BLOCKCHAIN THE MISSING PIECE OF THE INTERNET...2017/04/07 · Blockchain-based (i.e. distributed or shared ledger) implementations, on the other hand, require neither a trusted cen

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RESEARCH FOCUS | FRIDAY, 7 APRIL 2017, 10:26 CET 1/25

NEXT GENERATION

BLOCKCHAIN THE MISSING PIECE OF THE INTERNET

A NEXT GENERATION BRIEFING

• Following substantial interest in recent months, and the

immense amount of ‘hype’ around the topic in 2016, we

present our briefing on the potential of blockchain and

the key underpinnings of the technology.

• Blockchain technology — also known as distributed or

shared ledger technology (‘DLT’ or ‘SLT’) — encom-

passes protocols which form the basis for distributed,

encrypted, and theoretically ‘tamper-proof’ ledgers.

• The basis for today’s blockchain technology was first

deployed in 2009 with the initiation of Bitcoin — the

world’s first decentralised, peer-to-peer cryptocurrency.

• Though blockchain and Bitcoin emerged together, the

latter is but one of the possible uses of the former —

blockchain is an architecture, not an application.

• The many potential use cases range from revolutionis-

ing the post-trade infrastructure in capital markets, to

providing tamper-proof electoral systems.

• While we reckon adoption will eventually be substantial

due to the technology’s cost, speed and risk manage-

ment advantages, the timeframe, degree and fields of

adoption remain very challenging to determine.

• Our base case is, however, that blockchain will have far-

reaching consequences for industry and employment,

no matter whether adoption is incremental or disruptive.

• Nonetheless, direct equity exposure remains elusive.

Alberto Perucchini

+41 (0)58 88 62055, [email protected]

DIGITAL DISRUPTION

The phenomenon of digitalisation, led by the proliferation

of computing power and greater internet connectivity, is

affecting every corner of our lives. Importantly, digitalisa-

tion is not only transforming the way we consume data

and work, but also how people interact.

CONTENTS

What is blockchain technology? p. 2

The range of use cases for blockchains p. 10

Investment conclusion: Beyond hype, but early days p. 18

Postscript: Interview with Dr. Garrick Hileman p. 19

fdf EXECUTIVE SUMMARY

It is not a question of ‘if’, but ‘when’, ‘where’ and ‘how’

blockchain technology will be implemented in industries,

such as finance and trade, which deal with the storage and

exchange of trusted information and value. With quicker

transaction settlement times and lower resource intensity

than traditional ledgers, blockchains have the potential to

revolutionise how business networks operate.

The technology allows the development of protocols

which form the basis for distributed, immutable and tam-

per-proof ledgers. These can be designed with additional

properties which open up a myriad of possibilities, such as

‘cryptocurrencies’ (including the famous ‘Bitcoin’), ‘smart

contracts’, and the digitalisation (also known as ‘tokenisa-

tion’) of real-world financial and physical assets.

Based on these properties, blockchain is poised to stream-

line, rationalise and digitalise payments settlement and

the post-trade infrastructure in capital markets; revolu-

tionise trade finance; and cut financial institutions’ back-

office costs. We recommend that investors avoid firms

with high exposure to custody and registry activities, as

well as correspondent banks and traditional cross-border

payments systems operators. Firms which provide back-

office outsourcing and software are also likely to suffer.

Finally, we recommend investors avoid taking any long-

term positions in any permissionless cryptocurrency (such

as Bitcoin), due to poor governance and volatile adoption. ddd

NEXT GENERATION | BLOCKCHAIN: THE MISSING PIECE OF THE INTERNET | FRIDAY, 7 APRIL 2017, 10:26 CET 2/25

WHAT IS BLOCKCHAIN TECHNOLOGY? 333 SECTION INSIGHTS

The missing capability of the internet is an ‘Internet of

Value’, which would complement the ‘Internet of Infor-

mation’ built over the past decades. Blockchain could be

the technology which finally enables the seamless digital

transfer of value, as it embeds counterparty trust in con-

sensus mechanisms. Technology, not law, thus becomes

the source of trust within a network.

Blockchains possess a variety of properties which make

them interesting for handling value. By tweaking base

parameters slightly, some interesting additional features

emerge, which make them particularly interesting for in-

dustrial use. These additional features include cryptocur-

rencies, smart contracts and tokenisation, and substan-

tially expand the potential of the technology. dddd

Creating the ‘Internet of Value’

At its core, blockchain is the candidate technology which

should enable the shift from an ‘Internet of Information’ to

an ‘Internet of Value’. The internet has so far enabled its

users to share, exchange and modify most of the infor-

mation formats which commonly form part of human ex-

perience: text, image, sound (see Figure 1).

Figure 1: Blockchain is the ‘missing piece’ of the internet

Source: Credit Suisse, Julius Baer; TCP/IP=Transmission Control Proto-

col/Internet Protocol, HTTP=Hypertext Transfer Protocol, IP=intellectual

property, ID=identity

By contrast, the frictionless transfer of value over digital

channels has so far proved unattainable. Exchanging or

modifying assets (securities, intellectual property, wealth)

or trusted information (such as identity or ownership) over

the internet is not as straightforward as exchanging or

retrieving songs, e-books or video-on-demand online.

When one wishes to modify or exchange value online, one

generally has to go through stringent identification and

validation procedures, with most steps often still taking

place offline rather than online. More importantly, a trust-

ed central authority (or a series thereof) is required to

inspect, validate, clear and settle digital modifications and

exchanges of trusted information and assets.

Trust deficit can be resolved through technology

The fundamental issue is one of trust — or rather the lack

of it. It is the core hurdle impeding the frictionless transfer

of value over digital channels. Indeed, if value

exchanges or modifications were seamless and instanta-

neous, how could the proper verifications be carried out?

At a high enough processing speed, for instance, a mali-

cious party could sell or send two or more of a given asset

to two different counterparties, despite owning just one —

an instance of the so-called ‘double-spend problem’.

Blockchain technology, and its first and most widely-

known application (the cryptocurrency known as ‘Bitcoin’,

initiated in 2009), emerged precisely as a response to the

double-spend problem. It offers concepts and mecha-

nisms — derived from cryptography, economics, mathe-

matics and network theory — which seek to embed trust

into a protocol, to which all participants in a business net-

work can agree, in order to modify and exchange value.

Technology, not law, thus becomes the source of trust

between participants, enabling the digital notarisation of

information and exchange — and the Internet of Value.

By contrast, in a ‘classical’ (i.e. non-blockchain) set-up, in

which laws and regulations are the primary source of trust

for network participants, we see important failings

emerge. Their responses to the trust deficit and the dou-

ble-spend problem are comparatively inefficient.

The failings of classical ledgers

Ledgers are records of value: trusted information and/or

transactions (e.g. a record of bank transfers, or a registry

of real estate titles). In the classical case, participants in a

business network each hold their separate ledgers to keep

a record of value ownership and transfers at any given

time. For instance, in a nation’s banking system, each

bank will hold a record of asset ownership, as well as of

asset transfers with other banks. This is the classical case

illustrated in Figure 2 on the next page, in which each

participant in a business network holds its own ledger of

network transactions.

As you will note, a central authority is inevitably required

in the classical case, as business network participants

might (1) not trust each other, and (2) hold inconsistent

records across their respective ledgers. A trusted central

authority thus emerges as a consequence of holding mul-

tiple ledgers within the same business network. This cen-

tral authority performs reconciliation and risk manage-

ment on behalf of the participants. In most cases, this

trusted counterparty is recognised in laws and regulations

as the guarantor of trust within a given industry — say, a

central securities depository holding a permanent record

of which banks and banking clients own which securities.


Figure 2: A business network with a classical ledger (i.e. non-blockchain) set-up

Source: International Business Machines (IBM) Corp., Julius Baer

Figure 3: A business network with a blockchain-based (i.e. distributed ledger) set-up

Source: IBM Corp., Julius Baer

This holds some evident downsides: the processes of reconciliation and risk management slow down the modification of

trusted information and the exchange of value, also making the processes more expensive and resource-intensive. Fur-

thermore, were a trusted central authority to be compromised or turn malicious, both censorship and fraud are a possi-

bility, as it could tamper with the records and processes of the business network.

