The rapid rise of cryptocurrencies has ignited a debate about the fundamental nature of money and the future of traditional banking and financial services. While speculators have been flocking to virtual currencies with intense fervour, professional investors have largely taken a more cautious approach.
Roger Bayston (RB), Senior Vice President, Franklin Templeton Fixed Income Group; Austin Trombley (AT), Vice President and Data Scientist, Franklin Templeton Fixed Income Group; and Anthony Hardy (AH), Research Analyst with Franklin Equity Group, weigh in on the topic of the disruption of money. They discuss how digital currencies work, how blockchain technology has the potential to impact many facets of our lives, and how they feel about the investment case for this rapidly changing space. Attached is also an in-depth study on Cryptocurrencies, Blockchain and Digital Payment Systems for your reference which you can feel free to use at your discretion.
The Disruption of Money
Q: Crypto assets have grown over the past year, and as we talk about technological disruption in this area, how do you think about that as an organization and how does that feed into your investment process?
RB: In the area of money, specifically in the rise of the popularity and the wider distribution of cryptocurrencies over the past 12 months, there is representation of a theme that we have seen across the economy for a number of years now—the disruption that early movers in technology are impacting other parts of industries. We are going to see this, certainly in financial services, and in the concept of money as well. And, it is happening irrespective of people’s opinions on the values of the various cryptocurrencies that have become popular, including bitcoin. Irrespective of that, we know that because there has been so much value created in the space, there will be a lot of business models that will come together, and they will be funded in order to continue to disrupt businesses that have higher margins. Financial services tend to be one of those. Everything related to money and what financial services do—we can expect there can be a lot of disruptive changes as a result of these technological advances.
Q: What is meant by disrupting money exactly?
RB: Money is essentially a medium of exchange, and, all around the world, governments have had the responsibility for creating these currencies within their geopolitical boundaries to facilitate medium of exchange. And we would call that fiat money. What we’re learning is there are other things that people place value on for which they may exchange goods and services, and I think that’s the general category of the cryptocurrencies. They are not established by any particular government, but their wide usage and adoption—especially by another generation of potential consumers in the economy that already have less familiarity with cash and coinage and do have familiarity with electronic payments—is just a further step of confidence that those consumers in the economy are going to use [these new currencies] in order to exchange goods and services.
Q: What are some of the possible unintended consequences that you see in this disruption of money, whether it applies to cryptocurrencies or blockchain, that you have encountered in your research?
AH: A lot of the questions focus on bitcoin as a payment. It was started as a peer-to-peer payment system, but right now it seems like the use case has been as a store of value rather than the payment system. We have seen transaction costs increase given the volatility; it makes paying everyday things using bitcoin more challenging. In terms of unintended consequences, again the way I think about it; it started out as a payment system, and now it’s a digital store of value. You might see other cryptocurrencies fill that payment need, and we will probably see thousands of these be created. The other one is the fact that there are almost two different worlds in the blockchain space. There is the permission list—bitcoin, Ethereum, public blockchains—and then there is a whole other ecosystem where established financial institutions, kind of the traditional market if you want to think about it that way, is trying to apply this technology but in a different way using private networks where you don’t need the same trust because these banks will know each other.
Q: Can you explain what blockchain is and how this differs from cryptocurrencies?
AH: The easy way to think about it is a decentralized distributed ledger that records transactions. We are really just talking about a shared record system, but it solves a real problem especially within financial services where you have multiple parties trying to track the same transaction. If you think about trading a complex financial instrument, there can be 20 banks that are each maintaining their own ledger of this transaction, they have to reconcile with each other. It requires people, sometimes faxes, emails. Basically, with a blockchain it’s a shared ledger where each of the banks can have access to this one single source of truth and that reduces all of this reconciliation that’s needed. This concept of having one source of truth shared among different parties is extremely powerful and has applications not only within financial services but other areas of the economy as well.
There are interesting companies out there that can track diamonds to make sure that conflict diamonds aren’t being inputted into the economy. There are potential applications within health care, managing records. There are applications within insurance about smart contracts where you can program what happens if a certain event happens that can automate a lot of the processes. And every week, people are dreaming up new applications with this technology, which is one of the reasons why it’s so exciting.
Q: Why do you think investors should take disruption of money seriously, and is there anything that you think the media might be missing in the discussion?
AH: A lot of the media is focused on where is the price going, are these things real or not, and what gets lost is kind of the true innovation. The way I think about it, this is probably not going to be a linear adoption of these things. We are probably going to see a period of time, it could be three years, or 10 years, where companies are figuring out the best way to use these technologies. We might not see game-changing applications within financial services for the next few years, but the companies that aren’t thinking about it properly now are going to be at significant risk for disruption in five years.
Q: What might some of the hurdles to this adoption?
AT: One of them is the coordination, particularly with a new emerging technology. I think as the technology continues to improve, fixing some of the scalability or privacy issues, that should help with that problem, but it has been a hurdle so far. There is still a lot to be discussed on the regulatory front. So far, regulators, overall, have been open to blockchain as an option within financial institutions, but obviously, for understandable reasons, they want to be careful. We are seeing them crackdown in other parts of the market, look deeper into ICOs for example, so I think we do need some more regulatory, legal clarity around the smart contracts.
The volatility of the underlying assets could be a huge hurdle and re-education. Going back to school—five years from now, is that too late to go back to school and get caught up? I don’t know, that’s really tough, that’s going to be a hurdle.
I think more wide use would help too. Right now, it’s really hard for me to spend my bitcoin at a point of sale system. So usability and fungibility would start to cause widespread adoption.