Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
Executive summary: Bitcoin is a highly speculative investment in our view, but the technology which underpins it – blockchain – is both radical and transformative. The benefits of blockchain are significant: reduced costs, improved processing and dispute elimination via the creation of one source of truth, an open yet secure mutually distributed ledger. Although bitcoin has undoubtedly helped popularise the potential afforded by blockchain, the technology today is perhaps where the Internet was 20 years ago. Over $1bn of venture capital has been committed to blockchain start-ups and corporate spend on blockchain projects is currently expanding at a 60% compound annual growth rate. Trials are underway in many areas including finance, trade and logistics, retail, healthcare and even government. Meanwhile, many large banks, payment platforms and IT consultants are investing in blockchain development. Among the major players, IBM and Microsoft appear currently to have taken a lead.
Everyone seems to be talking about bitcoin: whether it may be the ‘next big thing’ or alternatively, an enormous bubble waiting to burst. In this note, we make one simple assertion: forget bitcoin, blockchain is the real innovation. Bitcoin (and other crypto-currencies) should be considered as highly speculative investments, almost impossible to value in our view. However, blockchain has the potential to be one of the most disruptive technologies emerging over the next decade, creating significant value and reducing costs for companies. It should be thought of as a fundamental rewiring of the underlying computational architectures central to the global economy; with blockchain, the middleman is eliminated.
The technology underpinning blockchain is a combination of computer science and cryptography. It has been around since the 1970s (where it was developed by engineers at Stanford University) and was originally conceived as a register for intellectual property. However, it was only when Satoshi Nakamoto proposed in his 2008 paper on bitcoin that blockchain would be the best source for the crypto-currency to reside that it has become popularised. Blockchain has existed as an open-source (free) technology since 2009. There is no doubt that blockchain works; the challenge now is how to commercialise it.
References to ‘the blockchain’ are highly misleading, implying that there is only one blockchain. The reality is that there are multiple blockchains (or mutually distributed ledgers – the terms are interchangeable). It is perhaps simplest to conceive of them as databases: public blockchains are networks open to the public, where users simply download the relevant open-source code; by contrast, a permissioned blockchain is a network open to known users granted permission by an authority. Blockchain is best defined as a generic tool to allow data and transactions to be secured and distributed.
Blockchain requires three core elements to work together: a network of users, digital assets to be shared or exchanged, and a shared ledger that tracks all transactions and conditions. The ‘blocks’ are therefore bundles of transactions, data records or other digital records that cannot be altered, and the ‘chain’ is a continuously growing string of blocks linked in chronological order and secured using cryptography. As a result, transactions and agreements can be carried out among disparate anonymous parties without the need for a central authority, legal system or external enforcement mechanism. In other words, all transactions are traceable, transparent and irreversible, shared in common and stored across multiple locations.
Against this background, the benefits of blockchain are evident. Recording and transferring data in ways that are transparent, safe, auditable and resistant to hacking means that there is one source of truth for data management. Blockchain does not require the parties in a transaction to involve an intermediary and hence can improve inefficient markets that have a large number of participants. This encompasses a lot of industries. Implementing blockchain solutions can reduce costs, improve processing speeds and eliminate disputes, not to mention fraud. The cost savings benefit could be equivalent to 30-50%, per Accenture.
Bitcoin is a good example of the power of blockchain: without a middleman or central authority, people all over the world use their PCs to help move digital money by verifying transactions. This blockchain tracks records of ownership so that each bitcoin unit has only one owner and is used only once. This, however, is just one use of blockchain. Pilots and trials are underway in many industries spanning finance, trade and logistics, retail and manufacturing, and healthcare. Governments and Central Banks are also increasingly exploring the possibilities offered by blockchain.
Major financial players have been the most proactive in investing in blockchain solutions (perhaps owing to the threat the technology poses to their business models). Blockchains are seen as a means for financial organisations to transfer and store digitised assets such as bonds, shares and payments in a frictionless way, automating back office reconciliation and settlement. A recent survey of 200 banks by IBM revealed that 65% of them expect to have blockchain systems in place by 2019. Bank of America, JP Morgan, Goldman Sachs, Nordea, Royal Bank of Canada and UBS among others have already launched blockchain applications. The new EU-wide payment services directive (PSD II) may further accelerate blockchain implementation by banks. Meanwhile, the Australian Stock Exchange has stated that it is in the process of evaluating the technology as a replacement for its post-trade settlement system.
