolen. The two most notable events were the loss of $450 million in cryptocurrencies by Mt. Gox, a Japan-based Bitcoin exchange in 2014 and the loss of $530 million worth of cryptocurrencies by Coincheck in late January 2018.2 When exchanges are hacked, individual investors rarely recuperate their lost funds. In short, cryptocurrencies appear to lack stability, as well as many of the typical safeguards provided by other mediums of exchange.

Inability to Value Drives Volatility and Speculation

Cryptocurrencies are not traditional investment assets that generate cash flows, making them impossible to appropriately value through conventional methods. According to NYU Stern Corporate Finance and Valuation Professor Aswath Damodaran, also known as the “Dean of Valuation”, crypto-assets are traded based on price, rather than being systematically valued. This is in part due to the lack of applicable valuation methodologies.3

EXHIBIT 5: A Comparison to Past Bubbles

Source: Coindesk, Factset, “The tulipmania: Fact or artifact?”, Earl Thompson

Driven by both professional and retail investors, Bitcoin’s trading activity appears to be exhibiting signs of a mania, rapidly climbing from $8,002 on November 23rd, 2017 to a peak of $19,343 on December 16th, 2017. At a 60x multiple of starting price, Bitcoin at its peak dwarfed the largest asset bubble to precede it—the Dutch tulip bulb mania of 1637. To provide comparison, at the peak of that bubble, one tulip bulb sold for approximately 5,500 guilders, an amount that at the time was “enough to feed, clothe and house a whole Dutch family for half a lifetime” or to buy “one of the grandest homes on the most fashionable canal in Amsterdam…complete with a coach house”.4 Similar to Bitcoin, the Dutch traded tulip bulbs at sky-high valuations with the hope and expectation that there would always be someone who would purchase the bulbs at a higher price. When demand disappeared, prices collapsed. Likewise, in a sell-off in early February 2018, Bitcoin lost 67% of its value, partially propelled by bans from credit card companies and regulators. Notably, this is the third largest drop for Bitcoin’s value to date, highlighting the cryptocurrency propensity for large swings of value.

Blockchain, the New Internet (Maybe)

While Bitcoin has attracted considerable investor attention and introduced the world to digital currencies, the true potential for revolution may lie with blockchain, the decentralized ledger database technology behind Bitcoin and the majority of other cryptocurrencies. Importantly, blockchain facilitates direct transactions between parties without an intermediary, and replaces the traditional third-party verification typically provided by a bank or custodian. Complex encrypted keys and passwords are required to access and transfer cryptocurrencies. If a key is lost, cryptocurrencies can be rendered inaccessible to their owners.

EXHIBIT 6: How a Bitcoin Transaction Works

To combat this, the blockchain maintains a continuous list of data records and transactions. Transactions are recorded by a ‘block’ transferred from one chain to another, after they are approved by every party in a network. Blockchain uses servers called “nodes” to maintain a public record of transaction entries and data is typically shared across nodes. The database behind blockchain not only proves the rightful owner of a given asset, but also provides a record of the public address of previous owners. By design, no one party can modify or delete a transaction, providing an irrefutable record of movements and transactions across the database. The key here is the distributed architecture of the transaction system, where no middleman is required to verify transactions. Instead, the system is both the middleman and the record-keeper.

Disruptive Innovation and Its Evolution

Many banks and large firms have been researching whether the blockchain concept could facilitate the processing of transactions, and how the technology might be leveraged for their internal architecture. Examples of current implementations include:

  • Morgan Stanley and Walmart have begun to use blockchain to optimize their currency trading and supply chain operations, respectively.
  • Blockchain-focused startup Chain has already built an internal blockchain-based business-to- business transaction application for Visa.
  • Microsoft has launched Azure, a blockchain service application that executes smart contracts on a distributed ledger database.

In addition to developing applications for the transactions space, other blockchain-focused startups are making headway in applications related to security and enterprise solutions. The inability to modify and delete records in the blockchain ledger makes it ideal for recordkeeping in areas related to healthcare, titles, ownership, voting and intellectual property. Other future-use cases for blockchain technology include e-commerce, global payments, remittance, digital rights and escrow management.

EXHIBIT 7: Potential Uses of Blockchain

Source: Bitblock, The Fintech Times

Further, Bitcoin competitors, Ethereum and Ripple have implemented next-generation blockchain platforms that have improved upon the former’s computational power and processing speed. The Ethereum blockchain can implement “smart contracts” and run software code of any decentralized application, while Ripple’s blockchain also allows for the execution of automated scripts similar to smart contracts. Smart contracts are executed or enforced automatically after reaching a trigger event using “if, then” logic.

