Digital Assets, Distributed Ledgers, and the Future of Capital Markets

Digital Assets, Distributed Ledgers, and the Future of Capital Markets

“Distributed ledger technology and digital assets have the potential to dramatically disrupt global equity and debt markets.” (World Economic Forum, May 2021)

Distributed ledger technology (DLT), otherwise known as Blockchain technology, will radically simplify financial markets and, more importantly, fundamentally change the market’s infrastructure. Specifically, distributed ledger technology decentralizes critical data and enables an entirely new financial system where capital flows without the need for traditional intermediaries.

While there are challenges and numerous detractors, DLT is an irreversible disruptive force transforming capital markets and the global financial system.

Regulators (a potential obstacle) are increasingly comfortable with this technology. Distributed ledgers, decentralized finance, and Blockchain-based platforms are creating products and services evolving from exploration and experimentation to commercialization. DLT will be transformative to the world’s largest industry and represents an unprecedented opportunity. New digital platforms created by decentralized finance companies integrate securities and other digital assets comprehensively. The platforms enable market participants and intermediaries to issue, trade, settle, and provide custody services for digital assets, usually consisting of digitally native equity tokens (ICO’s).

These digital asset and financing platforms exist in parallel to existing market infrastructure and securities markets, in many cases offering an alternative digitized version of a standard asset class. Fundamentally, what is disruptive is that this new technology disintermediates all parties, creating effectiveness and efficiency in the transfer and recording of transactions that is unprecedented in legacy infrastructure

The 6000 Year Bubble

The 6000 Year Bubble

Gold is built on a collective belief in its value. There is nothing fundamentally “inherent” in the price attributed to gold other than an agreed-upon value. The same is true with Bitcoin and other crypto. In fact, it’s fair to say that all asset prices are fundamentally based on the collective belief about value regardless of some perceived upon “inherent” value.

The pervasiveness of crypto as it exits a somewhat self-contained digital world and has institutional investor attention forming a basis for far-reaching financial transactions establishes it more as an economic force much more than a financial sideshow.

Game Theory contends that people act collectively if they believe others are doing the same. Essentially, the theory holds that many situations provide a clue, called a “focal point” around which people coordinate their actions, even if there is no explicit agreement to do so. As John Maynard Keynes has said, picking investments is much like guessing the winner of a beauty contest. It is not a matter of what you think, but it is predicting who most people think the winner should be. This is how markets move and it is based on a fundamental tenet of game theory.

Being Digital

Being Digital

“Being Digital,” the groundbreaking book by Nicholas Negroponte described what happens to a global economy when all assets can be digitized. Presciently predicting the impact on music, film, retailing, and commerce in general, Negroponte intuitively understood the disruption and the creative/destruction that would be unleashed when a globalized infrastructure could deliver all products and services, including assets and intellectual property, instantly via a worldwide digital infrastructure and network.

The same “digital” effect is impacting global finance today. Now, all financial assets are “being digitized” and can be delivered instantly on a global infrastructure, fundamentally upsetting the world’s largest industry with unprecedented creativity and destruction.

Crypto assets are the manifestation of that digital form. While there is debate about whether or not an asset can truly be “digital,” the market has spoken. While there will be continued volatility, speculation, creation, and destruction, a digital platform for financial transactions ranging from the simple transfer of funds to complex financial transactions, investment, and lending are here, disrupting a multiple trillion-dollar industry.

It’s a Cryptoasset, not a Cryptocurrency

Bitcoin is an innovative, rapidly expanding network for storing and exchanging value among investors.If it’s an asset, does it have an inherent value, like gold? Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin.

It’s a cryptoasset that has the safe haven characteristics of gold and will potentially compete with it for a place in portfolios. Bitcoin is not a currency and will not be adopted as a new medium of exchange. It is not a stable store of value, nor can it be easily transmitted and exchanged for any good or service at a consistently predictable value. But, that’s not important from an investor’s perspective. Bitcoin remains incredibly volatile, and its correlation with other major assets has been inconsistent, but allocations are seen as suitable among an increasing number of investment professionals, and, increasingly, it is seen as an alternative investment equivalent to a derivative or other call options, given the potential for spectacular returns. The downside is well-defined while the upside can be asymmetric and significant.

Inflation, Profits, and Bitcoin

“I believe that the present, accurately seized, foretells the future.” V.S. Naipaul

There is a lot of uncertainty today in the markets, but there has always been uncertainty in the markets. We have never had certainty regarding the economy or the future. The most reasonable exercise, as V.S. Naipaul reminds us, is simply to understand the present. So what’s going on? The economy is accelerating. Inflation isn’t a problem. The Fed is going to keep interest rates as close to zero as possible for the foreseeable. These components are driving valuations higher, and in some cases, approaching stratospheric levels. Some concern is warranted in certain sectors, but overall, things seem to be relatively steady and not too overblown. Earnings appear likely to grow, and in many cases, quite rapidly, for the next couple of years – assuming something unforeseeable does not occur (but this probability is not zero). Bitcoin has a few interesting characteristics worth understanding. It is a decentralized, permissionless, peer-to-peer network of computers that’s permanent and unhackable . An investment in Bitcoin is, in reality, a part of the peer-to-peer computer network (essentially, a slot on the database), and almost all of those slots have been allocated. Only 21 million Bitcoins will be produced and 18.5 million have already been mined and circulated. Price is a function of supply and demand (see Economics 101). Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin. Bitcoin supply grew 2.5% in 2020; it will grow 2.0% in 2021.The question for Bitcoin valuation is simple: Is demand growing faster or slower than 2.0% annually?

Coinbase, Bitcoin, Ethereum, and Dogecoin

Coinbase, Bitcoin, Ethereum, and Dogecoin

Everything you don’t understand about money combined with everything you don’t understand about computers.

Bitcoin and other digital currencies are going mainstream, and along with that, increased volatility. Last week, cryptocurrencies jumped in value as Coinbase, a cryptocurrency exchange, became a publicly traded company worth approximately $100 billion. In other words, trading in digital currencies, with all the expected volatility and unpredictable nature such securities bring, is here to stay.

Think Differently

Is It Really Different This Time? Well, sort of – and that makes all the difference. Interest rates are at zero, and worldwide markets assume that will change little for some time to come. Global coordinated monetary and fiscal policy are spiraling interest rates to this flattened level with little prospect of upward movement. The combination of monetary, fiscal, and interest-rate policy coordinated in this manner is unprecedented and is being pushed to its limits. A subliminal fear may be permeating the markets, generating extreme movements, causing both substantial profits and losses from massive capital flows magnifying price movements within compressed time frames. How do we explain this, and more importantly, how do we predict and profit from it? Bitcoin Explains Everything – Read That Twice If You Need To

Currency Values in a Zero Interest Rate World

We are rapidly approaching a zero-interest rate world. Interest rates are being driven to zero (or below zero in many cases) as a first-line tool for central banks to generate economic activity in the face of the dramatic negative impact of the pandemic, as well as existing and lingering economic fallout. This toolbox will be empty soon, and the only remaining weapon will be fiscal policy. Among other things, fiscal policy and domestic financial markets will have an overwhelming influence on global currencies. Capital flows will dramatically impact currency volatility as capital moves to more attractive countries with more liquid and robust asset markets.