Global Trend

The easiest and most basic way to think about the underlying technology of blockchain is to imagine a system that keeps a master list of everyone who has ever interacted with it and gives everyone access to that list. Logically it’s analogous to allowing others to make changes to a shared document in Google Docs; the program keeps a list of all the changes that are made to the document and by whom. Blockchain does that, but in an even more secure way so that every person who ever touches the document is trusted and everyone gets a copy of all the changes made so there is never a question about what happened along the way. That way, there is only one trusted document, and it keeps track of everything that’s ever happened to it.

Blockchain provides a secure way to demonstrate who has made any transaction, and this chain can be seen by all participants. As a result, blockchain provides a level of trust and transparency far beyond anything that has previously existed in the financial sector.

On the most basic level, a blockchain is made up of two critical components: a block and a chain. The block is where transaction data is created and stored. A chain is created whenever a transaction is initiated by any particular participant on the blockchain. A typical transaction is illustrated in the printable issue. (See “HOW DOES A BLOCKCHAIN WORK?”) When one party requests a transaction, it goes to the Peer-to-Peer (or P2P) network. Individual nodes on the network receive and validate the transaction. This validation is then processed and stored on the distributed blockchain ledger. Once the new block is added to the existing chain, the transaction has been completed and all participants know it has occurred.

What is unique about this process is that there is no single node that dominates the chain. The distributed ledger is recorded across the network, making it impossible to cheat or steal. Unlike a traditional bank where a robber could come in and steal money, there is no way to corrupt the chain.

Although someone could steal an individual’s network key and then use the stolen key to capture whatever of value is on it (as has happened with real-life Bitcoin thieves), the blockchain itself will not be affected. And since all transactions are recorded on the blockchain, even if someone’s key has been stolen, if the robber transfers the contents of the stolen key to their personal key, this will be captured on the blockchain.

The implicit availability of peer-to-peer transactions without traditional financial institutions represents a monumental step forward in the democratization of financial transactions. Therefore, it seems that blockchain technology could fundamentally transform financial markets around the world. However, what that means for governments, financial institutions and existing cryptocurrencies is unclear.

From its beginning, the Trends editors have recognized the enormous transformative potential of Blockchain technology which extends far beyond financial transactions. At the same time, we’ve been wary of the speculation and hype surrounding Bitcoin and other private cryptocurrencies.

To understand our rationale, let’s first consider, “What is the value of having a blockchain for financial transactions?”

The answer lies in its ability to create trust. Today on the Internet, an intermediary is providing trust for every single transaction that occurs. If you want to send money to your friend, you have to use a financial services provider to send them the money. You could Venmo $10 to your friend, with Venmo being the intermediary of your financial transaction. You can’t just send $10 directly, you have to use some type of financial intermediary.

Having an intermediary becomes more problematic across longer distances. Say you want to send money to someone outside of the United States. Now you run into the issue of having to go to a Western Union or some other international transfer service, pay a substantial fee to transfer funds, and then the recipient will have to go to their local branch of the service provider to get those funds.

The intermediary throughout this process is Western Union or some similar institution, and they get a cut of the transaction. This process is both expensive and time-consuming. If you could just push a button and send money abroad without having any intermediary involved, this would be great. It would make the transaction frictionless and allow capital to travel more efficiently.

At its best, blockchains promise to be fast, have no intermediary and maintain nominal costs, all while being transparent and secure. And the blockchain enables transactions to occur at a lightning speed compared to current methods of financial transactions. This is why our long-time friend Ginni Rometty, formerly CEO of IBM, stated that “Blockchain technology will do for transactions what the internet did for information.” And this is also why Jaime Dimon launched the JPM Coin cryptocurrency to dramatically accelerate the speed of transactions at the bank.

Blockchain was invented in 2008, but it was not until 2017, that it captured the popular consciousness. That’s when bankers, financial institutions, and regulators began to look at blockchain in a serious way. At the time, the World Economic Forum released a white paper on blockchain titled “Blockchain Beyond the Hype: A Practical Framework for Business Leaders.”

