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Blockchain Beyond Crypto
As the cryptocurrency market has grown, people have become more interested in the blockchain technology (also known as distributed ledger technology, or DLT) that underpins it. Yet many investors do not realize that blockchain is not inherently tied to cryptocurrency and its applications extend into alternative assets and digital currency.
By Justin Chapman, Global Head of Market Advocacy & Innovation Research, and Sebastien Sacre, COO of Northern Trust Private Capital Fund Services
Blockchain has entered the common lexicon thanks to the growing popularity of cryptocurrency. As the COVID-19 pandemic swept the globe, interest in cryptocurrency increased dramatically. In March 2021 the price of one bitcoin hit $60,000, a substantial gain from March 2020 when the price of one bitcoin briefly dropped below $4,000.i ii During the same period, the price of one ether grew from $135.44 on March 13, 2020 to $1,834.88 on March 8, 2021, going on to hit an all-time high of $4,867.81 on November 9, 2021.iii
As the cryptocurrency market has grown, people have become more interested in the blockchain technology (also known as distributed ledger technology, or DLT) that underpins it. Yet many investors do not realize that blockchain is not inherently tied to cryptocurrency and its applications extend far beyond the worlds of bitcoin and ether.
The history of blockchain dates to 1991 when scientists Stuart Haber and W. Scott Stornetta proposed the concept of a chain of cryptographically secured blocks. In 2008 a now-famous white paper introduced the first application of DLT technology, bitcoin.iv Published under the pseudonym Satoshi Nakamoto, the paper introduced the idea of direct person-to-person payments using a chronological series of recorded transactions stored in blocks.v Satoshi Nakamoto, whose true identity remains a mystery, kicked off the bitcoin market by mining the first coin in early 2009.
Today, blockchain technology has the potential to transform transactions across the financial services industry, helping create new asset classes and enabling the digitization of others. For example, alternative assets, a manual and sometimes opaque asset class, offer a great chance to use DLT to create new opportunities, either by digitizing the administration of the investment lifecycle, or in the long term, creating fractional shares (called tokens) of alternative assets, such as real estate, art, ships or private equity, making alternative investments more accessible, liquid and transparent.vi
For investors interested in dipping their toes into digital assets or taking advantage of the efficiency a blockchain may provide, working with an asset servicing partner that is on the forefront of these new frontiers is key. An experienced partner can use their expertise to help navigate these innovative markets and technologies.
Lauded for its security and transparency, DLT is defined as a decentralized digital system that records asset transactions at numerous places simultaneously, as it does in the case of the bitcoin network. For example, with bitcoin transactions, everyone can have access to all the data that is on the ledger. Outside of a crypto context, auditor firms or even regulators can have such access. Other important advantages of DLT include immediacy, efficiency, and very importantly, immutability.
But transparency is not a requirement of blockchain technology. It can also be deployed with restrictions on data access and use, generally called a permissioned network. This allows the owner of the data or the blockchain administrator to provide specific ‘permissioned’ access to the data on the ledger. For applications dealing with sensitive data and/or a ringfenced set of stakeholders, this optionality is key for considering a DLT approach.
The financial services industry’s traditional infrastructure is grounded in the principle of separate, independent record sets that are reconciled with each other. This reconciliation serves as a control point but also introduces costs in the form of infrastructure, human capital, and most significantly, time. The DLT model invites all stakeholders to share access to the same secure reference record set. This paradigm shift has the potential to remove a tremendous amount of latency and other direct costs that come with the traditional, reconciliation-based “mutual trust” model.
One of the biggest challenges facing the alternative asset sector is the sometimes opaque and manual nature of valuations and transactions. There is little standardization in these markets or among reporting formats, leaving many investors with unreliable data and wide-ranging estimates.vii The information is sourced from multiple channels and it is often an exercise in rummaging through thousands of documents to obtain the needed numbers. It’s nearly impossible to get a clear view of the valuation, exposure and liquidity of alternative investments in a portfolio.
The entire alternative assets market has been hindered by these issues for years and investors have been seeking greater transparency and efficiency. Using blockchain to automate and streamline processes for alternative assets has the potential to revolutionize the sector.
Recognizing the tremendous potential of DLT technology, Northern Trust pioneered the use of blockchain for private equity administration, using the technology to create a new level of flexibility and versatility in managing fund data. By applying blockchain to the entire operational workflow of a fund, every transaction and occurrence – from capital calls to audits to exchanges between GPs and LPs – is automatically captured and encrypted.
This capability is a game changer for all parties involved in the private equity lifecycle. With an audit process, for example, it allows fully transparent data to be supplied to auditors on a real-time basis, as well as responding to requests for regulatory information and other time-consuming tasks. In fact, blockchain technology vastly reduces the time taken for the year-end audit on a fund, because the fund is being audited with every transaction and every update. To allow a greater number of private equity funds to use the automated ledger solution, Northern Trust licensed the technology to Broadridge Financial Solutions in 2019, who have continued to develop the solution and added more capabilities to assist the end-to-end lifecycle of private equity funds.
