Global Market Commentary

Beyond Bitcoin


Last week we wrote a simple introduc-tion to digital currencies, describing the motivation of their creators, the tech-nologies that underlie them, and some of the pitfalls that may be waiting for speculators. A lot of readers found the piece helpful; if you haven’t seen it, please feel free to request a free copy.


Bitcoin and other digital currencies were designed as forms of “digital gold” that would meld characteristics of phys-ical gold with those of electronic money. They may or may not ever become viable media for storing and exchanging value. For now, they remain highly speculative, highly volatile, and subject to a variety of risks that are nearly impossible to evaluate. Some of those risks are exis-tential and could lead to the collapse of digital currency systems, either because of regulatory crackdown, or because of a technical failure from unexpected advances in computing technology. We concluded that, for now at least, digital currencies are for intelligent and careful speculators who have some idea what they’re getting into — but definitely not for investors.


With all that said, some of the most interesting things about dig-ital currencies are not the curren-cies themselves, but the technolo-gies that underlie them. We’re not kidding ourselves; the current bubble in bitcoin, ether, and several other digital currencies is much more exciting than the underlying technologies. Still, those technologies may ultimately prove to be more influential on the global economy and the global financial system than the currencies they were created to sup-port.


The Technologies That Make Bit-coin Work


As we mentioned last week, bitcoin rests on two key technological inno-vations: public/private key encryption and the blockchain. Public/private key encryption has been around since 1976; the blockchain was an innovation con-tributed by bitcoin’s anonymous inven-tor when he wrote the white paper that launched the currency in 2008.



Asymmetric Encryption


In public/private key encryption (also called asymmetric encryption), every user has a private key which only they possess, and a public key which is known by the recipient of their communica-tion. You encrypt a message using your private key and your recipient’s pub-lic key. They can decrypt the message using their private key and your public key. The critical thing is that if you just have someone’s public key, it’s impossible to fake a message com-ing from that person. The system relies on the application of some bril-liant mathematics — a function that is simple to solve in one direction, but impossible to “reverse engineer.”


So asymmetric encryption solves one basic problem of digital transactions: proving the identity of the person mak-ing the transaction in a purely mathe-matical way — one that doesn’t rely on any manual human intervention or eval-uation. (This is a much more secure way to confirm identity than a login/ password confirmation, for example, and less cumbersome than some other attempts at more robust authentication. Indeed, it’s instantaneous and in princi

Bitcoin married asymmetric encryption to another technology: the blockchain, which is really just one example of what could be called distributed ledger technology, or DLT. DLT is simply a record of transac-tions that is not held and maintained by a single, cen-tral agent. Instead, it is held simultaneously by many “nodes” of a network who have a system in place to reach a consensus about valid transactions and add those transaction records to the agreed-upon ledger.


Bitcoin’s blockchain incentivizes this process by setting up a verification race among the nodes, and rewarding the winners with newly minted bitcoins (the only way the currency can come into existence). Bitcoin’s ledger is fully public, and the system is set up to prevent malicious actors from inserting fraudulent transactions into the ledger. But in itself, DLT doesn’t require such a “verification race,” as we’ll describe below. The most important characteristic of DLT is that it is held simultaneously in an agreed-upon form by many different transaction participants — and thus it can allow transactions to proceed


Moving Beyond Bitcoin


The bitcoin system was set up to facilitate the exchange of bitcoins. However, it quickly became apparent to observers that DLT could secure, streamline, and transform any exchange — not just exchanges of digital currency.


All economic exchanges revolve around the ver-ification of identity and ownership, and in the past, those problems were solved through the presence of centralized records and trusted authorities in the exchange process. DLT suddenly created the pros-pect of “exchange infrastructures” where mathemat-ical algorithms could take the place of those central-ized records and trusted authorities — and get the job done a lot cheaper and faster.


It helped that this new potential exchange infra-structure was emerging at the same time as artificial intelligence and the internet of things — the begin-ning of a world where machines could be interacting and transacting with one another at the speed of a semiconductor.


