So what are they?
Blockchain first entered the public consciousness with the introduction of Bitcoin, which is why the two often get conflated. It is important to make the distinction at the outset between cryptocurrencies such as Bitcoin and, blockchain, the underlying technology upon which these currencies are based. Cryptocurrencies are the first and therefore most developed application of blockchain technologies to date.
Put simply, blockchain is a decentralised digital ledger. It works as a peer-to-peer system of distributed databases where transactions are recorded chronologically and permanently. Each ‘block’ contains information, which, once entered into the chain, becomes part of a permanent and immutable database connecting to other blocks all linked as if in a chain.
When a new transaction is performed on one of these databases, a time-stamped record of that transaction is stored in all blocks, which adjust accordingly. A block is simply a container for a number of transactions. This allows multiple transactions to be validated in a single process.
A cryptocurrency is an electronic form of currency that instead of being represented by a physical coin or banknote, takes the form of a secure digital token. The tokens represent a value that can be securely exchanged on a peer-to-peer basis over a network without the need to use a central processing authority.
In a traditional financial transaction, trusted third parties, such as a bank, act as intermediaries for the transaction and typically take a commission either in the form of exchange rate conversion or administration charges. In a Bitcoin transaction, the intermediary is replaced by collective verification from the whole system, which allows a traceable yet anonymous transaction. This is called a public or permission-less blockchain, where permission is not required to become part of this decentralised verification system.
A relatively new introduction is the stablecoin. Introduced in 2014, the coin was designed to address the value volatility of cryptocurrencies by pegging a coin’s market value to some external reference point such as the US dollar or a commodity such as gold. Tether was the first stablecoin and remained the only one on the market until 2018.
If cryptocurrencies have no central governing body, then where do they come from?
Some cryptocurrencies, including Bitcoin, are created through a competitive, decentralised computing process called mining. Individuals are rewarded by the network for their mining services. Bitcoin miners are processing transactions and securing the network using specialised hardware and are collecting new Bitcoins in exchange, which means the network is essentially administered by its own participants.
The key feature of both blockchain technology and cryptocurrencies is that they are decentralised technologies, meaning neither one depends on a single, centralised platform to administer and govern the system. The decentralised nature of blockchain and cryptocurrency is precisely what makes them so disruptive. Which begs the question: do big tech platforms such as Amazon and Google and mainstream financial institutions have something to fear in the face of these disrupters?
The evolution of cryptocurrency
Any discussion of cryptocurrencies is likely to start with Bitcoin, which came into existence in January 2009 and is widely credited to the elusive Satoshi Nakamoto, whose identity remains shrouded in mystery and cyber legend. Over the following 11 years, Bitcoin has spawned a number of rivals, including its closest competitor Ethereum in 2015, followed by Ripple, Bitcoin Cash, EOS and Litecoin, among others. The internet boasts about 700 cryptocurrencies in total and with no central authority to recommend common standards, interoperability and cross-trading are a challenge.
The evolution of cryptocurrency has not gone the way those who created the first coins imagined: creating a payment method for use by the general public. The value volatility of currencies such as Bitcoin has prevented them from being widely adopted as a means of payment. And as a further consequence, coins used as a means of payment have often been used for illegal purposes on the dark web, which hasn’t helped in the bid for wider adoption. Instead of becoming the native currency for the internet, cryptocurrency has instead emerged as a highly speculative investment commodity for specialist investors and is even starting to enter some mainstream investing portfolios.
A recent whitepaper by Bitwise Asset Management makes the case for adding Bitcoin to a diversified portfolio of stocks and bonds. The firm posits that on average a 2.5% allocation to Bitcoin would have boosted the cumulative return of a traditional bond portfolio in the past three years by 15.9 percentage points.
As the utility of Bitcoin and other cryptocurrencies are debated, detractors are quick to highlight their shortcomings. Cryptocurrency transactions require a huge amount of computing power with some analysts concluding that mining Bitcoin uses more energy than mining gold and produces more carbon emissions.
However, energy consumption is not the only downside. At present, because of the huge computational power required, cryptocurrency transactions are slower than traditional financial transactions, according to GlobalData. The analytics company also highlights that the requirement to mine coins essentially adds a middleman and extra cost to transactions instead of removing them. But perhaps the biggest barrier to adoption is the fact that there is no rational basis for the valuations of most cryptocurrencies. Market sentiment and perception rather than any objective measurement of a currency’s utility or technical capability provides a flimsy basis for a currency if it is to have any chance of longevity.
How are mainstream financial institutions dealing with the disruption?
The banking sector is undergoing a period of transformation caused by a broader wave of technologies such as open banking, crowdfunding, fintech, cloud mobility, machine learning and artificial intelligence, all of which gained traction after the last global financial crisis. It remains unclear where blockchain and cryptocurrency will develop alongside these advances.
Aside from any disruption cryptocurrency presents to financial services, many industry experts tout blockchain as a transformational technology for banking systems. However, others contend that current advances in banking technology are enough to solve the underlying challenges of faster and more secure cross-border payments and transfers without the adoption of blockchain.
Ask a cryptocurrency enthusiast whether the internet needs a native digital currency, and you are likely to get a resounding yes. Ask a banker and the response will undoubtedly be more nuanced. There is mounting evidence that cryptocurrencies are gaining greater acceptance among major financial institutions, with JP Morgan creating its own digital coin for payments between institutional clients, Fidelity launching a digital asset division, and the Libra project, which includes Facebook and Uber among its founding members, to name a few.
