Blockchain: The Next Wave of Technology Disruption

08.16.2018 - Viraj B. Patel, CFA, FRM, CAIA

Blockchain, the technology that makes it possible to use digital currencies like Bitcoin on the web, is slowly revolutionizing the world of online transactions—whether they are financial transactions or the exchange of sensitive information.

Every day, small entrepreneurial start-ups and large multinational corporations are finding new applications for Blockchain, leveraging the backbone of the digital currency world to drive innovation, reduce costs and improve online security.

As more investors understand that Blockchain is a distinct technology, separate from Bitcoin, and offers applications across a variety of industries, it is also attracting more investment capital. Blockchain is still in its infancy. But its potential as a long-term investment is clearly moving into the consciousness of mainstream investors.

Blockchain Makes Transactions More Secure

Blockchain was developed to make Bitcoin transactions safer and more secure. In simple terms, each buyer and seller has identification markers that confirm his or her identity. Those markers are combined with details about the transaction to create a “block” of information for each trade. It creates a permanent and transparent ledger of every transaction on the network and broadcasts that information to every user. When blocks are connected, they create a chain of blocks, i.e. Blockchain, that ensures the validity of each exchange (CHART).

In other words, Blockchain provides more trust on the internet by using mass collaboration and clever coding, rather than traditional intermediaries like banks and government agencies, which are susceptible to intrusion and corruption. Because it is a vast, global network running on millions of user devices called nodes, it is also insulated from hacking or alteration.

Beyond Bitcoin: Blockchain Will Be a Game-Changer

As Blockchain evolves, it is becoming increasingly clear that it offers benefits well beyond the world of e-commerce and digital currencies. For example, Blockchain is already being used to execute smart insurance contracts that automatically pay claims as soon as a certain event happens.

Blockchain also offers the potential to protect personal information, such as financial and medical records, by verifying a person’s identity and transferring it safely and securely. In the future, Blockchain could allow important legal documents to be notarized online, personal computers to be used for voting or for collaborating with your neighbors to solve an issue that affects your community.

In our view, however, Blockchain’s most attractive feature is its ability to reduce the direct and indirect expenses associated with online transactions, i.e. frictional costs. Because Blockchain is an automated process that uses algorithms to establish a clear set of rules for doing business on the Web, it eliminates steps that currently slow down the process, thus improving efficiencies and cutting costs.

Disrupting Traditional Financial Services  

In many ways, the original intent of Blockchain was to disrupt the traditional financial ecosystem. Its goal was to create a peer-to-peer medium of exchange that would eliminate the need for financial middlemen and allow anonymous online transactions. Ironically, many large banks and other financial institutions are now using Blockchain technologies to their advantage—leveraging private networks to reduce transaction costs.

For example, Wall Street is using Blockchain to reduce the collateral or margin investors are required to supply when trading options contracts, and stock exchanges are considering the application of Blockchain to settle trades more quickly and efficiently. Some of the largest insurance companies in the world are exploring Blockchain as a tool to speed up certain processes, such as transferring mortgage titles.

The big question is: Will large financial institutions be able to keep pace with change and maintain their role as intermediaries in this new financial ecosystem? Or will new competitors replace them?

In our view, traditional intermediaries are more likely to weave Blockchain into the current financial system than they are to be replaced by upstarts. Large, well-known banks and other financial services companies are investing heavily in Blockchain, which could cut costs by as much as $20 billion a year.

Roadblocks Ahead? The Potential Challenges

Although Blockchain is touted as an impenetrable system, security is still a concern as significant hacking incidents have tarnished its reputation. The rise of quantum computing, which promises to put more computing power in the hands of individuals than ever before, could add to this threat.

Other challenges include the limited portability of transaction data from one Blockchain network to the next, and questions about the business, legal and technical barriers businesses face when implementing Blockchain applications.

Finally, it appears likely that Blockchain will face some form of government regulation in the future, as organizations such as FINRA, the Federal Reserve,  the SEC, and the Commodities Futures Trading Commission carefully study the issues. On Capitol Hill, the Senate is considering a bill that would require Bitcoin handlers to report suspicious transactions, and a House bill seeks to impose capital gains taxes on Blockchain transactions.

Regulations can be burdensome for any industry, especially one in the early stages of development. But we believe a reasonable regulatory framework would actually improve Blockchain rather than hinder it by providing early adopters with clear guidance on the rules of engagement, protecting users, and eliminating the regulatory uncertainty hanging over the industry today.

How to Invest in Blockchain: Follow the Leaders

The environment for Blockchain today is similar to the one we witnessed in the early days of the dot-com boom. If it follows the same general growth pattern, we expect some of the early entrants to succeed and others to wash out. Until the market matures, it is impossible to know who the eventual winners and losers will be.

But because Blockchain is still in its infancy, and many of the most innovative suppliers are smaller, privately owned companies, the activities of venture capitalists in this area are worth watching. With this in mind, the most prominent contenders in Blockchain technologies today appear to include forward-thinking competitors in the semi-conductor business and Big Data research companies.

Blockchain won’t change the world overnight. But it is quickly revealing exciting new investing opportunities among small start-ups and well-established players alike. In our view, companies that are testing new Blockchain applications today could have significant competitive advantages in five or ten years.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of August 16, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. 
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