The comparative advantages of blockchain set-ups

Blockchain-based (i.e. distributed or shared ledger) implementations, on the other hand, require neither a trusted cen-

tral authority, nor the holding of separate ledgers by network participants. Rather, a single ledger exists, with identical


copies distributed among participants. Importantly, trust between participants is also not required. This blockchain set-

up is illustrated in Figure 3 above.

In the blockchain set-up case, participants need not waste resources or time validating modifications or transactions

with the support of a trusted central authority, which leads to gains in efficiency. Furthermore, and as we discuss below,

blockchain-based ledgers are theoretically both immutable and secure: they cannot be tampered with, and one cannot,

in theory, record fraudulent modifications or transactions onto them. How are these features enabled?

The technological foundations of blockchains

Blockchains are, ultimately, protocols which form the basis for the distributed ledger set-ups we have described above.

Their various properties emerge from their integrated technical design, which rests on the combination of three techno-

logical foundations, namely:

(1) Encryption and cryptographic tools: these ensure identification, validation and non-repudiation of identities

and operations on the ledger, as well as information integrity — various encryption methods are used, includ-

ing, famously, ‘public-key cryptography’;

(2) Consensus mechanisms: these are algorithms followed by network participants in order to determine whether

a ‘block’ of validated operations should be added to the network’s shared ledger (or ‘chain’), or rejected;

(3) Timestamps and ‘hashing’ of previous blocks: these ensure that each subsequent block on the chain in-

cludes an encrypted, consistent and immutable record of all previous blocks.

How these three pillars are concurrently used in order to generate working blockchains is both highly technical and quite

fascinating, though we will refrain here from examining the technicalities. We nonetheless provide a diagram of a gener-

ic blockchain’s workflow below (see Figure 4). Beyond technicalities, the key implication of the technologies employed

in a blockchain protocol is that they generate decentralised, trusted and immutable distributed ledgers. These distrib-

uted ledgers are called ‘blockchains’ since they consist in a self-consistent ‘chain of blocks’ created and agreed upon by

network participants, with each block containing an encrypted record of the most recent network-validated operations,

as well as of all the operations contained in all previous blocks.

Figure 4: The workflow of a generic blockchain protocol in four steps — from operation validation to ledger maintenance

Source: Julius Baer


‘5—4—5’: A summary of blockchain’s capabilities

What specific characteristics and capabilities thus emerge

from blockchain designs? We find it useful to think of

blockchain’s capabilities in terms of a scheme we call

‘5—4—5’: 5 properties, 4 advantages and 5 additional de-

velopment dimensions (see Table 1).

Table 1: The ‘5—4—5’ scheme in table format

Source: Julius Baer

Let us first consider the five properties of blockchain

technology. As we will also see further below, the five ad-

ditional dimensions which can be developed around block-

chains can either undermine or enhance some of these

properties: we thus include ‘caveat notes’ for each below.

Properties of blockchain protocols

(1) Decentralisation

Blockchain solutions remove the ‘single point of

failure’ embodied in a compromisable, trusted

central authority; consensus about modifications

and transactions of value is reached in an envi-

ronment in which trust has been disintermediat-

ed, decentralised and distributed through a tech-

nological instrument (the consensus mechanism).

Caveat: Some elements of centralised control can

be re-established under certain blockchain archi-

tectures, for regulatory or commercial reasons.

(2) Immutability

Because each block in a distributed ledger’s chain

refers back cryptographically to the previous

blocks, records are permanent as long as the par-

ticipants who carry out the chain’s consensus

mechanism continue to maintain the network.

Caveat: Events called ‘forks’ can occur, in which a

supermajority of a blockchain’s network decides

to retroactively alter a blockchain’s records, or the

network splits into factions following ‘forking’

(two or more) protocols and chains. Likewise, a

more centrally-controlled blockchain may see its

administrator(s) alter past records if required.

(3) Transparency

Network participants (and, for some protocols,

the wider public) have visibility access on the pro-

cess of consensus formation on-chain, as well as

on the blockchain’s entire record — this enhances

business-friendliness (for some use cases), and

guarantees an audit trail and a trusted workflow.

Caveat: Transparency does not mean ‘privacy’

(quite the contrary, in most cases) — due to regu-

latory and commercial concerns, some blockchain

protocols can segregate visibility access depend-

ing on the network participant’s identity or rela-

tionships.

(4) Security

Because on-chain ‘addresses’ are cryptographical-

ly secure, and participants can place their trust in

the integrity and secure features of the consensus

mechanism, the integrity of identity, information

and modifications/exchanges is guaranteed.

Caveat: All consensus mechanisms need to allow

some degree of fault tolerance, and thus are sub-

ject to some attack formats (though much less so

than traditional ledgers). Underlying code may al-

so contain exploitable weaknesses. Furthermore,

the ‘identity problem’ remains an issue, whereby

the very security afforded by cryptographic ad-

dresses might lead to participants being locked

out from their own on-chain holdings and rights.

Finally, and as noted for property (3), security

and transparency combined do not necessarily

equate to privacy, as a cryptographic address on a

high-visibility access network could be conceiva-

bly tied to a real-world participant with enough

investigating.

(5) Efficiency

Blockchain set-ups have the potential to be sub-

stantially more efficient than classical ones, in ei-

ther settlement speed (near-instantaneous),

costs (for network and chain maintenance) or risk

management (trust generated by consensus algo-

rithm). Blockchain implementations can further

be borderless, ‘distance-neutral’, achieve perma-


nent uptime and potentially create new revenue

streams (e.g. for on-chain data analysis services).

Caveat: Depending on the architecture of the

blockchain protocol and network in question (i.e.

type of consensus mechanism, degree of access

to the wider public, etc.), some implementations

might be slower or more resource-intensive than

their classical counterparts for some use cases.

Accordingly the four key advantages of blockchain-based

ledgers over classical ledgers emerge in property (5):

(1) Increased settlement speed;

(2) Reduced costs;

(3) Risk management efficiencies (i.e. balancing

trust, risk and efficiency);

(4) The potential to create new revenue streams

for participants/chain operators.

As alluded to above, both the properties and advantages

of blockchains can be enhanced or reduced, depending on

specific implementations. In fact, much of the work car-

ried out in ‘conventional’ industrial sectors (e.g. finance)

over the past years have centred around how to ‘tweak’

blockchain protocols to suit particular ends. It is thus cru-

cial for investors to grasp the five additional develop-

ment dimensions which have guided enhancements and

modifications to blockchain protocols’ core capabilities.

Additional development dimensions for blockchains

(1) Cryptocurrency

Cryptocurrencies (such as Bitcoin, the first cryp-

tocurrency) emerge from blockchain protocols

configured with specific consensus mechanism

implementations. Cryptocurrencies are on-chain

tokens (i.e. representations of ‘value’ on the

blockchain) which are ‘native’ to the ledger. In

other words, they do not represent any real-world,

off-chain asset (such as fiat currency or a finan-

cial/real asset), and derive their value directly

from their intrinsic supply and demand dynamics.

Traditionally, cryptocurrencies have been issued

as ‘reward tokens’ in the earliest-used blockchain

consensus mechanism, so-called ‘proof-of-work’

(PoW). Under this consensus mechanism, partici-

pants in the consensus process (nicknamed ‘min-

ers’) compete to solve a cryptographic puzzle,

which when solved enables the creation of a new

block. The winning miner is rewarded with native,

on-chain tokens (i.e. some cryptocurrency) in ex-

change for maintaining and updating the ledger

with their computing power.

This type of issuance is used in the case of

Bitcoin: bitcoins are awarded as compensation for

successful ‘mining’ of a new block. In other cases,

cryptocurrencies have been issued at initiation of

a blockchain network, in a fixed amount to all par-

ticipants (i.e. an initiation offering).

