Carl Brenton, of Intertrust, discusses the rise of blockchain and the fact businesses should wake up to the industry's growing adoption of Bitcoin. This article first appeared in The Drawdown's Private Equity Funds Report, October 2017.
Blockchain has a long and interesting history but before jumping into that history, it's useful to look at the concept of trade from a macroeconomic perspective. Humans dislike uncertainty and have always looked for ways to lower risk when trading with others. Trust between trading partners of goods and services needs to be established prior to participants being willing to engage in trading activity.
Prior to the mid-1800s, trade was typically transacted between a local economy, or a village, to simplify the comparison. Trade happened among villagers because everyone knew and trusted one another. If one villager didn't live up to their side of a trade, all the others knew this person was untrustworthy and would be unlikely to trade with them in the future.
As societies and trade routes grew larger and more complex, the ability to trade with more people outside of villages became possible. Trust issues grew as it was difficult to trust unknown individuals outside the village. This inability to trust others gave birth to the institutions we use today to facilitate economic activity; banks to trade currency, governments to enforce laws and regulations and marketplaces to exchange goods. These intermediaries allow us to put our trust in them instead of the people we are transacting with. You know if you swipe your debit card at Starbucks you will get a coffee and the bank will deduct the funds from your account and Starbucks knows that they will get paid for that coffee by your bank.
Other examples of trade facilitated by trust are Air BnB and Uber. Both platforms allow individuals to trade with one another where trust is established by property ratings on Air BnB or driver and rider rankings on Uber. These platforms, however, are still intermediaries facilitating trade between individuals, and intermediaries always want a fee for facilitating the transaction. Will blockchain technology remove the need for trust among traders while also eliminating the need for intermediaries? It's too soon to tell but on paper the potential fee reduction benefits are compelling.
The other side of the [bit]coin
In 2009 a programmer named Satoshi Nakomoto released an open source software to the world known as Bitcoin. Bitcoin became the world's first cryptocurrency, allowing transactions to take place between users directly without an intermediary such as a bank. The transactions are verified by network nodes and recorded in a publically distributed ledger called a blockchain. While Bitcoin was created using blockchain technology, its uses were focused solely on financial transactions. One of the first recorded Bitcoin transactions occurred in 2010 when Florida programmer Laszlo Hanyecz convinced someone to accept 10,000 Bitcoins he had "mined" on his computer in exchange for two pizzas delivered by Papa Johns. At the time of the transaction there was virtually no value for Bitcoin when compared to conventional currencies. Indeed, Ƀ1 was worth just fractions of a cent each in 2010 compared to $2,615 at the time of writing. While the value of Ƀ versus USD varies dramatically daily, those two pizzas would be worth well over $42,000,000 today. That is some expensive pepperoni!
While the tremendous growth in the value of Bitcoin is impressive, the technology on which Bitcoin is based holds the true value -- the blockchain platform.
In 2013, 19-year-old cryptocurrency researcher Vitalik Buterin proposed a new open-source, public blockchain-based platform that featured smart contract functionality. The system went live on 30 July 2015 and the true possibilities of blockchain technology started to emerge.
So, what are blockchains and smart contracts?
A blockchain is a decentralised database used to maintain a continuously growing list of digital transactions, called blocks, across a peer-to-peer network. A block can be thought of as an individual page of a stock transaction ledger, secured through cryptography, where transactions are recorded. Each block contains a timestamp and a cryptographic link to a previous block. New blocks of validated transactions are linked to older blocks, making a chain of blocks that show every transaction made in the history of that blockchain. The entire chain is continually updated so that every ledger in the network is the same. This replication of each ledger across the network makes it impenetrable to hacking. Not only would a block need to be forged, but every block in the entire chain across millions of computers on the network would need to be forged. This security is what provides trust among the participants to a transaction. Where trust has been traditionally given to an intermediary or middle man such as a bank to exchange currency, or the likes of Amazon and Ebay to exchange currency for goods, these intermediaries can be removed and individuals can transact directly with one another through trust established on the blockchain.
Taking things a step further, we enter the realm of smart contracts. Smart contracts were first proposed in 1994 by computer scientist Nick Szabo, but the full potential for the technology was not realised until the advent of the blockchain. A smart contract is a contract that self-executes. It handles enforcement, management, performance and even payment of the agreement within the contract itself. Looking back at our debit card transaction at Starbucks, when your debit card is swiped there are several companies involved in processing that transaction (each taking a small cut of the transaction). Several days later a "settlement" occurs in Starbuck's bank account. With smart contracts and blockchain technology that payment and settlement occurs simultaneously – the ledger is simply updated.
Smart contracts can be written on the Ethereum platform, as well as others, using code to automate the contract process. The practical applications of smart contracts offer tremendous value and an ability to disrupt the current financial and legal system.
Disruption from technology advancements
"Neither Redbox nor Netflix are even on the radar screen in terms of competition, it's more Wal-Mart and Apple." Jim Keyes, Blockbuster CEO in 2008.
This seemingly naïve comment in 2008 would be Blockbuster's undoing just five short years later when they declared bankruptcy.