On the government side, many central banks are evaluating the idea of issuing digital currencies, with China the first country to go ahead with piloting a central bank digital currency in a move that has four of the country’s largest commercial banks involved. However, central bank digital currency cannot strictly be a cryptocurrency, even though it is built upon the same technology, because it is a centralised currency controlled by government and anathema to the decentralised ideology upon which cryptocurrency was founded.
The UK, the US, Hong Kong and Singapore have the largest number of registered digital currency exchanges, according to Bitfury’s blockchain analytics platform Crystal’s Report on International Bitcoin Flows 2013–2019.
As with all global innovations, there is much jostling among locations for foreign direct investment (FDI) in crypto start-ups including non-traditional finance locations such as Lithuania, Estonia and Malta, which are all vying to become the crypto capital of the world. Some of these countries are making efforts to offer cryptocurrency ecosystems for initial coin offerings (ICO) – the cryptocurrency industry’s equivalent to an initial public offering. An ICO is a fund-raising method most often used by cryptocurrency and blockchain start-ups wishing to offer products or services.
However, questions remain around regulation of these non-traditional, nascent financial centres. In April 2020, the European Parliament issued a report on crypto assets underlining their global nature, which presents regulatory challenges within EU borders and beyond. Some EU members’ legislators have already taken measures, including Switzerland, Malta and France, but the report recommends that rule-making on crypto assets should take place at the European level, preferably in the execution of international standards.
It is still too early to tell if the establishment of new cryptocurrency centres of influence around the world will change the geolocation of traditional financial centres by changing patterns of FDI. But for the moment cryptocurrency represents a tiny proportion of the banking sector and it remains to be seen how it might evolve. To have any real impact on global trade, cryptocurrency would need to evolve from an investment commodity to some broader utility.
The Covid-19 effect
Long before the looming economic downturn in the wake of the Covid-19 crisis, Bitcoin and other cryptocurrencies were gathering a reputation for providing shelter for investors against macroeconomic trends; for example, investors in developing countries such as Zimbabwe are trading in Bitcoin and Ethereum to hedge against currency exchange volatility.
Investor sheltering may be accelerated by the Covid-19 crisis as cryptocurrency is now regarded in some investor quarters as an inflation-proof hedge protected against shrinking gross domestic products, economic slowdown, government bailouts and fiscal stimulus. It also does not adhere to central bank rules or political winds. Added to this, the supply of Bitcoin reduces over time as the number of new coins issued to miners is halved every four years, which means its value may be driven by its limited supply.
Blockchain technology – not just for crypto…
Many, including GlobalData, hold the view that cryptocurrencies will become less important in the long run when compared with the technology upon which they are based, as blockchain technology has the potential to impact cross-border trade when integrated into business processes.
Research analyst Gartner forecasts that blockchain will generate an annual business value of more than $3trn by 2030, but many business leaders view the claim that blockchain-based technologies will underlie a significant proportion of the world’s economic infrastructure as being too bold. Blockchain technology does have the potential to reduce costs, facilitate micro-transactions and provide greater transparency and traceability for many business processes, but widespread adoption is still a matter of conjecture.
Gartner found that 82% of blockchain use cases were in financial services in 2017, but that had dropped to 46% in 2018. Financial services remains the sector with the widest adoption, but areas such as industrial products, energy, utilities and healthcare are increasingly using the technology. In terms of the countries leading the way, Gartner says the early centres of gravity in the US and Europe are weakening as China comes to the fore.
US tech giant IBM is taking a firm lead in blockchain technologies for business by testing applications with a number of partners including Nordea Bank APB, Kroger, True Tickets and RCS Global. The firm has built blockchain trade finance platform we.trade, a joint venture company owned by 12 European banks and IBM, to streamline cross-border trade using blockchain. The platform manages, tracks and protects open-account trade transactions between small and medium-sized enterprises in Europe.
Potential blockchain uses include fund transfers, settling trades, voting, as well as utilisation in global supply chains. From sourcing raw materials to delivering the finished product, blockchain has the potential to increase transparency in the various stages of the industrial value chain, including complex supply chain monitoring and counterfeit detection, engineering design, identity management, asset tracking, quality assurance and regulatory compliance. Further down the line, if blockchain technology underlies multiple processes, data can be aggregated to create greater efficiencies in moving goods and services around the world. Ultimately, it could provide a platform for other advanced technologies such as the internet of things, augmented reality and 3D printing.
Taking over the world?
As blockchain technology begins to enter boardroom-level discussions, it is still unclear whether pilot projects are an attempt to appear innovative and avoid getting left behind or if they will garner wider adoption. According to research firm Gartner’s 2019 CIO Survey, while 60% of chief information officers expect some kind of blockchain deployment in the next three years only 5% rank it as a game changer for their organisation. Gartner says most organisations have only explored blockchain on a small, narrowly focused proof of concept basis.
Blockchain technology presents many opportunities for cross-border investment in streamlining and reducing the complexity of trading, tracking and transacting across borders, from obvious use cases such as customs interactions between countries to complex banking transactions. However, for wider adoption blockchain must be positioned as the solution to an existing problem rather than a solution looking for a problem. And above all, it must find a way to elevate itself above the hype.
Lara Williams is a senior reporter at Investment Monitor specialising in FDI in the tech and bio-pharma sectors.