Chart 1: The six major cryptocurrencies as at 6 April 2017

Source: CoinMarketCap, Julius Baer; data as at 6 April 2017, 16:00 CET

More recently, ‘initial coin offerings’ (ICOs) and

‘additional coin offerings’ (ACOs) have been or-

ganised, in a clear parallel to public equity offer-

ings on traditional stock markets (see Chart 2 be-

low). Early participants in the network here buy

newly-issued tokens (or ‘coins’) with fiat currency

or another cryptocurrency, thus injecting value in-

to the new cryptocurrency, and providing an equi-

ty liquidation ‘exit’ for the developers of a new

protocol. This method of issuance has become in-

creasingly popular, and has to a certain extent re-

placed some venture capital and angel funding.

Chart 2: Total funds raised in token offerings, 2013–YTD’17

Source: Smith + Crown, CoinDesk, Outlier Ventures, Julius Baer; data as at

the close of 6 April 2017; The DAO=The Decentralised Autonomous Or-

ganisation (retired), a former on-chain, decentralised venture capital fund-

like structure

18.81(68%)

4,10(15%)

1.26(5%) 0.55

(2%)0.50(2%)

0.27(1%)

0%

10%

20%

30%

40%

50%

60%

70%

0

5

10

15

20

Bitcoins(Bitcoin)

Ethers(Ethereum)

Ripples(Ripple)

Litecoins(Litecoin)

Dash(Dash)

Moneroj(Monero)

Market capitalisation (lhs)

Share of overall cryptocurrency market (rhs)

Market cap. (USD bn) Share of overall market (%)

13

150

0.626

7

103

40

0

50

100

150

200

250

300

2013 2014 2015 2016 YTD 2017

Funds raised inICOs andsimilar tokenofferings

The DAO(outlier tokenoffering in2016)

Non-finalisedICOs andsimilar tokenofferings

USD mn

253

53


All depends on implementation. Some blockchain

protocols are coded as to allow for dynamic cryp-

tocurrency supply and issuance management,

while others rely on hard-coded supply manage-

ment rules, or depend on mining activity rates.

Importantly, most blockchains being considered

for ‘industrial’ use do not typically involve crypto-

currencies, or involve them only because they ful-

fill a marginal technical function (e.g. ‘anti-spam’

features, as is the case for the Ripple blockchain).

Chart 3: ‘Blockchain’ slowly replacing ‘bitcoin’ in public mind

Source: Google Trends, Bloomberg Finance L.P., Julius Baer; XBT=Bitcoin;

data as at close of 2 April 2017

Cryptocurrencies are probably the most well-

known aspects of blockchain technology among

the wider public, which leads to some confusion

between the most famous of the cryptocurrencies

(Bitcoin) and the underlying technology (block-

chain). The Bitcoin blockchain, however, is but

one of hundreds of blockchain protocols already

developed. We will deal with the potential use

cases for Bitcoin and other cryptocurrencies fur-

ther below, in our use case discussion.

(2) Control

‘Control’ is a dimension which has been dutifully

explored by blockchain developers and prospec-

tive adopters. The fundamental idea is to diminish

blockchain’s decentralisation, transparency and

immutability properties in favour of privacy, secu-

rity and efficiency. The trade-off is clear: if some

degree of centralised control is reintroduced, a

number of optimising ‘tweaks’ become possible.

‘Permissioning’, which restricts participation in

the consensus mechanism only to a few vetted

and trusted participants, can lead to more cost-

and resource-efficient blockchains, as ‘permis-

sionless’ protocols (such as Bitcoin) generally re-

quire higher amounts of on-network energy ex-

penditure and computing power. When combined

with less resource-intensive and faster consensus

mechanisms (see ‘Consensus’ below), permis-

sioned blockchains thus have the potential to be

substantially more resource-efficient, private and

secure, over permissionless ones. In Table 2 be-

low, these trade-offs are briefly summarised.

Table 2: Permissioned and permissionless blockchain protocols compared, alongside traditional ledgers

Source: Paul Baran’s On Distributed Communications (1964), Credit Suisse, Julius Baer; *R3 CEV’s Corda is a distributed ledger solution inspired by block-

chain technology, but is not strictly a blockchain protocol — it is close enough to a permissioned blockchain, however, hence our categorisation above

0

200

400

600

800

1,000

1,200

0

20

40

60

80

100

2013 2014 2015 2016 2017

Google searches for ‘blockchain’ (lhs)

Google searches for ‘bitcoin’ (lhs)

XBT/USD exchange rate (rhs)

Index (adjusted) XBT/USD


Likewise, if the possibility to read and initiate on-chain operations (modifications and transactions) is restricted

only to a few vetted and trusted participants, the blockchain is made ‘private’. This reduces the ‘hackable sur-

face’ of the blockchain, and relies on the off-chain integrity of participants to ensure that only relevant opera-

tions are conducted. Again, choosing private over public ‘read/write’ access renders the protocol more effi-

cient, private and secure. Table 3 below provides a matrix summary of the major examples of permis-

sioned/permissionless and private/public blockchain protocols.

Table 3: Permissioned/permissionless & private/public matrix summary of the major blockchain protocols

Source: BitFury USA Inc., Julius Baer

It should be noted that adding substantial

amounts of centralised control back into block-

chain protocols somewhat denatures them. In

fact, some DLT solutions developers, who work on

permissioned, highly-visibility access-segregated

and private ledgers for industrial use cases, do in-

dicate that their ‘recentralised’ and segregated

solutions are more accurately described as in-

spired by blockchain protocols, rather than block-

chain protocols per se.

Nonetheless, private and permissioned blockchain

protocols are currently the best candidates for in-

dustrial use, as they allow better compliance with

regulatory and commercial standards, in terms of

privacy, identification and legal ownership re-

sponsibilities, than their permissionless counter-

parts with decentralised governance.

It should be noted, however, that more recent

permissionless blockchain protocols, and their as-

sociated cryptocurrencies, have used advanced

cryptographic methods (such as ‘zero-knowledge

proofs’, or ‘ZKPs’) to ensure greater privacy of on-

chain identities and operations without compro-

mising the decentralised nature of their permis-

sionless protocols. Such blockchains and associ-

ated cryptocurrencies include Zcash, Dash and

Monero. These alternatives to Bitcoin have also

attempted to promote greater resource-efficiency

than most other permissionless protocols through

their choice of consensus mechanism, thus add-

ing to their efficiency.

(3) Consensus

As we have alluded to above, the choice of con-

sensus mechanism for a blockchain protocol af-

fects several of its properties and dimensions: its

degree of efficiency, whether or not a protocol re-

quires a cryptocurrency to function and the de-

gree of permissioning and privacy (of visibility,

identity and operation) assumed on-chain.

While proof-of-work (PoW), discussed above in

the context of cryptocurrency ‘mining’, has been a

very popular choice for permissionless block-

chains, an alternative known as proof-of-stake

(PoS) has been gaining ground.

Most famously, the permissionless Bitcoin com-

petitor known as Ethereum is transitioning to

such a PoS algorithm, in which participants ‘bet’ a

certain amount of cryptocurrency that consensus

can be reached and block creation can occur. This

orients the incentives of the participants in mak-

ing sure that consensus can be reached, but with

the threat of a ‘malus’ in case of failure rather

than the prospect of a reward in case of success.

Many other consensus algorithms have been de-

veloped for permissioned blockchains, and they

generally rely on a greater degree of implied, off-


chain trust between participants, reflecting these

protocols’ more centralised design. Importantly,

both PoW and PoS can be more resource-hungry,

making them unattractive for industrial use cases.

(4) Contract

One of the most exciting emerging features of

blockchain protocols is the capacity to write code

and scripts onto the chain itself, enabling partici-

pants in the consensus mechanism to also run a

‘virtual machine’ and its decentralised applica-

tions as they maintain and update the blockchain.

The pioneer of this additional dimension — which

is often referred to as ‘smart contracts’, for rea-

sons which will be clarified below — was Ethere-

um, a blockchain protocol launched in 2015.

Ethereum includes a ‘virtual machine’ capability in

its code, allowing its network participants to write

and execute scripts on-chain that run infinitely

different decentralised applications (or ‘Dapps’)

on an automated basis.

This has often been touted as ‘smart contracts’,

given that this capability allows a blockchain pro-

tocol to become a trusted, automatic and decen-

tralised executor of contractual obligations be-

tween network participants. For instance, what we

now know as an off-chain corporate bond could

be simply transcribed on-chain as a piece of code,

delivering cryptocurrency or token payments at

given intervals to security-holders — much as a

real-world fixed income instrument would distrib-

ute coupons to bond-holders at fixed intervals in

time.

