Global Equity Observer
December 30, 2021
To the Moon? Quality Investing and Blockchain
Global Equity Observer
December 30, 2021
To the Moon? Quality Investing and Blockchain
December 30, 2021
2021 has turned out to be another year of the cryptocurrency. Bitcoin (~+97%), Ethereum (~+527%), and the now infamous Dogecoin (~+4,486%) have all dramatically outperformed the S&P 500 (+22%).1
In August 2008, in the midst of the Global Financial Crisis, a nine-page paper titled Bitcoin: A Peer-to-Peer Electronic Cash System was published under a pseudonym on a cryptography mailing list. Two years later, Laszlo Hanyecz offered 10,000 bitcoins in exchange for two pizzas, the first recognised commercial transaction on this new payment concept. Thirteen years on, Bitcoin still exists, functioning as a network to move value on the internet without the use of a central authority—even if Bitcoin itself has become more of a speculative asset than a stable substitute for money. Today, those 10,000 bitcoins are worth ~US$470 million and cryptocurrency system tokens have a total market capitalisation of around US$3 trillion.2
Last month the first a bitcoin-linked exchange traded fund (ETF) was finally launched, becoming the fastest ever ETF to reach US$1 billion of assets.3 An ETF which directly owns Bitcoin (rather than Bitcoin futures) still awaits approval from the U.S. regulator, the Securities and Exchange Commission (SEC).
Blockchain – the underlying technology
Bitcoin is underpinned by blockchain. For many, blockchain is a difficult field to get comfortable with because it sits somewhere between economics, cryptography/database construction, theoretical statistics, and sometimes even philosophy— academic disciplines of which few people have a combined understanding. It is also surrounded by a huge amount of noise from fringe libertarian followers, and the system is rife with hype from fraudsters. Whilst blockchain was initially a consumer-led innovation, dismissed by professional investors and regulators, a recently renamed social media company’s 2019 digital currency project was a turning point; the potential of a well-funded company with over a billion users to create a more or less instantly scaled, systemically important private currency was a wake-up call.
Without getting into how blockchains work, the key concept is that they are a new type of database architecture with the potential to disintermediate many existing business models, particularly, but not exclusively, in financial services. This new database structure facilitates the transfer of value between parties over the internet without a central authority. It also allows for the creation of automatically-executing ‘smart’ contracts and programmable money—which we explain later. Its presence and properties could theoretically lower the costs of verification and network construction in the economy.
In more tangible terms, today when you use digital money on a debit or credit card to buy something, banks and payment networks extract fees for verifying you are good for the money you are giving to the merchant in exchange for a particular product or service. Verification costs are even higher when multiple parties need to verify/audit the transfer of assets through a chain of correspondent bank ledgers across borders. This is the reason cross-border remittances are slow and costly. Blockchain technology could enable such transfers more quickly and cheaply, in ways that are more easily auditable by all parties involved. Blockchain database structures allow for one central “source of truth”, a ledger, to be distributed across many parties that can store a copy of it, access it and add to it.
Blockchain also has the theoretical ability to lower the barriers to entry to building a new network. If you wanted to build a new centralised payment network today, it would entail very high startup technology and security costs. Blockchain networks can be built up over time far more cheaply, using incentives for users, investors and developers, with both the security and the value of the network itself scaling as the network grows. We believe that this innovation in verification and in networking economics has implications for the long-term outlook of moats around the returns of some quality companies and how they do business today.
Opportunities posed by blockchain
We believe that the properties of blockchain can pressure existing industries to become higher quality and can also allow the creation of new quality businesses, which centralised system economics have so far failed to achieve. Pressure from blockchain on incumbents could alter current competitive industry dynamics and encourage co-operation among natural competitors—or ‘co-opetition’. A good example is supply chain finance, a US$16 trillion industry4 with an all-too-common reliance on archaic paper forms and stamps.5 Blockchain competition is encouraging banks, commodity firms and shippers to group together, standardise and digitise their processes in ways that previously proved elusive. Thus paper methods move to digital, saving significant operational costs, increasing efficiencies and speed and also releasing collateral capital from the system. The most bullish estimates suggest this could free up over US$1 trillion of cost from the system.6
Whilst blockchain networks are ideally suited to large multi-party networks with significant agreements to move ownership rights, the eventual solution may not be a new, decentralised blockchain company. It may actually be preferable simply to upgrade incumbent systems on existing centralised databases using apps, or to use a more centralised permissioned blockchain—which isn’t that different to the systems that exist today. Either way, the presence of blockchain is forcing progress. Without the existential threat it poses, many industry incumbents lack the impetus to change (inevitably in many instances the threat may not be enough). There are opportunities not just around systems that already exist; there are many new ideas and functions which could become very high return businesses of the future—for instance a blockchain network allowing customers to buy art or real estate, thus replacing complex auction and legal fees.
Continuing the supply chain theme, blockchain experimentation is leading to innovation in tracking the provenance of goods. This could significantly reduce waste. While not a decentralised blockchain system like bitcoin, an American multinational retail corporation is experimenting with blockchain company Hyperledger Fabric to bring greater transparency to food supply chains. This could enable highly selective recalls of specific batches of contaminated foods, such as E. coli infected food, eliminating the huge wastage that occurs in indiscriminate recalls when contamination is detected today.