As we have seen with how fast Uber and its competitors are disrupting the traditional taxi model, or how Air BnB is disrupting the hotel industry, technology has the ability to disrupt longstanding industries and disrupt them fast. Is the world of finance the next industry to get left behind with Blockbuster? Blockchain technology and smart contracts' ability to potentially eliminate many longstanding processes means the finance industry is definitely taking notice and investing in this technology.
Practical blockchain and smart contract applications
While this technology can be confusing, it is easier to see the possibilities once we look at some real world examples of how it can disrupt and improve different sectors today.
Tremendous effort is spent by organisations globally to properly
identify their customers, especially in the world of finance, asset
management and entity management. Every institution has largely
staffed compliance departments to request, receive and manually
determine if the identification documents received are valid. If
more information will be requested the process can take as long as
50 days to onboard a client at many large corporations.
Beyond the resources used for this endeavour, the risk of sensitive client documents being intercepted while being sent via email only increases with the rise of cyber-attacks. Blockchain's ability to create secure and verified digital identities eliminates much duplication of effort. A user would need to only load their KYC data once and keep it current in one location, rather than with every institution that they transact with. Similarly, institutions wouldn't all need to perform the same verification procedures on the same person or entity. While there are many challenges with KYC including security, who has access and what standard of KYC is required, the focus should be on the potential upside to customer experience.
- Audit procedures: Blockchain technology has far reaching implications for the current audit process. A significant amount of audit time is spent verifying transactions and balances.Accounts receivable confirmations are manually sent to customers and manually received, collated and tallied. Bank confirmations are sent to financial institutions to verify balances reported in their financial statements. Imagine if all these transactions and bank balances were verified using blockchain technology. The need to verify balances with third parties would disappear. An account receivable for Company A would show as an account payable for Company B and both would match the blockchain records. Blockchain technology could essentially make the majority of audit procedures unnecessary. With the ability of blockchain technology to severely disrupt the accounting profession, we would expect accountants to be taking notice; however, a recent survey showed that only 4% of respondents selected blockchain as a disruptor that will have a great impact on their business 25 years from now.
- Cryptocurrency hedge funds: Managers are already launching hedge funds primarily involved in holding coins and participating in Initial Coin Offerings (ICO's). With the enormous profits made on Bitcoin alone since its inception, it is no surprise managers are interested in participating in this sector. One of the bigger names to enter this space is Pantera Capital, who launched their first US digital asset fund in 2013. Pantera is launching a new ICO Fund in 2017 with a $100m target and $35m already pledged from their existing investor base.
- Private equity fund
administration: Northern Trust and IBM have recently
collaborated on a new blockchain-based system to record
transactions involving private equity funds. The system records
transactions involving the fund, such as contributions by limited
partners -- currently a very manual process. The distributed ledger
even features an active mode that provides real-time data to a
European regulator, making the information more reliable and timely
than traditional reporting methods. In addition to making the
onboarding process for new investors much faster, the use of smart
contracts in place of subscription agreements will also expedite
the capital call and distribution process which typically takes no
fewer than eight steps by the manager, investor and
With a smart contract all manual intervention could be eliminated. When funds are needed for deployment, and are in agreement with the contract, the appropriate ledgers would simply be updated, reducing the investors' bank balance and increasing the funds bank balance. Deployment of those funds could potentially even be automated in the smart contract. While this trial of the technology at Northern Trust is limited to just one client, this could be the tip of the iceberg for adoption in the industry.
While we are in the very early stages of widespread blockchain adoption, we should also reflect on how the internet got its start. Originally developed by the US government in the 1960s to connect computers, creating a fail-safe backup in case of a nuclear attack, early use outside of government was for universities and scientists to share data in the early 1980s. It wasn't until the mid-1990s that the general public started using the internet. Similarly, with blockchain it is expected that large corporations and governments will lead the first wave of adoption, with smaller companies creating applications to improve systems and processes related to how citizens interact in the economy.
Just eight years ago Bitcoin was created; it took two years before Bitcoins could be exchanged for pizza, and today Bitcoin is accepted at an estimated 260,000 retailers in Japan alone, while 10,000 ATM's in the EU now dispense Bitcoins. The majority of large American corporations such as Dell and Subway are already accepting Bitcoins demonstrating how quickly adoption can happen.
With all big four audit firms issuing whitepapers on blockchain and large financial institutions such as J.P. Morgan, Microsoft and Intel forming the Enterprise Ethereum Alliance to build business-ready software on the Ethereum platform, we are seeing the early, large corporation, adoption that will certainly spur widespread use like the internet experienced.
The concepts of blockchain, smart contracts and cryptocurrency can be overwhelming. Even when you think you understand them you realise you don't when you try to explain them to someone in simple terms. Once you start reading and investigating further, you may be left wondering what to do next and how to ensure you or your business are not left behind along with Blockbuster.
Continue educating yourself, researching what new technologies are being adopted and make sure you can have an informed discussion with your clients about this topic. With the rise of companies investing in this technology, it is only a matter of time before one of your clients does the same.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.