In that paper, the authors examined the unique potential blockchain has to affect the business world and analyzed its value by looking at demand, the business rationale for it, and the best way to use it. Taking a closer look at their arguments provides a roadmap for where blockchain technology could go in financial markets.

But that begs the question, “If Blockchain has so much potential to improve financial transactions, why don’t the Trends editors see a bright future for Bitcoin and its peers?”

The first problem with private cryptocurrencies is the potential for market manipulation. The market for Bitcoin and its peers is a bit like Wall Street in the days before there was an SEC. In such a world, organized market manipulation is easy.

The second problem with private cryptocurrencies is a lack of intrinsic value. So, even if there is no intentional manipulation of prices, the market for private cryptocurrency is inherently volatile because there no discernible “peg” to a currency or a commodity with a discernable value. That’s one positive feature of the Petro, a Venezuelan cryptocurrency backed by Venezuelan oil.

The third problem with private cryptocurrencies is the absence of a value supporting entity like the Federal Reserve, the European Central Bank, or the Bank of Japan which is charged with effectively maintaining the value of the cryptocurrency.

The fourth problem with private cryptocurrencies is the ease of substitution among them. The value of Bitcoin in particular depends on its first-to-market brand name. Another, newer, better, cryptocurrency could displace it just as MySpace was replaced by Facebook and Google displaced Yahoo.

Finally, for all the reasons stated above, private cryptocurrencies all fail as a reliable ‘store of value” or “medium of exchange.” From the time a Bitcoin is acquired until the time it is transferred to the next owner, its value can fluctuate wildly and unlike volatile industrial and agricultural commodities, it can’t simply be consumed by the owner because it’s just a string of characters with an arbitrary value.

So, beyond speculative greed and the “fear of missing out,” the biggest rationale for owning cryptocurrencies is that “it’s only a matter of time before cash and credit cards are essentially replaced by a more convenient and equally ubiquitous payment systems.” But there is every reason to believe that governments will ultimately prevent Bitcoin and its clones from becoming part of this new world.

Why?

First Bitcoin and its peers are to criminal activity what water is to a wet sponge: it permeates all manner of criminal activity. Whether it’s the latest phishing scam, cyber blackmail, or a ransomware attack, the legions of criminal schemers all prefer the anonymity of Bitcoin to a less anonymous alternative. This creates a big motivation for government to eliminate private cryptocurrencies.

Second, even though Bitcoin is also a commodity subject to capital gain and loss, governments seeking to capture either are usually hard-pressed to determine those gains and losses for tax purposes. Someone who purchased Bitcoin at $10,000 and uses some or all of it to pay a debt when his Bitcoin holdings have appreciated to $20,000 has recognized a gain, but good luck to the tax authorities trying to assess the tax on that gain. This creates a second motivation for government to eliminate private cryptocurrencies.

If private cryptocurrencies must be eliminated to thwart criminals and tax-cheaters and both cash and credit cards make increasingly less sense, the answer appears to be Central Bank Digital Currency , or “CBDC.” CBDC has been a work-in-progress since at least 2015.

The benefits to governments of CBDC over Bitcoin and its clones are innumerable. From tracking pay ments, to avoiding criminal activity, to more direct and effective monetary policy, to aiding in the elimination of tax fraud, CBDC clearly benefits the national interest.

To implement CBCD, Congress will need ban trading in, and ownership of, Bitcoin and its clones, just as President Roosevelt banned the private ownership of Gold in the 1930s. Bitcoin’s wide use as the means of exchange in criminal activities, and the veritable impossibility of assessing tax on gains from it, should be a sufficient predicate to ban the cryptocurrency and its clones. Then simultaneously, the Treasury should issue a US Dollar-based CBDC.

When considering the merits of replacing private cryptocurrencies, it’s important to make clear that cryptocurrencies in their current form, including Bitcoin and Ethereum, do not really help financial markets in the aspirational ways proponents had hoped. The primary reason for this is that they have become speculative vehicles divorced from their underlying purpose. Since the underlying purpose of any currency is to exchange value and the vast majority of cryptocurrencies have little to do with this, their functional utility is very different today from what proponents argued it would be.