This additional dimension is full of promises, ena-

bling countless processes currently conducted in

the real world (with expensive notarisation and

verification procedures) to be moved on-chain.

(5) Tokenisation

The final additional dimension enabled by block-

chain protocols is the capacity to ‘tokenise’ real-

world, off-chain value (such as wealth, identities

or assets). We have spoken at length of crypto-

currencies, which are native, on-chain tokens or

assets created by certain blockchain configura-

tions. Tokenisation is altogether more revolution-

ary, allowing the digitalisation of real-world value

into seamlessly-exchangeable digital value.

Because of the likely sensitivity of digital asset

creation, it is unlikely that existing regulators will

allow mass tokenisation of off-chain value to be

conducted on permissionless protocols. This

means that permissioned protocols, which retain

some degree of centralised control, will be best-

positioned to capture the full potential of tokeni-

sation, with any type of security (shares, bonds,

derivatives, etc.) and ownership title (for real es-

tate, merchandise, etc.) holding the potential for

digitalisation and tokenisation.

Nonetheless, it is worth noting that some proto-

cols, such as the ‘coloured coin’ protocol devel-

oped to be overlaid on the Bitcoin blockchain,

seek to advance tokenisation on permissionless

protocols, with some very modest degree of suc-

cess.

Figure 5: A summary of the ‘value’ concept in the context of blockchain technology

Source: Julius Baer


THE RANGE OF USE CASES FOR BLOCKCHAINS

Figure 6: Potential fields of application (use cases) for blockchain technology

Source: Julius Baer; P2P=peer-to-peer, C2C=consumer-to-consumer, B2C=business-to-consumer, KYC=know-your-client, AML=anti-money laundering,

B2B=business-to-business

ddd

SECTION INSIGHTS

Industrial-use blockchain protocols require some specific

properties in order to be implemented on a mass scale:

privacy, scalability and interoperability, to name a few.

This is mainly because blockchain operators and develop-

ers need to respond to commercial and regulatory re-

quirements.

While the technology itself has many merits for industrial

use, and holds an inherently strong disruptive potential, it

is highly likely that regulatory and competitive constraints

in a number of use cases will mitigate its short- to medi-

um-term disruptive potential. Therefore, adoption and co-

option of the technology by incumbents is highly likely.

We think cross-border payments and correspondent bank-

ing, as well as business-to-business (B2B) supply chain

and trade finance, present the strongest fields for radical

disruption. By contrast, adoptive dynamics are more likely

in capital markets’ post-trade infrastructure and in inter-

bank (non-cross-border) payments settlement. Further-

more, we do not see card and merchant payments net-

works as facing disruption. fff

ddd

An overview of potential use cases, needs, challenges

Given our current understanding of the capabilities and

potential of the technology, we recognise four broad fields

of potential applications for blockchain solutions going

forward, as summarised in Figure 6 above. We will focus

here on the two major fields, finance and trade, and how

these might be disrupted, or incrementally altered, by the

adoption of blockchain technology.

The running thread through each broad field, however, is

deeply shared: industrial blockchain solutions will need to

provide improvements over classical ledgers in order to

thrive. This means delivering on desirable properties, such

as control, security, privacy and efficiency. Visibility on,

and vetting of, on-chain identities will be especially im-

portant for industrial blockchain operators going forward,

both for commercial and regulatory reasons.

Moreover, additional criteria such as scalability (for high-

volume networks), resilience and sustainability (for

high-speed and long-duration networks) and interopera-

bility (to facilitate communication between existing infra-

structures and future and current blockchain protocols)

will be in great demand. Finally, blockchain solutions also

need to be used in areas where their properties are rele-

vant: that is, networks in which trust between participants

is relatively low, and in which the capabilities of the tech-

nology can be made to shine in terms of efficiency.

All of these desired properties place permissioned proto-

cols, developed for specific industrial cases and with in-

teroperability in mind, in a better position than permis-

sionless protocols for eventual adoption. While we do not

discount some disruption at the margins from cryptocur-

rency-enabled permissionless protocols (such as Bitcoin),

we are less convinced by their long-term capacity to con-

vince consumers, corporates, incumbents, network opera-

tors and regulators that they will deliver efficient, sustain-

able and supervisable systems for handling value.

Importantly, the regulatory and competitive landscape of

each industry, beyond efficiency gains and other im-

provements, will matter immensely as to whether block-


chain technology proves to be radically disruptive, mar-

ginally disruptive (for instance, through pricing pressure

on the incumbents), incrementally adopted by incum-

bents or disregarded.

Overall, we will find that there are only a few cases in

which radical disruption to current intermediaries and

incumbents could conceivably occur within the current

competitive and regulatory structures. Nevertheless, regu-

lation is not the ‘be-all, end-all’ in order to determine

adoption or disruption, as regulatory rules and expecta-

tions might evolve over time. For now, though, it does

place some constraints over the medium-term disruptive

impact of blockchain, beyond the merits of the technology

itself.

Finance & capital markets: Digitalisation unleashed

Capital markets, payments and financial services were

originally envisaged as the primary field of application for

blockchain technology. Bitcoin vowed to become a decen-

tralised, borderless payments system. Sceptics of central

banks’ monetary governance and fiat currency issuance

also envisaged it as an alternative store of value.

Beyond these early and extreme ambitions, finance re-

mains one of the most promising fields for the application

of blockchain technology, with distributed ledgers poised

to deflate costs, settlement times and multidimensional

risks. We will consider here the three key prospective seg-

ments for blockchain use in finance:

1. the post-trade infrastructure of capital markets

(across processes and asset classes);

2. payments systems;

3. the ‘back-office’ operations (reporting, audit and

compliance) of financial institutions.

Post-trade infrastructure: Differential disruption

Regulation notwithstanding, the post-trade infrastructure

of capital markets is ripe for disruption. The current infra-

structure, especially in the developed world, is highly

complex and fragmented, crowded with intermediaries,

and weighed down by legacy systems and technologies.

Such environments would theoretically be a ‘no-brainer’

for technological disruption.

Alas, in order to ensure trust among the various disparate

participants in capital markets, regulators have empow-

ered certain trusted actors with artificial monopolies. This

has been accomplished either by erecting high regulatory

barriers to entry, or designating certain actors as monopo-

listic owners of key post-trade processes.

We see this as mitigating disruption in the short term,

with regulators ‘warming up’ to blockchain-based technol-

ogies and business models in the medium to long term.

Likewise, this will likely shift blockchain in the post-trade

environment from a disruptive to an adaptive role, in that

we expect its disruptive potential to be partially harnessed

by incumbents.

Friction in post-trade processes

In order to understand how blockchains could change

capital markets, it is key to grasp how they currently func-

tion (see Figure 7 on the next page for a graphical sum-

mary). The post-trade infrastructure includes all processes

taking place after an agreement to transact (a ‘trade’) has

occurred, as well as securities lifecycle management.

A REFRESHER ON POST-TRADE INFRASTRUCTURE

The post-trade environment involves the following six key

processes:

1. CLEARING, performed by central counterparties

(CCPs, also known as ‘clearing houses’) — involves

managing and taking on counterparty default and li-

quidity risk until transacting parties are ready to set-

tle the transaction;

2. SETTLEMENT, performed by the various parties in

the settlement process — involves ‘settling’ the

transaction, by delivering the transacted security in

exchange for a cash payment (delivery-versus-

payment, or ‘DvP’);

3. DEPOSITORY, performed by central securities de-

positories (CSDs) — involves the legal safekeeping

and maintenance of securities in a ‘central deposito-

ry’ on behalf of custodians, in materialised or dema-

terialised form;

4. CUSTODY & ASSET SERVICING, performed by cus-

todians — which involves the safekeeping of securi-

ties on behalf of the end-investors, along with ‘asset

servicing’ (e.g. receipt of dividend payments for stock

held);

5. REGISTRY, performed by registrars (also known as

‘share transfer agents’ or ‘share registries’) — involves

liaising with issuers in order to ensure they are aware

of the current ownership of their issued securities;

6. ISSUANCE, performed by registrars, issuers and

CSDs — involves the issuance of further securities by

issuers, and their onboarding onto CSDs’ platforms.

