Inside the Blockchain Revolution: Will it Change Business as We Know It?
The cryptocurrency/bitcoin mania appears to have subsided in recent months, as prices have declined materially from highs and appear to have stabilized. As the dust settles, some investors are still scratching their heads wondering what the heck bitcoin and cryptocurrencies are, where they came from, and what they mean.
To understand cryptocurrencies and bitcoin, one must first understand blockchain. If cryptocurrencies are the houses, and sometimes a house of cards, then blockchain is the concrete foundation. Blockchain is the technology that is driving the cryptocurrency movement, and if you understand blockchain’s technology and potential, it might make navigating an investment in cryptocurrency and other new technologies less of a challenge in the future. Once you understand blockchain, we find it fairly convincing that this new technology can and probably will fundamentally change the way we conduct and transact business.
The biggest barrier for investors today in this context is that understanding blockchain is difficult. The technology is new, as is much the terminology that goes with it. But perhaps the best way to understand blockchain is to dig into how business transaction systems work now, and how blockchain intends to fix those systems.
Let’s start with an example that made major headlines recently: the Equifax hack. In that hack, some 143 million customers had their social security numbers and other data stolen by hackers who infiltrated Equifax’s system. The information was relatively easy to steal for expert hackers, because much of it was essentially stored in one place, in what is known as a centralized system or centralized database. Think of it this way: if all the gold in the world was stored in a single vault, the crooks would know exactly where to aim the explosives.
In the financial sector, the existence of centralized systems creates the need for businesses to be constantly “reconciling” transactions. When a check clears at a bank, both parties must reconcile the amount. When a stock is traded in the markets and ownership changes hands, both parties must reconcile the transaction. When large amounts of money are moved between global financial institutions, a centralized system known as “SWIFT” enables/facilitates the transaction. The “intermediary” in all of these transactions serves as the extra layer of security and reconciliation needed to facilitate transactions. The system works, but it is arguably (and verifiably) quite vulnerable to hacking and fraud.
Blockchain’s Claim: Centralized Systems are Old, Vulnerable Systems
The creators and entrepreneurs fueling the blockchain revolution see the ‘centralized’ system as fundamentally flawed. Without getting too deep into the weeds and to borrow a metaphor mentioned earlier, blockchain enthusiasts would say, “instead of storing all of the world’s gold in a single vault (centralized system), why don’t we store it in millions of vaults across the world and attach a digital record to each bar of gold (decentralized system), so that we can always know the gold’s location and ownership?”
In a nutshell, the “decentralized” feature is the essence of blockchain. Indeed, blockchain by definition is a decentralized network structure. So, instead of businesses recording transactions through an intermediary and/or on databases ‘securely’ located on their server, they would do so on a ledger that is distributed and shared throughout a system. The system in this case is blockchain, and a network of connected peer-to-peer computers represents the ‘millions of vaults’. In the simplest and most ideal blockchain, there is no centralized system or party that can exercise control over the network.
On this new type of ‘ledger,’ a history of work is kept by all computers on the network and cannot be changed, unless all computers on the network ‘agree’ to the change. For a hacker, fraudster, or thief, this means that stealing would involve hacking all of the computers in the vast network instead of hacking a single server. To think of this another way, for a thief to steal a bar of gold it would mean having to find millions of tiny gold hidden in the sand of the largest beach of the world, and then putting all of those gold specks together to make a gold bar. It seems virtually impossible.
How to Apply Blockchain Technology in the Real World
Blockchain, if applied on a broad basis, could lower costs substantially for both financial institutions and consumers, while also potentially preventing fraud. This could upend the financial markets as we know it, in a good way, in our opinion.
With blockchain, virtually any type of asset can be stored digitally and securely, meaning that money, equities, bonds, contracts, deeds, and so on can be moved from peer to peer potentially eliminating large scale fraud, and without vulnerable (or costly) intermediary like a bank or a government enabling the transaction. In this world, two or more parties can make transactions, forge agreements, and exchange value without the need for an intermediary to verify identities, handle the record keeping, clear the transaction, or settle any funds. Blockchain makes this process secure and instantaneous.
In this sense, blockchain could upend a number of complex intermediate functions in the financial industry like identity verification, moving value (payments and remittances), storing value (savings), lending and borrowing (credit), trading value (marketplaces like stock exchanges), insurance and risk management, and audit and tax functions.
Here are a few specific examples of potential applications:
Clearing and Settlement of Trades
Every seasoned investor knows that when you make a trade in an account, you generally have to wait for 2 - 3 business days before the cash “settles.” Using blockchain technology, there would potentially be no need to wait for 3, 2, or even 1 day for the cash to settle. Since the value of the assets would correspond to a digital key, the records could be changed instantaneously and the assets could securely be used again immediately.
Government Regulation
Governments could have many uses for blockchain technology, the most important of which is verification of transactions in the capital markets. The government is consistently trying to track financial transactions - whether in the stock markets, corporations, or between individuals - and blockchain technology can provide them a new set of compliance regimes to do so effectively.
Audit Trails
At present, banks and other large financial institutions have to take multi-level measures to secure the client account information they hold. Banks can spend billions of dollars to keep information secure, but not all businesses that have sensitive information are banks. The end result is a field day for hackers who want to target businesses and expose customers' intimate financial details. Think Equifax.
Blockchain technology offers a method for automatically creating a record for who has accessed information or records and to set controls on permissions required to see the information.
Markets
If you think of blockchain as digitally unique keys that control code, and in turn, that code expresses ownership rights of any asset or physical item, then it wouldn’t take much additional imagination to see how that ownership of code can come to represent a stock. Blockchain technology can then be calibrated to perform transactions or report transactions of trades, keeping an exact digital record that cannot be altered or fabricated.
Getting in the Game
The endgame for these financial institutions is fairly obvious: cut costs dramatically and eliminate fraud altogether (which also cuts costs dramatically). As it stands today, given the amount that banks spend on security and infrastructure for financial transactions, they could potentially save tens of billions of dollars.
For financial services, blockchain activity began a few years ago and has been advancing through closely managed pilots and tests. Behemoths like Banco Santander, RBC, JP Morgan, Citibank, BNY Mellon, American Express, Visa, and MasterCard are all reportedly experimenting with multiple blockchain-related efforts and have internal working groups or dedicated people focusing on blockchain technology.
These efforts are no longer backroom operations, either. In April 2017, American Express applied for a patent for a new customer rewards program that uses blockchain for record-keeping and cryptocurrency for reward points. In November 2017, Visa unveiled a pilot of its blockchain-based business-to-business payments service called “B2B Connect.” In March 2017, MasterCard applied for a patent for the blockchain-based storage of payment histories between vendors and customers.*
The list goes on and is almost certain to continue growing into the future. In the next two decades and beyond, we could see blockchain move from tech geek lingo into the mainstream of how we conduct and transact business.
Please keep this in mind as you make your plans for 2018. Also keep your eyes open for any trends that could be beneficial to your portfolio.
Although blockchain is still in its infancy, and an untested financial technology; one established trend which we outline in our Zacks Advantage, The Savvy Investor’s Guide, is how our actively managed robo advisor can leverage the use of new financial technologies by:
