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Not long ago, a client asked us to have a general discussion with them to help them better understand blockchain technology and crypto assets and to share our views on the sector. We do not yet view cryptocurrencies or assets as an investable sector and we do not encourage investment. Still, we always try to stay informed and knowledgeable about evolving opportunities in our industry. The most recent volatility in crypto assets further confirms to us that the space is still maturing, with the value of the sector not fully clear. For those interested, we share here our conversation of the background and structure basics of the technology.
The vision of a Decentralized Financial System Post-2008
When blockchain first started getting going and people really understood it, Walmart came out big saying “this is going to be awesome; we are going to build a blockchain because it will manage our supply chains in incredible ways.” And when you think about the idea that blockchain is a decentralized ledger, then, in theory, it would have been an extremely efficient way to be in touch with vendors and manage a supply chain. Yet the promise of that has yet to come true. That does not mean it won’t, but it is clearly still too much of the wild west.
The whole underlying premise of this technological evolution is that there is value in the idea of something that is decentralized instead of centralized- like our central banking system. The original blockchain and every blockchain since then has basically been built by convincing you, your buddy down the street, and some other inspired person to invest in a piece of equipment- a computer with enough computing power- to add on to the decentralized chain to mine a cryptocurrency and build out a network around the world of computing power to allow crypto-based transactions to take place. The premise of the whole thing was “how can we do this in a decentralized way and maintain security, so we won’t be vulnerable to another 2008 financial collapse?” That is really where the interest in all of this took off- out of the 2008 experience.
There is something appealing about that, but where we are today there is also something a little bit shady still about that. Particularly because the network itself is not transparent. We like that it is decentralized and can be rather anonymous. However, it’s not really anonymous because you have a ledger, and while you don’t know specifically who people are, you can figure it out rather easily. The FBI has already proved this. But underlying these features are the nodes of the network themselves. For each of the nodes that create the network. there is little necessity or confidence that the node is managed or run by the quality of a manager that you would want. Anyone with the money to buy a powerful enough computer can launch a node. Why it all works and could continue to work is you’ve got these built-in incentives to create and maintain the node. For launching the node, you then will mine some sort of crypto asset that will have a value, potentially. You hope the financial incentive is sufficient to keep it a stable, decentralized network.
Now, in contrast, we’ve seen JP Morgan, Citi Bank and Goldman Sachs say that they are building blockchains internally. This is because they like the idea of transactions that can come off of multiple nodes, with security, and with a security protocol to collateralize transactions, but they are implicitly saying “whoa, we don’t want it so decentralized that we don’t know who manages every node of this thing. We want it decentralized up to the point that it is still completely under our control.” When they build these networks, they maintain the infrastructure and security. This is evidence that the blockchain concept and structure might have appealing features, but not as it is evolving in the public domain.
So you’ve got that stress of when and how this technology and structure really becomes a long-term, a backbone to many things in our world and our economy. Does it stay the current wave of Bitcoin, Ethereum, or one of any number of other public-domain backbones that are being built and managed by unknown computer owners? Or if we start putting in any type of regulation or oversight, do we take away the desired value of decentralized and uncontrolled network? Does increased oversight add stability and confidence, or does it eliminate exactly what people wanted about it? To my mind, these are the underlying key questions as to what investors, developers, and participants are struggling with today.
The Structure of Blockchain
Bitcoin (with a capital B) is the blockchain network structure that was designed to deliver a decentralized, anonymous platform for transacting. The structure relies on a “proof of work” when a transaction is executed to assure that both parties are legitimate. To achieve this confidence, it was designed to have some latency in it to allow for the proof of work security to execute. The latency is necessary to allow for that extra beat to check both sides. There are some people who argue that is why Bitcoin could never be the surviving blockchain structure, not because of the security, but because that latency can never scale. The open code behind Bitcoin is considered rigid in that there is not much that can be developed or evolved to further address the latency issue. This is why they are trying to find other ways to anonymously ensure a transaction- such as “proof of stake.” Several other techniques are being tried, but as each of them goes faster, they also give up something on that assured, anonymous security.
Ethereum is the blockchain that seems to have the most Defi (Decentralized Finance) on it with over 3,400 apps built and running on it today. The most technological innovations that are being added onto blockchain today are mostly on Ethereum. After years of delays, Ethereum is upgrading its software (known as the “merge”) in September to become more energy efficient. Moving to a proof of stake approach for validating transactions will reduce the computing power needed for processing, increase the speed of processing, and reduce the need for ever more computer nodes on the network.