For instance, the goal of Bitcoin was to be able to exchange value on a P2P basis without any intermediary. However, the technology underlying Bitcoin made transaction speeds slow, thereby reducing its utility as a means of exchanging value.

With Bitcoin and other cryptocurrencies, speculators came in and inflated the price, often with little understanding of the primary purpose of these coins. Most of these speculators simply came in to buy cryptocurrencies with the hope of “making a quick buck.” And far too few gave any thought to what the real value of cryptocurrency actually is or could be.

The initial purpose of cryptocurrency was as a means of exchanging value in an easy to trace and verifiable way. However, all of the speculation around private cryptocurrencies has essentially eliminated their utility as a means for exchanging value. Instead, they are traded just like other asset classes.

One of the most interesting and questionable phenomena related to using private cryptocurrencies as an investment vehicle are so-called Initial Coin Offerings (or ICOs). Here entrepreneurs typically formulate a business idea related to block-chain. They normally publish this idea as an on-line whitepaper. Then, they sell proprietary cryptocurrency tokens associated with the business idea. Depending on the specifics of the offering, the tokens can be used as the preferred form of currency for transactions associated with the business, as an enabler of enhanced capabilities within the block-chain enterprise, as an actual ownership stake in the venture, or as all of the above. The SEC is increasingly seeing ICOs as a means of skirting securities regulations. Therefore, they are likely to be just “a passing fad.” What’s the bottom line?

Blockchain technology is one of the most important trends of the Fifth Techno-Economic Revolution. On the other hand, private cryptocurrencies appear to be highly flawed manifestations of that trend. Even for investment expert, it’s wise to look at the “big picture” from a long-term perspective. Following the herd down a path to speculative frenzy will lead to disappoint (or worse) for all but a lucky few.

Given this trend, we offer the following forecasts for your consideration.

First, cryptocurrencies, and specifically CBDCs, are a transformative financial innovation that will inevitably be adopted.

There are simply too many benefits for governments to pass up the opportunity to adopt CBDC. And just as gold used to back the value of paper currency, fiat currency will be used to back up new cryptocurrency. This is where the potential of cryptocurrency will shine through. Hypothetically, if the US government issued cryptodollars that are all tied back to the U.S. money supply, this could transform the way financial transactions occur. The government would have a clear chain demonstrating where every dollar went in the economy. This would make it impossible to steal and the ability to dodge taxes would virtually be eliminated. Furthermore, illicit exchanges of money would no longer be anonymous because of the blockchain. Privacy advocates will say this is far too much government intrusion into how individuals use money. Civil libertarians will also fuss and protest. But just as with the ubiquity of surveillance cameras and phones today, people will eventually become accustomed to it. Plus, there would be plenty of advocates who would highlight how this increases the speed of transactions, trust, and eliminates corruption.

Second, the rise of CBDC will destroy the value of private cryptocurrencies, which are already highly vulnerable as a means of exchange and a store of value. The primary question at issue is the timing of CBDC’s wide adoption.

Third, governmental replacement of private cryptocurrency with CBDC will most likely occur in the face of a crisis, such as the collapse of a “pumpand-dump” bubble.

Because they have a finite cap on supply and nearly infinite demand from speculators, Bitcoin and Litecoin are particularly susceptible to manipulation.

Fourth, when blockchain technology really takes off in financial markets, it will radically disrupt traditional financial institutions.

The role of traditional institutions as third party intermediaries will diminish, unless of course they become the creators and owners of digital tokens. JPMorgan has taken a first-mover approach in this space and it’s likely that all of the other major banks are planning on launching their own digital coins too. Therefore, until the launch of CBDCs, regulators will have to adapt to the different distributed ledgers out there in order to monitor transactions. If the distributed ledgers work as expected, the role of regulators would essentially be eliminated since all transactions would be seen by everyone on the network. And,

Fifth, the application of blockchain technology to the financial sector is just the beginning of its ultimate impact on business and society.

Beyond the realm of CBDCs and private cryptocurrencies, blockchain technology will begin to be used in genomic data management, digital rights management, drug traceability, and many other applications. Smart in vestors and entrepreneurs should watch carefully for new business models that create competitive advantage by exploiting blockchain to address such opportunities.

* *