DLT has evolved rapidly since Satoshi Nakamoto published the bitcoin paper in 2008. Where could it go next? There is plenty of potential for practical applications in the Environmental, Social and Governance (ESG), digital asset and digital currency spaces.
- ESG investing
Over the past few years, institutional investors have become increasingly focused on ESG. With the public becoming more socially conscious, companies are looking for ways to improve their ESG ratings. DLT has the potential to vastly improve corporate governance transparency, allowing potential investors to see more information about a prospective company. Transparency can never be underestimated because the more financial data and information available, the more certainty for investors. For ESG investing, it significantly helps a company’s credibility if interested parties can see clear, easy-to-understand data that shows the corporation is following the ESG principles they espouse.
The technology can also be used to improve the voluntary carbon markets, which are seeing tremendous growth as governments implement emission regulations and companies promise to go carbon neutral by buying credits to offset their emissions. Companies that are promoting blockchain solutions for carbon credits, e.g. Toucan and Moss, believe that DLT will add transparency and increase accessibility to the carbon credit market, which has been criticized for fraud and opaque accounting. DLT offers the possibility of tying each carbon credit to metadata showing its unique origin and caliber, allowing for a liquid and credible marketplace. viii ix
Demand for carbon tokens to use in offsetting is on the rise as businesses face increased pressure to cut carbon emissions. For example, the European Union has promised to be carbon neutral by 2050 and to cut greenhouse gas emissions by 55% (based on 1990 levels) by 2030. EU officials are working to achieve these goals by expanding their emissions trading scheme, a carbon allowances market. x As a result, European carbon credit prices have skyrocketed over the past year, with a credit trading at 82 euros on January 11, 2022 compared to 34 euros a year earlier.xi U.S. companies that have promised to go carbon neutral over the next few years include Amazon, Starbucks, Walmart and JetBlue.xii
- Digital assets and currency
If companies want to be in the digital assets and currencies markets, they should embrace the role of DLT as an intrinsic technology to those investments. Digital assets can be defined as any item in a digital format that is owned by a person or entity. The Ethereum blockchain, the world’s largest blockchain ecosystem, is a digital asset management platform which uses NFTs to securely record ownership of digital assets. xiii xiv Digital works of art are commonly referred to as NFTs but NFTs are actually the tokens used to represent ownership of any digital asset (i.e. essays, domain names and much more) on the Ethereum blockchain. The immutable record of ownership and transactions can offer trust and liquidity to investors.
The consensus in the financial services industry is that digital assets are the future, with 76% of financial services industry senior executives and practitioners surveyed in Deloitte’s 2021 Global Blockchain Survey saying that digital assets will replace fiat currency in the next five to 10 years.xv Interest is rising in digital currency systems that cut out intermediaries, making the transfer of money from the payer to the payee instantaneous.xvi
For example, stablecoins are a type of digital currency that relies on DLT technology but, unlike cryptocurrencies, are backed by a reserve asset such as the euro, the U.S. dollar or the price of gold or oil. Combining the benefits of crypto and fiat currencies, these currencies are growing in popularity. As of April 6, 2022, the third-largest crypto token by market capitalization, following bitcoin and Ethereum, was U.S. dollar-backed stablecoin, Tether.xvii
Governments across the globe, including the U.S., the U.K., Japan and the EU, are exploring central bank digital currencies (CBDC), which may or may not rely on DLT technology. Sveriges Riksban, the central bank of Sweden, is currently testing blockchain technology to underpin its own digital currency. Even if a CBDC (such as the Chinese digital yuan) does not rely on blockchain, central banks are finding DLT could be very useful for cross-border, interbank transactions. In 2021 China, Thailand, Hong Kong and the United Arab Emirates tested using DLT technology for CBDC payments between countries. xviii xix
Beyond digital currencies, DLT is being used to modernize the bond markets, allowing bonds to trade digitally like stocks. In 2020 Northern Trust collaborated with its strategic partner BondEvalue, a blockchain-based bond exchange, to trade the world’s first fractionalized blockchain-based bond on its BondbloX trading platform. Relying on the blockchain gives BondbloX enhanced transparency, liquidity and faster settlement.
As digital assets become more commonplace, blockchain technology is here to stay. Its key benefits of transparency, security and real-time insights will only become more valuable over time. Institutional investors will want to seek out partners who can work with them as they expand their portfolios to include digital assets and as they seek the benefits that DLT can provide.
The future is digital and blockchain is the highway.
i Bitcoin USD (BTC-USD) Interactive Price Chart - Yahoo Finance
ii Bitcoin loses half of its value in two-day plunge (cnbc.com)
viii Crypto Carbon: Can Blockchain Networks Fix Carbon Offsets? (msn.rsioncom)
ix clean_dev_mechanism_en.pdf (europa.eu)
xii 16 Companies That Have Pledged To Go Carbon Neutral (yahoo.com)
xv Blockchain Survey: The View From Financial Services - WSJ
xviii The US dollar could go digital. Here's what you need to know | CNN Business