There are great expectations for this evolution in Ethereum, but to my mind, it highlights that there are still major roadblocks in execution that are not easily addressed on even the most popular blockchain networks. For app developers, there is a desire for more speed with security, but once an app is deployed on a network, there is no going back. That app stays there in perpetuity even if it is no longer used or if it is deemed inappropriate in any way. The network is public and unsecured, so developers have no oversight or host to rely on.
There are also still major roadblocks in the structure that need to be addressed- such as energy consumption and scalability of a node network. All these challenges encourage the next blockchain to emerge to address them. There are few barriers for any new blockchain entry that can address these needs, and it is easier to create anew than to evolve a blockchain that is already deployed. Blockchain networks are all open-source code, and many people are trying to find ways to improve and build on the existing options.
When blockchain first started getting going and people really understood it, Walmart came out saying, “this is going to be awesome; we are going to build a blockchain because it will manage our supply chains in incredible ways.” And as you think about the idea that it is a decentralized ledger, then in theory it would have been an extremely efficient way to be in touch and manage a supply chain. Yet we are still waiting for the promise of that to come true. That does not mean it won’t, but it is clearly still too much of the wild west.
Status of Crypto Assets?
It is easy to pick your favorite cryptocurrency and follow its development, crash and occasional resurgence. Bitcoin was designed to explicitly mimic a gold standard-linked currency, and many people believe that this decision alone has doomed bitcoin from ever achieving true currency status. More importantly, to date, none of the cryptocurrencies have the features of a reliable, robust currency. Broader acceptance of cryptocurrencies will likely happen only when people actually need a cryptocurrency-when it is the available or even preferred way to make a payment on a mortgage, taxes, or any other type of liability. From here, it is still very unclear how any of the current offerings might evolve into a global asset of trusted and sustainable value- such as any sovereign currency “backed by the full faith and credit of” a government.
As for some of the existing end uses of blockchain technology other than supporting cryptocurrencies, most of them are still pretty flimsy. The ongoing goal is to develop something that is essentially computer code representing economic value. In common terms, we are calling this a non-fungible token or NFT. A couple popular tokens out there were even explicitly made as jokes. The companies that have embraced NFT’s are using them mainly as a marketing or promotional tool designed to interact with consumers or to get in front of new, younger audiences. Consumer goods companies like Nike, Adidas, Dolce and Gabbana, and Tiffany & Co have been active in this space; most of these tokens were issued as “digital collectibles” of some of their popular products or “digitally exclusive” items. Some video game companies have also experimented with NFTs, but have received pushback from players who see the potential of these tokens to turn into a “pay-to-play” scheme where those that spend the most cash in the game have an advantage over others who choose instead to progress in the game by actually playing and competing in it. Digital tokens and other blockchain-supported Defi should continue to proliferate, and we have no clear view yet as to what may eventually confirm lasting value here or not.
Most recently, the SEC has moved toward classifying some digital assets as securities with a goal of defining oversight and regulation of the investments. This move is likely to launch widespread pushback from the crypto community, which views the assets more as commodities. “Securities” are subject to different regulations than “commodities,” so this may turn out to be a defining decision in the evolution of digital assets and value.
Investing in the technology, not a Crypto Asset?
To the specific question of how to invest if this evolution intrigues you, and you are not interested in a digital asset, let us share a few thoughts. If it is the idea of the technology and where it is going that interests you, a somewhat easy way to get involved is a global blockchain ETF that is invested in a lot of players such as Bitwise Crypto Industry Innovators (BITC), one of the highest volume funds investing in the space, or Schwab Crypto Theme (STCE), a low cost fund that Schwab just launched focused on a broad range of companies involved in the development, mining, or facilitation of transactions in crypto assets. You can also look at investing in Coinbase (COIN), the company providing an exchange for predominantly retail cryptocurrency trading. Another way to think about the space is to look at Cathie Wood’s approach. Her funds have been high flying for years but have been devasted since the recent peak of the market. The flagship fund is ARK Innovation (ARKK), with two sub-funds trading as ARKW and ARKF. She and her team have been brilliant at identifying future, speculative trends and investing in them early. Yes, ARKK own Tesla which they got into very early, but the fund has always owned a rather short list of really “this could be big” kind of things. If you wanted to ask, “Is there a team out there you can bet on to see future trends early?” one way to do it would be to make a bet with the flagship fund or sub-funds there.