In the field of trade and logistics, Maersk is trialling blockchain and sees it as an efficient solution to replace the manual, paper-based process of managing the shipment of products on containers. The ports of Rotterdam, Antwerp and Singapore are similarly exploring container port automation via blockchain. The logic is compelling given that the World Trade Organisation estimates that around 20% of all shipped goods suffer some form of delay, while cutting friction from global trade could increase volumes by around 15%. Elsewhere, Walmart is employing blockchain technology to track the origin and shipments of fruits and vegetables, while Unilever and Nestlé are developing blockchain projects to improve food safety and reduce contamination.
Additionally, there is increasing evidence of state buy-in for blockchain. Within the field of healthcare, patient records would be stored securely and could be accessed whenever relevant, while Central Banks see the technology as a mechanism for eliminating fraud. In emerging economies, blockchain solutions could represent a solution for the underbanked, providing them with secure access. The Federal Reserve, the People’s Bank of China and the Reserve Bank of India are all currently conducting feasibility studies regarding the implementation of blockchain.
However, while the potential for blockchain is evident and the design deceptively simple, the implementation and utilisation is significantly more complex. The technology remains fragmented, does not scale well and can be both costly and energy inefficient. For businesses, it is hard to know which blockchain platform to choose, especially given the rate of technological evolution and the ongoing uncertainty of platform interoperability. This may delay implementation. Furthermore, in order for blockchain to go fully mainstream, there are major scalability problems that need to be resolved. Take the example of crypto-currencies: bitcoin can handle around 5 transactions a second and Ethereum around 20. By contrast, the Visa network processes 4,500 transactions every second and has the theoretical capability to handle 10 times this amount. Then there is the concern about energy consumption, since complex applications require huge amounts of server power. Some reports suggest that bitcoin mining, for example, currently consumes as much electricity as a US city of 300,000 people. The benefits of scale and improved technology means that these concerns should be solvable, even if they take time.
The broader concern is that the corollary of increased automation, transparency and decentralisation afforded by blockchain is huge job losses, especially in roles that are largely repetitious and administrative. Figures from the US Commerce Department suggest that up to 20% of US jobs could be at risk. This concern is, of course, not novel and has similarly been raised in the context of the evolution of robots, artificial intelligence and so on. The reality tends to be more complex; most businesses are evolving gradually (rather than wholescale revolution) and indeed there is, at present, currently a shortage of skilled blockchain engineers and consultants.
McKinsey foresees the commercial development at scale of blockchain technologies by 2021, a view endorsed by many other experts on the topic. By this stage, spending on blockchain projects could have exceeded $1bn, surpassing $5bn by 2025. With only $226m spent on blockchain projects in 2016 (per Gartner), the exponential growth of the industry is evident, equivalent to a compound annual growth rate of over 60%. The broader benefits of implementing blockchain (additional revenues and/or cost savings) are not covered in these forecasts, but to provide some context, around $400trillion in non-cash transactions are handled by banks globally. Were only a small percentage of this figure to be transacted over blockchain systems, then this would be significant.
From an investment perspective, blockchain is perhaps today where the internet was 20 years ago. The robustness of blockchain technology is not up for debate; the challenge is how to commercialise it. In the near-term, the speculative hype surrounding bitcoin and other cryptocurrencies may end up distracting from the full potential that blockchain has to offer. Nonetheless, over $1bn of venture capital has already flowed into blockchain start-ups (per a Deloitte 2015 study; the figure is almost certainly much larger now). Institutional and retail investors have sought exposure to the theme via digital currencies (and futures contracts), yet the underlying blockchain platforms are still privately-owned. These include Chain, Digital Assets, Ethereum, R3 and Ripple. Many large banks (especially Goldman Sachs), payment networks (MasterCard and Visa) and IT consultants (Accenture and Capgemini) have taken stakes in these platforms as a way of gaining exposure to and knowledge about blockchain. Expect more activity here. And, among the major tech businesses, IBM and Microsoft already offer BaaS (blockchain-as-a-service) modules in their software suites. Meanwhile Google has recently become a major investor within the blockchain arena. Watch this space: blockchain looks here to stay.
Alexander Gunz, Fund Manager, Heptagon Capital
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