As the prices of cryptocurrencies fluctuated wildly over the last year, bitcoin and blockchain—the underlying technology that powers it—captured the popular imagination.
Blockchain is a distributed-ledger technology that employs cryptography to ensure the integrity of the data it stores, with control of the data distributed among all parties using it. Because the data is public, care must be taken to ensure its integrity. The key innovations of blockchain have been to use cryptography, proof of work and tokens (e.g., cryptocurrencies) as incentives for participants to perform the work to ensure the data’s integrity.
Blockchain’s shared ledger eliminates the need for intermediaries to establish trust and authenticate identity between two untrusted parties who want to transact. As a result, blockchain has the potential to cut out the financial middleman.
Titles to everything from property to securities to cryptocurrency can be written into blockchain, allowing parties to verify ownership without needing a financial intermediary to facilitate the transaction. Parties can move almost immediately from execution to settlement, collapsing the time required for settlement from days to minutes. This can potentially eliminate not only the back-office costs associated with clearing, but also costs associated with putting up margin until a transaction closes.
While blockchain technology can be adopted by existing financial institutions, it has the potential to enable a new set of payment rails that circumvents the existing financial establishment while, for example, allowing merchants to bypass elevated credit card processing fees.
In addition, blockchain has new capabilities such as the ability to deploy “smart contracts,” self-executing contracts that are written into the computer code. If the mutually agreed upon conditions of the transacting parties are met, the smart contract will execute automatically with transparency and no reversibility, reducing transaction costs.
Although it is still unclear whether bitcoin will become a lasting piece of the financial firmament or is just a passing fad, it does provide the three key functions of a currency—it works as a store of value, a mechanism of transaction and a unit of account. Particularly in countries that have histories of financial instability, bitcoin could prove to be an attractive alternative to local currencies. It could potentially play a similar role to the one gold has historically, as a hedge against uncertainty.
To put it in context, the bitcoin in circulation today is worth around $125 million while the value of all gold ever mined is worth around $7.9 trillion. If bitcoin began to function more like gold on the world stage, those valuations could converge.
We believe there are three key challenges that blockchain will need to overcome.
First, achieving critical mass. Blockchain-related technologies benefit from a network effect, meaning the addition of each person to the network increases the value of being on the network to everyone else. While a network effect is a strong competitive advantage in a mature business, the downside is that they are very difficult to start.
Second, regulatory uncertainty. Regulatory bodies across the globe have increased their focus on all aspects of blockchain-related businesses—for instance, both China and South Korea have banned initial coin offerings—and new regulations that limit what can be done with blockchain could reduce its attractiveness.
Third, resource requirements. Storage demands grow exponentially as more nodes/users are added to the system, and the proof of work calculations needed to confirm bitcoin transactions require a large amount of electricity—by some estimates, about as much as is used by the entire country of Denmark. In order to continue growing, changes to the protocols will need to be made to reduce their resource requirements.
Blockchain is still in the early innings of development, but over time it has the potential to become as ubiquitous as the internet. We will probably see a mixture of both blockchain-native companies and companies adopting the technology to improve their existing business processes and to attack new market opportunities. We believe blockchain will continue to garner increasing mindshare in the years ahead.
Dennis Lynch and Stan Delaney are part of Morgan Stanley Investment Management’s Growth team.