Within three to five years, blockchain-based investments are likely to be part of typical mainstream investment strategies the way private equity, hedge funds, real estate, commodities and derivatives contracts are today.
This is not to say that Main Street will be investing in cryptocurrencies, although they may, but rather that existing investments will rapidly migrate to blockchain recording and settlement systems. Look at the recent announcement by Intercontinental Exchange Inc., the parent of the New York Stock Exchange, that it will launch its own cryptocurrency exchange this year.
In fact, before we know it, blockchain could very well underpin entire markets. Imagine the New York Stock Exchange itself running on blockchain. It will happen sooner than we think.
While this future is achievable, many potential investors are turned off by recent headlines that describe exchange or wallet hacks where tens of millions of dollars of blockchain assets are stolen. Concerning as that is, it is extremely important to note that the issue isn’t with blockchain networks themselves but rather the secondary applications on top of the network.
Blockchain asset ledgers, such as bitcoin
are among the safest networks in the world. Hundreds of thousands of mining nodes secure the network by competing to solve cryptographic algorithms, which are used to protect data from unwanted access. In most cases, security breaches are due to human error.
The good news is there are steps that can be taken to improve the safe keeping of blockchain assets. The benefits of this technology are huge. The underlying technology of the blockchain, first introduced in 2008, could provide increased efficiencies across such industries as health care, supply-chain management and financial services.
For example, Australia’s main stock exchange says it plans to become the first exchange globally to clear and settle trades on blockchain, also often referred to as distributed ledger technology (DLT).
But to reach that point, blockchain innovators and the broader financial community must cooperate to mitigate the risks — real and perceived — in three key areas: custody, valuation and market manipulation.
Custody: Today, traditional assets such as stocks and bonds are settled and cleared by third-party clearing houses that sit between banks, broker-dealers and individual investors. These assets are often held on our behalf at wealth-management firms. Blockchain, one type of a distributed ledger, avoids central clearing houses as independent computers can verify, record and synchronize ownership of digital assets.
For distributed ledgers to be used, retail investors can self-custody using software wallets, hosted exchange accounts or store their funds in so-called cold storage (meaning it’s offline). A custom multi-signature wallet is the first step for compliant security standards as the risk of loss or theft of a single key is significantly reduced where multiple parties are needed to confirm any value transfer. Custody can be secure in systems when assets can only be accessed by cryptographic keys being signed, or unlocked, by multiple parties, such as one from the investor and the other from their third-party financial institution. Setting industry-wide custody standards around the use of signatures and permissions-based controls has the potential to eliminate key risks in blockchain investing.
Valuation: When an investor trades a security on the New York Stock Exchange, there is usually a deep order book with competitive bid and ask prices. Consequently, when we place a market order, an investor will match his bid within a penny or two of the price at which the trade will be executed. With blockchain asset exchanges, each exchange calculates their bid and ask prices based on its own propriety methodology. In some cases, there is room for price variance between exchanges, presenting an arbitrage opportunity. Blockchain asset exchanges need to develop industrywide price transparency. The industry could establish valuation metrics to minimize arbitrage, perhaps by posting bid/ask prices that are based on weighted averages across exchanges. In addition, exchanges should transparently disclose their valuation data the way broker-dealers disclose trade data to TRACE in the fixed-income markets. The decentralization of traditional asset markets will require methodologies to maintain established safeguards during the coming transition from centralized exchanges to peer-to-peer networks.
Market manipulation: Because of the comparatively thin trading volume on many blockchain asset exchanges, large volume transactions by institutional investors can cause dramatic valuation swings in any trading pairs (such as bitcoin to U.S. dollars.) Similarly, some investors may use arbitrage price variations across different pricing sources to manipulate prices. To counter that, blockchain-based markets should establish processes and circuit breakers that protect against market manipulation by automated trading algorithms and mitigate the risk of flash crashes.
Addressing these bedrock concerns will go a long way toward mainstream adoption of blockchain assets. Overcoming these hurdles will require cooperation among blockchain startups and established financial industry players (such as banks, broker-dealers, exchanges and regulators) to establish standardized approaches and best practices.
As with any nascent market, acceptance will come from institutional investors once custody issues are resolved. Acceptance among individuals is leading the way with investments in cryptocurrencies, a staple of many strategies.
Perhaps only after the revolutionary benefits of blockchain are realized, through practices like taking personal custody of health records, will corporate adoption follow. I am confident that within three to five years there will be a growing acceptance of investing in blockchain and of the tokenization of assets — provided these key concerns are addressed.
But whatever your position, it is exciting to watch a new market unfold.
Gregg Bell is chief operating officer of SALT Lending and chief investment officer of SALT Blockchain Asset Management.