Make no mistake: there are a lot of hurdles to overcome before DLT starts to take over the “infrastructures of exchange” in earnest. The hurdles aren’t just technological; they’re psy-chological and regulatory. Most financial exchanges are highly regulated, and the use of these technolo-gies will require regulatory buy-in. Still, they will be adopted more quickly in some areas than in others; and in many areas where regulators will drag their feet, they will ultimately acquiesce because of cost savings.

So what are some of the areas where bitcoin-derived technologies can really shake things up?



Industries Facing Disruption


To our mind, the most immediate application of DLT is in the sharing economy and social commerce. DLT could cause the sharing economy to accelerate rapidly — to the detri-ment of incumbents and the advan-tage of innovators.


At the core of the sharing economy and of social commerce is the management of reputation by buyers and sellers. AirBnB is a prime example: the functioning of this platform depends on reliable social credentials. Safety is a key concern; both guests and hosts want to know that the person they’re interact-ing with has a track record of honesty and straight-forwardness — that the people and accommodations involved are what they seem to be. This is one pri-mary reason, for example, that female travelers, on the whole, are less willing to use home-sharing plat-forms to find accommodations. AirBnB has fairly robust systems in place to ensure the identity of people on the platform, but there is still a period of negotiation and direct communication between guest and host where each has to get an intuitive sense of the other before going forward. While usually smooth, this process can often take a day or more. Such transactional friction makes the system incrementally less attractive than traditional hotel accommodation in spite of any economic savings.


Another example from the world of social com-merce is Yelp [NASDAQ: YELP]. Yelp is a platform where users can review businesses. Identity has been problematic on this platform in both directions


  • ensuring that reviews are neither fraudulently gen-erated by businesses to artificially boost their ratings, nor fraudulently generated by bad actors to artifi-cially reduce a competitor’s rating

What DLT technology suggests is the possibil-ity of a “social blockchain” to resolve identity issues. Remember that the fundamental character-istic of a distributed ledger is that it is verified and agreed upon by all stakeholders, and that once an entry has been made, it can’t be modified. A social blockchain would aggregate user behavior and trans-actions across multiple platforms. In YELP’s case, for example, DLT could ensure that a reviewer was a bona fide patron of a particular business before per-mitting a review to be added to that business’ “led-ger” of reviews.


In AirBnB’s case, the entire review history of pro-spective guests and hosts would be instantly avail-able — not just from AirBnB, but from other social commerce transactions as well, giving users a much greater sense of security. While AirBnB is gradually taking market share from more traditional forms of travel accommodation, removing some of the trans-actional friction through the use of a social block-chain could accelerate that process — and potentially help business travelers more rapidly identify shared accommodations that are suitable to their needs.


The construction of a social blockchain could ultimately resolve many of the inconsistencies and weaknesses of the existing reputation management systems that social commerce platforms depend on and help them make even faster inroads into tradi-tional business models.

How Broader DLT Use Will Differ From the Bitcoin Blockchain


This use-case highlights a critical way in which DLT, as it is more broadly applied, will differ from the bitcoin blockchain model. Bitcoin’s blockchain is designed to be public. As we noted last week, this is a key strength and also a key weakness. Because bitcoin sought to remove the need for any trusted intermediaries, it needed to come up with a way to have a consensus public ledger that could be verified by anyone. Broader DLT applications will not necessarily be public. While anyone can run a bitcoin node on their home computer, other DLT uses will involve a limited number of stakehold-ers who are permissioned to access and use the database. The “social blockchain,” for example, could permission a particular restricted set of users, social commerce businesses, and financial entities to make changes to the ledger.


This restricted, or private, blockchain will charac-terize most applications of DLT outside the bitcoin universe, and will smooth the way to regulatory ap-proval of DLT uses in areas where privacy is impor-tant — for example, in medical and financial applica-tions.



