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Equity Perspectives

Speculation aside, companies across a wide swath of sectors are exploring the potential opportunities. Technology, regulation, and compliance will be key.

When it comes to assessing the implications of disruptive technologies (and investment crazes)—especially those with the potential to upend traditional modes of finance and investment— Lord Abbett portfolio managers and research analysts take a very meticulous and collaborative approach.  The emergence of cryptocurrencies is no exception. Amid the well-publicized gyrations of “crypto”-linked financial instruments, these investment professionals are not about to embrace the notion that any of the leading cryptocurrencies will become a widely accepted alternative means of payment or, for that matter, the next major asset class. By contrast, a number of institutions have ventured into those waters, most notably hedge funds seeking to arbitrage price differences across multiple venues.

However, they are very careful to assess the potential of the underlying blockchain technology, which is a shared, decentralized, and encrypted ledger technology that requires consensus to update.  Blockchain eventually could lead to faster, better, and cheaper ways of doing business, in our opinion, not just in the banking sector but also across a broad set of industries. (See Chart 1.) But for that to happen, computers, semiconductors, regulation, laws, and accounting systems will have significant hurdles to clear.

Such was the consensus that emerged from a recent meeting of Lord Abbett investment professionals and senior management. While they recognized that some companies are already leveraged to cryptocurrencies and blockchain (e.g., semiconductors and computers required for the “data mining” required to determine values), the long-term investment implications are rife with uncertainty.

“The regulatory and taxation debate won’t be settled anytime soon,” said Eric Ghernati, Lord Abbett partner and technology research analyst. “But [in the case of cryptocurrencies], what is settled is the technology: it will take more powerful computing to mine digital currencies with a finite supply, and the chips running the algorithms will be either graphical processing units [GPUs] or application specific integrated circuits [ASIC] with some participation from flexible and software programmable architectures like field programmable gate array [FPGA].” (More on that later.)

Tackling Blockchain
Some futurists have suggested that, over time, blockchain technology will help transform the modern capital system. But some questions arise. For example, would that apply to sectors where there already has been massive investment and innovation (e.g., credit cards)? Probably not. But blockchain certainly has stirred interest in sectors still plagued by friction and red tape.

Here’s what we know now: Amid considerable doubt about cryptocurrencies being integrated into the global financial system, as either a fiat currency (i.e., that which a government deems legal tender) or alternative form of payment, major companies in a variety of sectors are actively researching how blockchain could streamline operations and boost shareholder value. The cost of such research is relatively minuscule, but the companies with the most at stake want to be ready to embrace such innovation when it becomes feasible.

One case in point concerns an enterprise software firm that is working with more than 100 banks, financial institutions, regulators, trade associations, professional services firms, and technology companies, spread across six continents, to develop a distributed ledger platform designed specifically for financial services.

That consortium grew out of a common frustration among banks and other financial institutions with multiple generations of disparate legacy financial technology platforms that struggle to interoperate, causing inefficiencies, risk, and spiraling costs.

Another example is a global asset management association that is attempting to shape regulation and promote industry-wide best practices; drive research and education; promote security best practices; and influence future governance procedures around blockchain systems.

Meantime, a wide array of companies has raised capital in the form of “initial coin offerings” (ICOs). In an ICO, investors provide fiat or even cryptocurrency in return for a newly issued cryptocurrency. Interestingly enough, the sector with the most blockchain ICO offerings is gaming and gambling, followed by infrastructure and development; media and advertising; asset management; and payments and banking.  (See Chart 2.)

While many of these ICOs may be fraught with risk, some well-known companies, such as Eastman Kodak, have also jumped on the ICO bandwagon as a cheap means of raising capital and providing customers a convenient alternative form of payment in a peer-to-peer network.  (In Kodak’s case, the ICO is tied to the establishment of a payment system to help photographers monetize the use of their images.)

In general, what will make or break such ICOs is the ability to demonstrate a clear path to fungibility (i.e., interchangeability) and utility.

“From a payment perspective, you have to have enough leverage within the marketplace, like an AirBnB, for this to work,” said Tulu Yunus, Lord Abbett research analyst, who covers Internet and business services companies. “Otherwise, restricting the kingdom to a select group of people is probably not going to produce a great business outcome.”

 

Chart 1. A Centralized Ledger versus a Secure Distributed Ledger 
Traditionally, a centralized-ledger approach (left) solves the transaction trust issue by tracking the movement and ownership of value.  A secure-distributed ledger (right) removes the counterparty, as the transaction record is universally visible and immutable.


Source: Credit Suisse research.

 

Chart 2. 135 Blockchain Startups Have Been Funded by Initial Coin Offerings (ICOs)

Source: CB Insights, TokenData.io, and company data, as of August 9, 2017. 
* The chart is only for illustrative purpose and is not an exhaustive list.

 

Chips: GPU versus ASIC 
One of the biggest issues in the evolution of cryptocurrencies and blockchain is the amount of electricity computers consume for each transaction. Much of that power consumption has been via graphic processing units (GPUs), a type of programmable logic chip specialized for display functions.  For a while, a few chip manufacturers benefited mightily because cryptocurrencies and blockchain platforms could only run on their specific GPUs.  To reduce power consumption, a number of platforms have since moved to application-specific integrated circuits (ASICs), which are far more efficient microchips designed for a special applications.  “Future application of cryptocurrencies and blockchain will hinge on semiconductor manufacturers’ ability to make chips more energy efficient,” said Ghernati.    