Source: Credit Suisse, Citigroup, Bank of America Merrill Lynch, Goldman

Sachs, Julius Baer


Figure 7: Current capital markets infrastructure for publicly-traded securities

Source: Credit Suisse, Citigroup, Bank of America Merrill Lynch, Goldman Sachs, Julius Baer

Much of the complexity and fragmentation of the post-

trade world arises out of the various participants (custodi-

ans, issuers, registrars, CSDs) holding their own, separate

ledgers in order to carry out the processes listed above.

Consequently, they spend time and resources on reconcil-

iation and risk management, in order to ensure that trans-

actions can be, and are, appropriately carried out.

This has important consequences, efficiency-wise. The

CCP, which fulfils the clearing function, takes on various

risks whilst transacting participants ensure settlement.

Accordingly, the CCP needs to fund its risk onboarding

with capital provisions, and therefore charges interest and

fees for its services to transacting participants.

The CSD, on the other hand, needs to reconcile its deposi-

tory ledger with the custodians’ and the registrars’, charg-

ing a commission for its services, which custodians and

registrars pass on to their end-customers. Equally, custo-

dians and registrars perform other services for their end-

customers, mostly related to settlement and ledger

maintenance, for which they charge further fees.

Therefore, transactions which are agreed upon in fractions

of a second during trading, ultimately settle long after

trades are concluded (days, generally), with layers of costs

and fees in between.

By contrast, we do not believe, in line with industry and

blockchain observers, that blockchain will have a signifi-

cant impact on the trading infrastructure of capital mar-

kets (e.g. the securities exchanges). This is because the

technology deployed currently in trading venues, such as

global stock exchanges, is extremely efficient in regards to

the requirements of trading (i.e. high transaction speeds).

Blockchain solutions do not possess comparable ad-

vantages in terms of transaction speed — it is rather for

settlement speed that the technology’s properties can be

leveraged.

Removing friction with post-trade blockchains

The purpose of a blockchain solution in post-trade infra-

structure would be to render settlement near-

instantaneous, eliminating these layers of time, fees, costs

and risks. This would be achieved by allowing the various

end-participants access to a blockchain storing tokenised

securities, notarised ownership and issuance information,

and other relevant data (as posited in Figure 8 on the next

page).


Furthermore, this post-trade infrastructure blockchain

set-up could be linked to a blockchain-based payments

system (see next section on payments for further details)

and end-customers’ custody accounts, enabling DvP set-

tlement. It presumably would also enable smart contracts,

in order to provide on-chain asset servicing, as well as

other post-trade services. Of course, this blockchain

would be permissioned, managed by a controlling entity

(or a series thereof), and with privacy features enabled, in

order to comply with regulatory requirements.

Near-instantaneous settlement in capital markets, ena-

bled through a blockchain technology, would bring im-

mense benefits — particularly to end-investors and issu-

ers. Savings would be achieved in terms of capital re-

quirements, as the necessary capital to be held for collat-

eral and default provisions would decrease. Equally, there

would be a general reduction in counterparty credit and

liquidity risk, interest charged, operational costs and vari-

ous categories of fees linked to post-trade processing.

Under a blockchain set-up, the necessity of the continued

existence of some of the intermediaries currently involved

in post-trade processes would come into question. Assum-

ing that near-instantaneous settlement poses no unfore-

seen operational or credit risk — as a blockchain would

theoretically allow instant verification of participants’ cash

balances and security holdings — CCPs would be hard-

pressed to justify their continued participation. In effect,

clearing houses could in theory be disintermediated en-

tirely.

Likewise, the current ‘doubling’ of custody and safekeep-

ing roles between CSDs and custodians would also be

difficult to justify. One or the other would be able to offer

the full range of post-trade services. A similar reasoning

applies to registrars, which would also struggle to justify

their services to issuers, if these could liaise directly with,

say, a blockchain-operating CSD.

Determining the winners…

The key question is therefore which actor(s) would own

and operate the post-trade blockchain infrastructure.

There is no simple answer to this consideration. The spe-

cific markets involved — whether we are dealing with ex-

change-traded or ‘over-the-counter’ (OTC) securities,

‘vanilla’ products or derivatives — as well as the jurisdic-

tions in question, will matter immensely as to determine

which actor(s) are best positioned to capture the block-

chain opportunity. Importantly, we think the degree of

vertical integration of firms in a particular post-trade

space, as well as the competitive dynamics in particular

jurisdictions and the openness of the local regulators, will

Figure 8: A theoretical implementation of blockchain in post-trade infrastructure

Source: Julius Baer


also be key determinants in order to identify adopters,

disruptors and disintermediated parties. Across the vari-

ous geographies, we see Australia and the Euro Area, for

instance, as the markets with the ripest conditions (in

terms of competition, vertical integration and, in Austral-

ia’s case, friendly regulation) for blockchain adoption.

Some fields, however, can be designated as ripe for block-

chain disruption with much greater certainty. Disruptive

blockchain solutions on a mass scale are very likely to arise

(1) in smaller markets dealing in non-exchange-traded

and relatively unregulated securities and derivatives; and

(2) in jurisdictions with little or no pre-existing post-trade

infrastructure (e.g. frontier markets ‘leapfrogging’ from

having limited to blockchain-based capital markets).

For the former, we see complex, OTC instruments such as

syndicated/leveraged loans, swaps or privately-traded

shares as early candidates for tokenisation onto a block-

chain. American market actors such as Nasdaq Inc. (Buy,

Price/Target: USD 69.13/80) and the DTCC (Depository

Trust & Clearing Corp., not listed) have started experi-

menting with such solutions.

For us, it is not a question of ‘if’, but rather of ‘who’, ‘when’

and ‘how’ blockchain technology transforms capital mar-

kets. While these are very early days, post-trade partici-

pants the world over are actively engaging with blockchain

start-ups and in-house developers in order to improve

their competitive positioning. In parallel, regulators are

evaluating their responses in view of the benefits which

the technology could bring to financial markets.

Even if they are not the operators of post-trade block-

chains, exchanges linked to blockchain-enabled infrastruc-

tures should benefit from greater trading volumes, given

the greater ease of transacting, while the seamlessness of

near-instantaneous settlement should lure both investors

and issuers the world over towards blockchain first-

movers. Despite the shackles of regulation, therefore,

blockchain-based infrastructures should constitute unmit-

igated competitive advantage.

A key risk to adoption by incumbents will be the degree of

cultural inertia within their organisations, as well as

whether the trade-off between blockchain-based and non-

blockchain solutions will be economical (e.g. lower interest

income v. lower operating costs for clearing).

Payments: Cross-border most disruptable area

Payments systems are the original target of blockchain-

based disruption. While Bitcoin and myriad other permis-

sionless cryptocurrencies have appeared since 2009, a

dominant alternative payments system with a critical user

mass has failed to materialise as of yet, and we estimate

that they will continue to constitute only a marginal share

of global payments volumes going forward.

We will consider the future developments of blockchain

technology within the three major payments infrastruc-

tures:

1. the interbank system (which is confined to a given

monetary jurisdiction);

2. the cross-border system (enabled by correspond-

ent banking);

3. card & merchant payments networks.

Interbank payments: Tokenised fiat on the way?

In our discussion of post-trade blockchain solutions

above, we briefly touched upon the linkage of such solu-

tions to payments systems (i.e. cash exchange systems).

While blockchain-based post-trade infrastructures could

be made compatible with existing payments systems, the

benefits they bring would be dampened and mitigated if

the payments themselves were not also blockchain-based.

In other words, if assets and securities are tokenised, so

should, ideally, fiat currency, in order to enable seamless

value transfers either post-trade, or even in simple inter-

bank transfers.

Broadly, there are four scenarios which could be envisaged

for interbank payments systems going forward:

1. Status quo — interbank payments systems are

maintained according to the status quo (as de-

scribed in Figure 9 below), with settlement taking

place either on a delayed net (‘DNS’), real-time

gross (‘RTGS’) or correspondent basis;

2. Permissionless cryptocurrency used — finan-

cial institutions utilise an existing permissionless

blockchain and cryptocurrency (e.g. Bitcoin) to

transfer cash (and value) between themselves;

3. ‘Settlement coin’ — financial institutions create

a permissioned blockchain and cryptocurrency,

the latter of which is pegged to fiat currency (i.e.

a form of ‘settlement coin’);

4. Tokenised fiat currency — central banks issue

fiat currency in a tokenised form onto an inter-

bank blockchain.

Financial institutions and monetary authorities are cur-

rently exploring, or experimenting with, all four possibili-

ties. We see, however, either (3) or (4) as more likely in

the long term given the advantages brought by ‘fiat-like’

tokenisation in terms of settlement speed, traceability,

stability and overall resource intensity. Crucially, some key

central banks (e.g. the Bank of England and the People’s

Bank of China) have already either expressed their enthu-

siasm for blockchain-based fiat or launched prototypes.


Figure 9: Current interbank payments infrastructure (three channels)

Source: Julius Baer

Importantly, we do not see permissionless cryptocurren-

cies as strong contenders for replacing fiat, either in the

interbank or the cross-border applications (the latter of

which we discuss further below). All existing permission-

less cryptocurrencies currently exhibit unsustainable levels

of price volatility in relation to fiat currencies — mainly

due to their unstable and rapidly-shifting demand dynam-

ics — as well as questionable scalability.

Furthermore, they are often plagued, as is the case for

Bitcoin, by inbuilt restrictions which aim to emphasise

decentralised governance, often leading to conflicts within

their code development and network maintenance com-

munities, and thus to unstable outlooks. While decentral-

ised governance and democratic decision-making were

admittedly the purported goals of most of these crypto-

currencies, these make poor design choices for monetary

governance and price stability generation, leading to a

deficit in participant trust for their utility in storing and

exchanging value.

It is thus more likely, in the long term, that either settle-

ment coins or tokenised fiat could be implemented in a

jurisdiction’s interbank payments system, with a view to

integrating with post-trade blockchain implementations.

Pending issuance by central banks, some financial institu-

tions, such as UBS Group AG (Buy, Price/Target: CHF

15.69/18) or The Bank of New York (BNY) Mellon Corp.

(Hold, Price/Target: USD 47.31/48), and start-ups (e.g.

Clearmatics Technologies Ltd., not listed), are working on

settlement coin solutions. Success for these initiatives will

mainly depend on adoption by a wide network of settle-

ment and interbank payments participants.

Cross-border payments & remittances

The cross-border payments system shares broad similari-

ties with how the interbank correspondent banking pay-

ments rail functions. Currently, cross-border payments

rely on a network of financial institutions holding corre-

spondent banking accounts across borders and jurisdic-

tions, facilitating payments for banks which do not pos-

sess a cross-border and cross-currency infrastructure.

This set-up relies on transnational institutions and inter-

national standards (such as the cross-border payments

messaging protocol, SWIFT), and constitutes a profitable

business for correspondent banks. Despite improvements

over the past decades, settlement times are, much like in

the case of post-trade infrastructures, slow (i.e. days).


The main objective for cross-border payments blockchain

applications would be to disintermediate correspondent

banks and enable faster payments settlement. Here, even

the prospect of a tokenised fiat does little to solve the

terminal issue of cross-border and cross-currency pay-

ments, as it is likely central banks will still wish for to-

kenised fiat to remain under their control within national

interbank blockchains.

A number of blockchain start-ups are working on solutions

which rely on existing permissionless cryptocurrencies

(principally Bitcoin) for cross-border value transfers.

These solutions suffer from exposure to the usual flaws of

permissionless protocols, which we have already discussed

above.

It is possible, however, that some use for Bitcoin and simi-

lar protocols will be found in the high-volume, low-value

area of cross-border remittances, in which speed is less of

a concern, and low transaction values justify avoiding the

high fees associated with existing cross-border payments

systems. Equally, some emerging and frontier markets

with limited payments infrastructures might look favoura-

bly on Bitcoin-based payments as a low-cost ‘leapfrog’.

We do note, nevertheless, that other non-blockchain solu-

tions for remittances in the FinTech space might be even

more cost-effective than cryptocurrency-based ones.

On the high-volume, high-value side of cross-border pay-

ments, one of the more ambitious projects to emerge in

the blockchain space has been the Ripple blockchain and

cryptocurrency (developed by Ripple Labs Inc., not listed).

The Ripple solution builds out an on-chain network of

financial institutions which closely mirrors existing cross-

border arrangements — though with near-instantaneous

settlement, high visibility and embedded network trust.

We see the Ripple solution, which relies on the use of its

native cryptocurrency and on-chain settlement coins or

tokens pegged to fiat, as one of the strong contenders to

disrupt correspondent banking in the medium to long

term.

Card & merchant payments networks

This is one of the application areas, alongside trading and

securities exchanges, for which only very marginal benefits

could be attained by implementing blockchain solutions.

Much as in securities and derivatives trading proper, card

& merchant payments networks, such as the ones operat-

ed by Visa Inc. (Buy, Price/Target: USD 89.09/100) and

Mastercard Inc. (Buy, Price/Target: USD 112.43/120),

rely on delivering consumer and merchant value through

high payments transaction speeds. As we have discussed,

existing blockchain technology is comparatively inefficient

at delivering high transaction speeds, though it may deliv-

er near-instantaneous settlement.

It is unlikely that either consumers or merchants would see

the benefit of enabling near-instantaneous payments

settlement within a retail context. In fact, postponed

payments settlement on the consumer side (through cred-

it cards) is actually one of the benefits of card payments

networks, as it allows a variety of credit options and prod-

ucts. While such a credit dimension could also be moved

on-chain through, say, smart contracts, this appears su-

perfluous.

Reporting, audit, compliance: Back-office cuts

If blockchain solutions are to be applied en masse in either

capital markets or payments systems, they will need to

comply with regulatory requirements in terms of customer

onboarding (‘KYC’, or ‘know-your-client’), monitoring

(especially ‘AML’, or anti-money laundering) and report-

ing (account balances, fees transparency, trading confir-

mations, etc.).

Blockchain solutions are thus likely to include on-chain,

trusted and notarised information about the identity of

customers, as well as ownership and holdings of assets

and currency. This has important consequences for the

infrastructures which financial institutions have built up in

their back offices in order to reconcile ledgers, monitor

transactions and manage multidimensional risks.

In effect, such infrastructures might become largely su-

perfluous — assuming friendly regulation — if blockchain

solutions are adopted, as blockchains are theoretically

fraud-proof, and would potentially contain all required

trusted information. In fact, such solutions might be de-

signed purposely to substantially decrease back-office

costs, with dire consequences for employment within

these areas.

Such developments would be a boon to financial institu-

tions with high regulatory and compliance costs, and a

clear detriment to firms providing outsourcing services or

software to back offices. This particular use of blockchain

technology is often cited as one of the more potentially

troubling effects of blockchain adoption, driving employ-

ment out of repetitive ‘medium-skill’ areas into high-skill

software or blockchain development niches.


Trade/supply chain finance: Vanishing intermediaries

The use of blockchain technology for trade finance and

supply chain management emerged as a distinct possibil-

ity only after financial use cases had been first considered.

Interestingly, these areas are likely to become the sites of

the first industrial-scale uses of blockchain technology,

given relatively lower regulatory requirements and the

immediacy of the benefits provided.

Currently, global supply chains are plagued by a lack of

transparency and high network complexity, with the most

efficient trade networks providing financing and opera-

tional services which are premised upon high inter-firm

trust. The latter is not necessarily forthcoming, and would

perhaps be considered the exception rather than the rule.

There are three ways in which blockchain solutions could

provide improvements to the supply chain management

and trade finance areas.

Firstly, blockchain-based ledgers could be harnessed to

deliver immutable, tamper-proof records of a network’s

trade and supply chain dynamics — documenting which

commodities have been delivered, which payments have

been received, etc. This would greatly improve transpar-

ency in trade and supply chain management, allowing all

network participants to peruse, document and analyse the

status and efficiency of their processes and transactions.

Secondly, based on the heightened transparency provided

by a shared ledger, alternative ‘B2B’ (business-to-

business’) payments, trade financing and credit solutions

and products could be more readily provided. Instead of

relying on banks and financial institutions providing cred-

it, cross-border payments, and trade finance, corporates

linked onto a blockchain network could provide alternative

forms of payments, credit and financing based on the on-

chain status of items and transactions. This is already

industry practice, especially in the context of long-running

business and supplier partnerships, with alternative forms

of credit (and advance payments) provided between sup-

ply chain partners (so-called ‘payables financing’).

Thirdly, even when third-party bank credit or financing is

required, granting third parties access to the shared ledger

network would allow them to automate, streamline and

rationalise the production of their financing products

(such as ‘letters of credit’ or ‘LCs’, which are ubiquitous in

trade finance). The cost and capital savings generated

would allow them to provide better cost-adjusted financial

services to trade and supply chain participants.

These developments, of course, would also need to be

underpinned by friendly regulation (however more lax,

say, B2B supply chain financing is likely to be), and would

require the tokenisation of off-chain assets, extending to

physical trade goods. This presents logistical issues of its

own, but a number of start-ups and incumbent firms have

already collaborated to produce tokenisation, supply chain

management and trade finance solutions based on block-

chain technology.

A topical example would be the recently-announced part-

nership between International Business Machines Corp.

(IBM, Hold, Price/Target: USD 172.45/169), Trafigura

Group Ltd. (not listed), and Natixis SA (not covered) in

order to develop a blockchain for US crude oil trade fi-

nance. As a side-note, IBM seems particularly well-

positioned to capture demand for ‘enteprise blockchain’

solutions in trade finance and supply chain management

in the short term, with its early positioning in the space

with its ‘Bluemix’ offering. The Bluemix blockchain solu-

tions suite is based on open-source blockchain code de-

veloped within Hyperledger, a non-profit consortium.

It is as yet unclear whether financial institutions active in

trade finance will be disintermediated and disrupted by,

say, industrial-scale use of blockchain-based B2B trade

financing, or whether they would adopt the technology

within their credit and financing offerings. What is certain

is that development of blockchain-based trade finance

and supply chain management solutions are progressing

very quickly, setting the stage for a rapid transformation

of the industry.


INVESTMENT CONCLUSION

Beyond hype, but early days

Having examined the two most seminal fields of prospec-

tive application of blockchain technology, which conclu-

sions should we draw?

The benefits of the technology, as stated previously, are

clear for a wide variety of use cases. The key question is

whether incremental adoption or radical disruption is the

most likely scenario, and under which timeframes, seg-

ments and conditions. It is highly likely that, in the long

run, a standard blockchain protocol, or an interoperable

set of protocols, could underpin a global network of value

storage and exchange. In other words, the ‘Internet of

Value’ is a distant, but likely prospect.

In the meantime, these are very early days for the tech-

nology, with start-ups proliferating, alongside incumbents’

announcements of collaborations and developments, both

in-house and in the context of industry-wide ‘consortia’.

Within the next one to two years, we expect industries to

move beyond proof-of-concepts, and start using fully-

functional prototypes for certain applications — transi-

tioning to the first industrial blockchain solutions within

the next three to five years.

We see the development of an industry-standard protocol

(or set of protocols) as a key catalyst for wider technologi-

cal adoption, given the likely network and critical mass

growth effects this would generate. Equally, we think par-

allel developments in cryptography, Big Data analytics,

cloud computing, and artificial intelligence/machine

learning could aid the development of the technology.

Investment avoidance opportunities

Unfortunately, investment opportunities remain beyond

the grasp of most investors, with the majority of in-

development blockchain solutions financed in-house by

incumbents, or external opportunities captured by incum-

bents’ venture capital arms. Importantly, we do not be-

lieve that any effect from blockchain solutions develop-

ment or use will have an impact on incumbents’ underlying

fundamentals within the next one to two years, and so do

not draw investment conclusions unnecessarily driven by

blockchain developments for the time being.

There are some key investment avoidance recommenda-

tions we could make, however. In light of our discussion

above, we are cautious regarding any participant in post-

trade infrastructures (especially custodians and registrars)

which is not developing blockchain solutions, or partici-

pating in their development. We are also wary of financial

institutions exposed to cross-border payments and corre-

spondent banking, as well as third-party trade finance and

credit providers.

Likewise, we do not recommend long-term holdings of any

of the major permissionless cryptocurrencies (including

Bitcoin), which we see as easily replaceable by more stable

alternatives and plagued by chaotic governance (including

the risk of value-destroying ‘hard forks’). We are perhaps

less negative on Ethereum, given the protocol’s popularity

with incumbent institutions (due to its smart contract

capabilities), but we remain sceptical of both the quality

of its governance and the scalability/stability of the pro-

tocol itself. Any positioning involving cryptocurrencies is

highly speculative in our view, and would entail a short-

term time horizon — which is beyond the scope of Next

Generation investing.

Finally, we continue to vigilantly monitor the development

of the technology, as well as the competitive landscape

and the shape of the future monetisation of blockchain

solutions, in order to ascertain investment opportunities

going forward.

Risks to our investment conclusion

Faster adoption and/or disruption: 1) Industrial, mar-

ket, technological and/or regulatory developments spur

faster adoption of blockchain technology across various

industries within one to two years, leading to the rapid

disintermediation of many incumbent firms positioned

across existing industrial supply chains. 2) Unexpectedly

greater adoption of permissionless cryptocurrencies (e.g.

Bitcoin) for payments and other use cases (tokenisation,

smart contracts, etc.), leading to radically disruptive dy-

namics.

Blockchain technology only marginally impactful:

1) Blockchain technology proves to be non-cost-effective

for incumbents, and/or uninteresting for disruptors (e.g.

unviable business models, with excessive price deflation),

leading to very marginal adoption. 2) Regulatory crack-

down. 3) Development of quantum computing makes

classical cryptography obsolete, endangering the security

and integrity of all existing blockchain protocols.

Summary of equity ratings for companies referenced in text

BNY Mellon Corp. (Hold, Price/Target: USD 47.31/48)

IBM Corp. (Hold, Price/Target: USD 172.45/169)

Mastercard Inc. (Buy, Price/Target: USD 112.43/120)

Nasdaq Inc. (Buy, Price/Target: USD 69.13/80)

Visa Inc. (Buy, Price/Target: USD 89.09/100)

UBS Group AG (Buy, Price/Target: CHF 15.69/18)


POSTSCRIPT

INTERVIEW WITH GARRICK HILEMAN, PhD, MBA

Senior Research Associate, Cambridge Centre for Alternative Finance (Judge Business School, University of Cambridge)

Dr Hileman is an economic historian currently holding positions at both the University of Cambridge and the London

School of Economics. He is an expert on financial and monetary innovations, including alternative monetary systems,

cryptocurrencies and blockchain technology, and was ranked by City A.M. in 2015 as one of the top 100 most influential

economists in the United Kingdom and Ireland. He kindly answered some of our questions.

Garrick, when do you believe that blockchain technology will become ‘mainstream’, irrespective of the specific

applications involved? With Bitcoin turning 10 years old in 2019, do you believe this is around the time when its

underlying technology will encounter industrial-case use?

No one knows for sure when a blockchain use case will become mainstream, but what we can say is that the foundation is

now in place for this to happen at any moment. A future financial crisis could propel retail interest in cryptocurrencies, or

successful deployments in 2017 of blockchain applications by the DTCC, CME, or others, may accelerate adoption in capital

markets. The technology and concepts that enabled the peer-to-peer/sharing economy were around for many years before

the advent of Airbnb and Uber. Bitcoin and blockchain technology have been around for eight years, but it is only in the last

two to three years that a broader group of people began to seriously explore its vast potential.

Which use cases do you see as most likely to be penetrated by blockchain technology in the near future, and

for which reasons (cost, speed, efficiency, compliance, transparency, security)? Potential use cases which we

have identified range from post-trade processes and interbank payments, to intra-firm asset registries and

supply chain management.

This is the topic of a forthcoming paper which I will publish shortly with the Cambridge Centre for Alternative Finance, and

so I will refrain from commenting for now. I enjoin you to read it upon publication, however.

What about the potential use of ‘proof-of-existence’ (PoE) or ‘proof-of-ownership’ (PoO) models, such as for

electoral rights, media content rights, real estate titles and the management of the sharing economy?

I believe this is an area of significant potential. For example, the potential knock-on effects in many parts of the world from

honest, digital public elections — secured by blockchain technology, and made more accessible through e-voting platforms

on smartphones, etc. — could be profound. If such a system had been in place in the United Kingdom, I think we could have

seen much higher voter turnout from young people and a different Brexit referendum result. In other parts of the world,

corrupt elections undermine government legitimacy, drive up public borrowing costs, and contribute to a great many other

problems.

If blockchain technology is widely adopted in the global financial services industry, do you expect to see a sig-

nificant convergence in protocols or protocol standards?

A lot of really interesting work is being done right now on interoperability across different blockchains that may obviate the

need for protocol standardisation. However, the technology is still rapidly evolving, and it is too early to know which ap-

proach or chain(s) will ultimately ‘win’. Some of the best evidence for this view comes from the data my research centre is

collecting. The fact that there are over 70 pure DLT service provider firms, and approximately 30 cryptocurrencies with a

market capitalisation greater than USD 10 million indicates a very wide-open playing field.

Do you believe Bitcoin will ever achieve the critical mass it requires in terms of adoption to be sustainably op-

erational into the distant future, or do you believe interest in it will fizzle out over the next few years — pre-

sumably due to more advantageous, efficient or flexible alternatives?

I do not see interest in Bitcoin (and cryptocurrencies in general) fizzling out in the next couple years, and I can imagine

scenarios where Bitcoin continues to grow well beyond today’s levels both in terms of value and use. It is important to also

remember that a cryptocurrency like Bitcoin has the capacity to evolve, both in terms of its technical capabilities as well as


its governance. For example, even rules currently deemed sacred, like the 21 million maximum coin issuance, can be

changed down the road. In addition to internal drivers, the external world will shape Bitcoin’s fate. Looking at the global

macroeconomic landscape, privacy concerns and the growing interest in abolishing cash, the rise of the Internet of Things

economy and other factors, it is not surprising that interest in Bitcoin and permissionless cryptocurrencies continues to

grow.

Do you believe smart contracts and/or near-instantaneous settlement could potentially pose systemic risks to

global financial markets if applied en masse in payments and settlement practices?

Possibly yes, but I believe that properly implemented they have much greater potential to reduce the systemic risk associat-

ed with current market structures, trading and settlement processes, and technology.

Do you believe early adoption in emerging markets will significantly contribute to broader global adoption of

blockchain technology overall?

Many individuals and institutions in emerging markets have more to gain from the use of cryptocurrencies and blockchain

technology than in advanced economies, and this may drive faster or broader adoption in those parts of the world. I have

actually published a detailed paper specifically on cryptocurrency use cases for emerging markets.

Do you believe regulation, on an aggregate basis, will be supportive of, or resistant to, the rollout of block-

chain technology?

Regulators are quickly realising the potential benefits of blockchain adoption in traditional financial services, and I antici-

pate they will be largely supportive of, and even perhaps drive, adoption. With cryptocurrencies, the feeling is more mixed

and it’s impossible to say how regulation will evolve. On the one hand, crime and terrorism committed with a blockchain

offer regulators a number of advantages over similar acts committed with cash, such as a digital ‘paper trail’, and the entic-

ing prospect of identifying and halting criminal acts in advance. At the same time, technical progress is being made on

transaction anonymity. We have yet to publicly identify a major terrorist incident committed with a cryptocurrency, and

how policymakers would respond to such an event is unknown. We know terrorists are using private messaging apps but that

hasn’t led to a wide-scale crackdown on such apps. For any crackdown on cryptocurrencies to have a lasting impact, signifi-

cant coordination across many different jurisdictions would likely be required.

Conducted by Alberto Perucchini on 10 February 2017, 15:00 CET Source: Cambridge Centre for Alternative Finance (Judge Business School), Julius Baer

JULIUS BEAR NEXT GENERATION

The Next Generation investment philosophy and process

represents a thematic investing approach with a focus on

long-term structural growth. The objective is to seek out

sustainable growth opportunities by identifying compa-

nies with a competitive advantage within structurally-

growing markets, and thus harness megatrends to deliver

superior investment returns.

www.juliusbaer.com/nextgeneration

http://www.juliusbaer.com/nextgeneration


IMPORTANT LEGAL INFORMATION

This publication has been produced by Bank Julius Baer & Co. Ltd., Zurich, which is authorised and regulated by the Swiss Financial Market

Supervisory Authority (FINMA). This publication series is issued regularly. Information on financial instruments and issuers is updated irregu-

larly or in response to important events.

IMPRINT

Authors Alberto Perucchini, Next Generation Thematic Research, [email protected] 1)

1) This analyst is employed by Bank Julius Baer & Co. Ltd., Zurich, which is authorised and regulated by the Swiss Financial Market Supervisory Authority

(FINMA).

APPENDIX

Analyst certification The analysts hereby certify that views about the companies discussed in this report accurately reflect their personal view about the companies and securi-

ties. They further certify that no part of their compensation was, is, or will be directly or indirectly linked to the specific recommendations or views in this

report.

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Structure

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link:

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Price information Unless otherwise stated, the price information reflects the closing price of the previous trading day.

Disclosure No specific disclosures.

Equity research

Frequently used abbreviations

CAGR Compound annual growth

rate

EPS Earnings per share P/B Price-to-book value

DCF Discounted cash flow EV Enterprise value P/E Price-to-earnings ratio

EBIT Earnings before interest and

taxes

FCF Free cash flow PEG P/E divided by year-on-year EPS

growth

EBITDA Earnings before interest, taxes,

depreciation and amortisation

MV Market value ROE Return on equity

Consensus

rating

Consensus rating indicates the

analysts' opinions on the security.

It shows the number of analysts

covering the security and the

breakdown between Buy, Hold

and Sell ratings.

Consensus

target

The consensus target is the

average price to which analysts

expect the security to rise.

FY Fiscal year

Equity rating allocation as of 12/04/2017

Buy 31.4% Hold 65.8% Reduce 2.8%

Julius Baer does not provide investment banking services to the companies covered by Research.

Equity rating history as of 12/04/2017

Company Rating History

Bank of New York Mellon Hold (Initiation of coverage) Since 02/06/2016

International Business Machines Hold Since 19/07/2007

Mastercard Buy (Initiation of coverage) Since 04/05/2011

NASDAQ OMX Group Buy (Initiation of coverage) Since 03/06/2015


UBS Group Buy Since 05/02/2013

Visa Buy (Initiation of coverage) Since 02/12/2014

Rating system for global equity research (stock rating)

Buy Expected to outperform the regional industry group by at least 5% in the coming 9-12 months, unless otherwise stated.

Hold Expected to perform in line (±5%) with the regional industry group in the coming 9-12 months, unless otherwise stated.

Reduce Expected to underperform the regional industry group by at least 5% in the coming 9-12 months, unless otherwise

stated.

Frequency of equity rating updates An update on Buy-rated equities will be provided on a quarterly basis. An update for Hold and Reduce-rated equities will be provided semi-annually or on

an ad-hoc basis.

Risk rating systerm for global equity research (stock rating) The risk rating (High/Medium/Low) is a measure of a stock’s expected volatility and risk of losses in case of negative news flow. This non-quantitative

rating is based on criteria such as historical volatility, industry, earnings risk, valuation and balance sheet strength.

Thematic research / Next Generation

Theme exposure rating (“NG Rating”) for Next Generation research Companies are rated according to exposure towards a given theme or topic. Any theme exposure rating (“Next Generation Rating” or “NG Rating”) must

be understood in connection with a corresponding theme or topic. Companies’ exposure is rated as outlined in the table below.

High Company which business model is defined by its role in providing critical services/products consistent with the investment theme or

topic, and showing a high sales share in the context of the theme or topic.

Medium Company which business model is defined by its role in providing services/products consistent with the investment theme or topic, but

showing a moderate sales share in the context of the theme or topic.

Low Company which business model is not defined by its role in providing services/products consistent with the investment theme or topic,

but showing limited or projected sales exposure in the context of the theme or topic.

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