Cryptocurrencies and the central banks
Pressure to change even extends to central banks. Today, consumers have two main forms of money: cash directly issued by central banks in a physical bearer form, and account-based money inside the banking system. We believe that Bitcoin has proven the concept of a new form of peer-to-peer value, a private form of currency in the form of a digital bearer asset, with a pre-programmed monetary policy. Whilst private currencies are not a new invention, digital private currencies have the potential to scale up and provide a decentralised check.
Furthermore digital programmable bearer assets represent many new opportunities. They can increase the safety of the payment system. Historically, cash was a reasonable alternative to account-based digital money. However, as the use of cash declines, and the systemic dependence on the private companies operating payment systems risks single points of failure, what happens if any major card network gets hacked, or simply breaks? If a central bank could issue tokenised digital cash, they could create a viable alternative digital payment system. Central bank issued tokens could also have additional features which are not present in the system today. For instance, they could automatically be linked to central bank interest rates, positive or negative. This is particularly interesting for negative rates, whose real efficacy today is more constrained by the presence of physical cash. Singapore, Canada, China and Sweden have all been testing some advanced digital currency programs.7 One of our portfolio companies runs the E-krona project for the Bank of Sweden.
Outside creating new digital bearer forms of cash, tokens can be structured in many ways, both fungible and non-fungible. Some are designed as revenue utility tokens—think of them like a token which represents a single use of an arcade game or laundromat machine. Some are structured more like equity, giving theoretical rights over fee pools and profits. Other tokens are digital representations of assets, from stable coins which are fungible and represent fiat currency, to NFTs (non-fungible tokens) which represent ownership over digital art for instance, but could also represent physical art, or even your home. The customisable nature of tokens opens up all sorts of other parts of finance and asset transfer.
Tokens are also another way to bring liquidity to fund businesses. You may have heard about ICOs (Initial Coin Offerings). As a structure, they have the potential to turn private venture capital funding or expensive initial public offering processes from being local and closed, to global and open to everyone. Asset tokenisation can extend far beyond financial services; theoretically the Mona Lisa could be turned into a token and ownership of the painting could become far more accessible and liquid. Owners of a Mona Lisa token could attain rights over ticket revenue to view the Mona Lisa. In the coming decades, it isn’t beyond the realms of possibility that something akin to a Mona Lisa token could form part of a future global equity strategy designed around strong franchises.
In the meantime, why is all of this of interest? Many of our team’s existing holdings are already investing in blockchain and are creating new services to profit from blockchain. For example, a multinational professional services company has already been mentioned as a key partner with the Swedish central bank, the Riksbank. One of the world’s largest software companies runs one of the largest blockchain-as-a-service (BAAS) products on its Azure platform, enabling its clients to deploy blockchain networks, build apps with confidence and store data off-chain. A multinational IT services company similarly has a BAAS offering integrated with its cloud product Leonardo. An American technology conglomerate is creating a search engine for blockchain and has partnered with Chainlink, a blockchain platform which provides data signals, or oracles, from the real world for smart contracts. A global payments company is instrumental in enabling fiat currency to crypto payments, and it is pursuing a large amount of experimentation and investment in blockchain, including investment in Anchorage Digital, one of the leading custody providers in crypto. A Singaporean financial services corporation is part of the eTrade Connect consortium to modernise trade finance using Hyperledger. At this stage these exposures are not material—but could be very material on a 10-year view.
We are still very early in the advent of the ‘Internet of Value’. Most concepts to date do not work properly at scale outside of highly controlled experimental environments. Blockchain is going to have to prove that it can solve real problems in an economically viable way. The list of problems to overcome is long. It includes scalability, speed, privacy, security, environmental impact/energy intensity, governance, and more. Know Your Client, anti-money laundering, general data protection regulation (GDPR) and investor protection issues are all being considered by regulators, but approaches vary between getting blockchain organisations to fit into existing financial services registrations and creating new frameworks. One common area of global focus has been on the stock exchanges as they interface with the existing financial system. Ultimately, the cryptokitty is now out of the bag and there probably isn’t any going back.
Shoot for the moon?
It is very hard to say what the future looks like, but if we were to hazard a guess, where centralised, scalable systems work well in the main—like a global payments company’s platform which processes approximately 2,000 transactions a second—blockchain is more likely to encourage innovation by incumbents and disintermediate the pricing in some of the functional layers these businesses undertake today. In these instances, there often isn’t a massive problem to fix, but rather a series of things to improve. However, where incumbents have so far resisted change and sleepy, paper-based value transfer is the norm, new blockchain companies may well completely replace existing ways of verifying asset transfer. In the meantime, one of the biggest obstacles immediately ahead is regulation, but once there is a framework for how blockchain fits into public policy, institutional adoption will likely be further enabled, and progress should re-accelerate.
Many prominent investors and economists are contemptuous of cryptocurrency. Dogecoin may turn out to be tulip mania, or maybe, as the official Dogecoin song8 goes: ‘To the Moon!’, the HODL (Hold On for Dear Life) Doge Army is rightly throwing down the gauntlet to all of us to be more imaginative about what the future could look like.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small- and mid-capitalisation companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. ESG strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance. Cryptocurrency (notably, Bitcoin) operates as a decentralised, peer-to-peer financial exchange and value storage that is used like money. It is not backed by any government. Federal, state or foreign governments may restrict the use and exchange of cryptocurrency. Cryptocurrency may experience very high volatility.
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