Cutting Through the Hype
“Everyone understands this will take time to evolve,” said Subrata Ghose, Lord Abbett technology analyst. “The technology will be more evolutionary than revolutionary, especially with regard to time-sensitive transactions. Anything that is time sensitive and needs instant verification cannot happen on current blockchain platforms.”

Take the credit card industry, for example, where the leading payments networks have invested vast amounts of capital over decades to ensure that their cards are widely accepted around the world. No cryptocurrency comes close to such “acceptance ubiquity.”   

”Bitcoin’s [blockchain] platformprocesses seven transactions per second; Visa and Mastercard process 2,000–3,000 transactions per second,” Ghose said.  “With Visa and Mastercard, the system works beautifully as a four-party system [consumer, merchant, network, and card-issuing bank]. The costs for merchants isn’t too onerous, and blockchain platforms can’t compete with the speed of validating transactions.”

All of which may help explain why Amazon and Google have been noticeably quiet about applying their prodigious technology resources to alternative payment systems. “They could do this in a heartbeat, but they haven’t,” said Ghernati.  “Nor have they really commented on where this fits into their long-term business model.  So, the question is why they haven’t made any forays in this area.”

Even so, 58% of senior executives interviewed by Deloitte in the consumer products and manufacturing sectors said they were implementing blockchain solutions in 2017; 53% of executives of life sciences and healthcare companies said they would use some kind of blockchain solution.

Deployment of blockchain solutions in the financial services industry is likely to take longer, although a number of analysts believe the technology has the potential to shorten settlement times for corporate bonds, OTC [over-the-counter] derivatives, equities, syndicated loans, and private debt instruments.  According to one recent survey, 33% of financial services executives polled expect to see commercial adoption of blockchain during 2018, and 49% expect adoption by 2020.  (See Chart 3.)   

At any rate, the anonymity of blockchain transactions, the authentication of users, and the verification of underlying contracts will weigh heavily on the minds of bank executives, regulators, and taxing authorities.

“Big banks are waiting to see where the regulations fall, and until the regulators say which applications they will allow, no one wants to go into it at full speed, because if something goes wrong, the banks will be held liable,” said Ghose.

 

Chart 3.  When Financial Services Leaders Expect to See Commercial Adoption of Blockchain


Source: BI Intelligence, Cognizant, and Credit Suisse research. For illustrative purposes only.

 

The Bottom Line
Chart 4 illustrates how the broad blockchain timeline may evolve.  It also suggests that blockchain’s development will be far from linear.

“In 2018, we are entering a growth phase, where the products and platforms should move into more comprehensive production phases,” said Credit Suisse analysts Charles Brennan, Brad Zelnick, and Matthew Yates, in a recent report.  “For the time being, we do not expect them to replace current legacy systems but rather to run alongside to allow for testing and refining.  After all, much of blockchain’s utility is derived from its network—the more development and the more applications that can be built upon the platforms, the more solutions we will arrive at through blockchain.” 1

Assessing the long-term potential for financial institutions, Asad Mawjee, a Lord Abbett research analyst, sees blockchain as a tool, not a threat.  For instance, many banks are already running trials that someday may determine blockchain’s applicability to cross-border payments transactions.  But considering the range of legal, regulatory, and technological uncertainty, Mawjee doubts that blockchain will replace the SWIFT [Society for Worldwide Interbank Financial Telecommunication] network for interbank payments anytime soon.  SWIFT was built in the 1970s, and it is now the backbone of the banking industry worldwide, with roughly $5 trillion in currency traded over its network each day.  It also plays a critical role in global securities settlement.

“If anything changes, it’s likely to happen slowly and help banks do things better and cheaper,” Mawjee said.  “But a lot of government bodies, regulators, and central banks have to opine on such transformation.  They’re the key actors.”

Many central banks are investigating whether blockchain (or the underlying “digital ledger technology”) can be applied to transactions in a permissioned network between a central bank and trusted wholesale counterparties, Mawjee added.

This is where the high-performance computing abovementioned comes in. According to Rick Vallieres, a Lord Abbett research analyst, banks are a prime target market for a major technology company that recently introduced a powerful new mainframe with embedded security, encryption systems, and artificial intelligence that can greatly accelerate interactions with existing business data on various databases for blockchain users worldwide.   

Meanwhile, the outlook for cryptocurrencies varies from country to country.  In any case, no cryptocurrency has an intrinsic value like gold.  From a legal standpoint, no country defines cyrptocurrencies as currencies per se. Some define them as property. The United States, on the other hand, defines a “cryptocurrency” as a commodity; as a result, authorities have warned that investment gains are likely to be taxable.  

Could the U.S Federal Reserve issue its own cryptocurrency some day?  The practical obstacles to widespread adoption are enormous, especially given concerns that bank runs could be bigger and much faster on such a decentralized system.

It also is important to remember that the financial services industry worldwide has paid out tens of billions of dollars in fines and legal settlements since the global financial crisis of 2008–09.  All of which underscores how cautiously banks, exchanges, and asset managers will embrace major innovation.  The risk of hacking customer information residing at a large number of nodes in a vast decentralized network cannot be underestimated.  Nor can the impediments of current “know your customer” and anti-money-laundering rules, which are the antithesis of cryptocurrency anonymity.

 

Chart 4. Blockchain Development Is Still in the Early Innings
As the hype subsides and new obstacles arise, companies will focus on winning the race to deployment.


Source: Accenture and Credit Suisse estimates.  For informational purposes only and should not be construed as research or investment advice. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

Reported by Steve Govoni

 

1 Charles Brennan, Brad Zelnick, and Matthew Yates, “Cryptocurrencies Are Only the Beginning,” Credit Suisse research, January 11, 2018.

 

 

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