Other Applications of DLT


DLT could also be applied in many financial settings. One where the case for DLT is especially strong would be in property titles. As it is, an entire industry — title insurance — has grown up around the need to investigate property titles before real estate transactions can occur, to make sure there are no issues or encumbrances, and to insure transacting parties against potential problems. Most of the work in title insurance is manual legwork across a wide variety of potentially incomplete and inconsistent databases maintained by many financial and govern-ment entities. In developed economies, this process is laborious enough — but in many developing econ-omies, existing property title systems are so frag-mented and disorganized that property transaction



costs can become extremely high. In Brazil, for example, transaction costs in real estate sales are estimated to average 12–14% of the total value of the transaction. We don’t have figures for India, but we suspect they are even worse.


A distributed ledger of property title data would solve most of these problems. Partic-ularly in developing market economies which could leap-frog legacy systems and adopt DLT directly, real estate transactions and financing could become much smoother and easier. In India, for example, such a system could indirectly offer a significant boost to GDP growth by facilitating property sales and devel-opment.


DLT is also likely to offer significant back-office savings in various parts of the financial industry by smoothing and accelerating the process of clearing and settling a variety of market transactions. The Australian Stock Exchange is already beginning to experiment with using DLT as it upgrades its clearing and settlement systems.


Finally, DLT may see use in the “internet of things” (IoT). We can imagine a case, for exam-ple, where smart meter technology and a distributed ledger are used to facilitate micropayments directly between homes that are producing excess electricity from their solar panels, and their immediate neigh-bors who need that electricity — without involving the central utility electricity distributor at all. In the IoT, such micropayments could disintermediate many economic actors, but only if instantaneous transac-tions are possible. DLT can facilitate such transac-tions by removing the need for human evaluation and review.


To sum up, digital currencies may or may not last as a challenge to traditional asset classes.


However, the  technologies  that  underlie  bitcoin


  • the combination of asymmetric encryption and distributed ledgers — are already being explored far beyond the digital currency world. In some indus-tries they will facilitate cost savings — and in others they will be more radically disruptive.


Investment implications: For now, there are no direct investment opportunities associated with the wider deployment of distributed ledger technology. We think that DLT will have its first big impact in social commerce, where it is less likely to hit regulatory roadblocks. Look for the arrival of a “social blockchain” which will make social commerce credentials porta-ble across a wide variety of sharing econ-omy platforms, and could accelerate the penetration of those platforms into tradi-

tional markets. Eventually, DLT will lead to significant cost savings in many parts of the financial ecosystem, could disrupt some spe-cific industries severely, such as title insur-ance, and could be used to spark economic growth in parts of the developing world. Finally, DLT could help accelerate the decen-tralized operation of the internet of things by facilitating instant micropayments. Watch the development of this technology more to help you understand the evolving shape of these parts of the U.S. and global economy.


Market Summary



The U.S. Market


The U.S. continues its choppy consolidation after the strong performance of some sectors in the past months, and as the market rotates from its recent favorites to a new set of industries. We believe that U.S. stocks will continue to move ahead.


We continue to favor the big tech growth stocks even though some have declined recently as a result of the market’s rotation; we think that after this pause, investors will continue to flock to them in search of secular, long-term growth stories driven by innovation, and social and technological transfor-mation. We also like U.S. banks and financials, where investors are finally turning after regulatory relief has started to become more visible. U.S. stocks are also being helped by a compliant U.S. dollar, whose weak-ness is allaying fears of dollar appreciation that had accompanied the Fed’s gentle and tentative talk of tightening plans.





We are less enthusiastic about Europe, which has upside potential but is less attractive than the U.S. In spite of stock markets that are generally less expen-sive than the U.S., political worries and turbulence in Europe seem to continue to be front and center in news and investors’ minds. The continent can’t seem to get out of its own way, in spite of a synchronized uptick in economic growth around the world.



Emerging Markets


We continue to like certain emerging markets — par-ticularly Vietnam, Taiwan, Korea, and Thailand — kjhh although we think that corporate profit growth may soften in emerging markets in the second half of the year.





On a technical basis, gold should be fine if it stays above $1244, and will appreciate gradually over time. A break below $1235 could signal a deeper correc-tion.


Thanks for listening; we welcome your calls and questions.