Ethereum supports a broader set of computational instructions than Bitcoin, which is more transactional in nature. Examples of future use-cases for Ethereum include the automation of land title recording and property transfer, insurance claims processing and automatic payments of dividends and stock splits.

Ripple, much like Ethereum, is run by an umbrella organization focused on creating and upholding a decentralized monetary system. Ripple was founded in 2004 and eventually successfully created its own exchange protocol to validate decentralized transactions. On average, Ripple processes a transaction within 3.3 seconds, compared to 45 minutes for Bitcoin, and at a fraction of the cost. Recently, American Express partnered with Ripple to build a blockchain-based payments system. Additionally, US-based currency transfer company MoneyGram has teamed up with Ripple to reduce costs and increase speed of their payments processing.

The Search for Blockchain Investment Opportunities

Unlike the impossible-to-value crypto-currencies, some businesses focused on blockchain applications and their uses will likely eventually turn a profit and deliver a more typical shareholder return. Some investors have chosen to allocate to the space directly through specialist blockchain-focused venture capital funds like Pantera Capital and Ethereum Capital or indirectly through stakes in generalist venture capital funds like Andreessen Horowitz and Union Square Ventures, who have invested in nine blockchain applications between 2013 and 2017. Such investments have already experienced initial success with stakes in Ripple and Coinbase, a digital cryptocurrency exchange.

EXHIBIT 8: The "Blockchain" Naming Effect

Source: Bloomberg
*Indicates share price rise the day after adding blockchain to name

Interest in blockchain is significantly widespread, although there are many parallels to the dot-com bubble in the late ‘90s. For example, Pets.com, a business characterized by memorable advertising and internet hype, saw its stock price rise significantly after adding the “.com” to its name, despite an unprofitable business model dragged down by low margins. The terms Bitcoin, blockchain and cryptocurrency also seem able to boost the price of any venture of even remote association. Recently, the Long Island Iced Tea Company added “Blockchain” to its name and saw a 500% stock price jump. Similarly, Eastman Kodak saw its stock surge 89% after announcing its own cryptocurrency. In light of retail investor exuberance, the Securities and Exchange Commission ordered two Blockchain ETFs to take the word “blockchain” out of their name.

Also much like during the dot-com bubble, blockchain-enabled technologies are rapidly evolving. Look no further than Bitcoin to see the risk of such evolution. The market share of Bitcoin dipped from total market domination at the beginning of 2017 to a third of the market by the beginning of 2018. The percentage of Bitcoin-related companies out of all bockchain-related venture-capital deals also dropped from 91% in 2013 to 39% in 2017. It is very possible the leaders of today will rotate in the near-term, a risk investors need to recognize. Bitcoin may be the Netscape5 of the cryptocurrency revolution.

Blockchain: A Technology To Watch

Despite Bitcoin’s rapid price appreciation and the overnight billionaires, cryptocurrencies and blockchain-related investments are still speculative assets for now, although all are not equal due the nascent nature of the technology behind them. However, the properties that facilitate decentralized ledger database and innovative smart contracts could offer the potential for future applications that drastically reduce transaction costs, create transparency, enhance security and remove costly intermediaries. For that reason, applications utilizing blockchain are likely to have implications for financial services and other industries with significant recordkeeping or transaction needs, such as healthcare records, real estate titles and escrow.

Sources:

1Board of Governors of the Federal Reserve System. “The Fed – How much U.S. currency is in circulation.” Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/faqs/currency_12773.htm

2Bokolin, Lex. “Hackery Hacker Hacks.” Autonomous Next. https://next.autonomous.com/thoughts/hackery-hacker-hacks

3Cheng, Evelyn. “NYU’s ‘dean of valuation’ says can’t ‘value’ bitcoin, only trade it” CNBC. http://www.cnbc.com/2017/10/24/nyus-dean-of-valuation-says-bitcoin-is-a-currency.html

4Sooke, Alastair. “Tulip mania: the flowers that cost more than houses.” BBC.com. http://www.bbc.com/culture/story/20160419-tulip-mania-the-flowers-that-cost-more-than-houses 

5Netscape was the original internet browser company formed by Jim Clark in 1994. Today, internet browsing is dominated by Microsoft (Internet Explorer), Alphabet (Google Chrome), and Apple (Safari).

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