Unpacking the Future of Blockchain

We discuss our 2023 outlook.

Key Points

• The travails of cryptocurrencies in 2022 overshadowed the thematic evolution and expanding use cases of blockchain technology.
• An expanding protocol, proof-of-stake, drastically reduces energy consumption, an important step towards creating an efficient, sustainable and environmentally friendly method to execute and record transactions on a blockchain network. 
• Public companies are turning to blockchain solutions to improve disclosure and promote sustainable business practices and environmental and social outcomes.
• The metaverse and Web 3.0 are secular tailwinds that have the potential to drive incremental investment in blockchain projects.

Focus on the Benefits of Blockchain Technology Amid Cryptocurrency Turmoil

2022 has been a dramatic year for cryptocurrency and digital-asset markets, starting with the failure of algorithmic stablecoins (a type of cryptocurrency whose value is tied to an asset like the US dollar with the aim of maintaining a stable price) and progressing to the insolvency of FTX, one of the largest cryptocurrency exchanges. These events were precipitated by a lack of regulatory oversight, poor governance and speculative excess fueled by free money and low interest rates. Unfortunately, many participants in crypto markets repeated the mistakes that led to the 2007-8 global financial crisis by borrowing against illiquid assets, underestimating financial leverage, and failing to properly underwrite credit risk. 

A silver lining from the fallout in crypto markets in 2022 is that regulatory oversight of digital assets should follow in 2023. Regulation is necessary to protect investors and ensure financial stability. Notably, the troubled crypto platforms in the headlines are by and large private, unregulated entities that lack strong balance sheets and financial discipline to survive in periods of economic stress. Unlike their private counterparts, publicly traded regulated financial institutions have been cautious in their approach to digital assets. However, many traditional banks, brokers and custodians are now building digital-asset infrastructure, which we believe presents an emerging investment opportunity for our Blockchain Innovation strategy. These institutions have the operational expertise, financial strength and compliance infrastructure to deliver blockchain products, services and solutions in a manner that promotes the safety and soundness of the financial system while protecting the interests of individual and institutional investors. 

The recent focus on crypto has overshadowed the thematic evolution and expanding use cases of blockchain technology. Below, we highlight several promising developments and applications of blockchain technology that we believe are often overlooked or misunderstood by investors. 

Demystifying Proof of Work vs. Proof of Stake

Energy consumption has been a controversial topic for digital assets. There is a common misperception that all digital assets and applications of blockchain technology are energy intensive. While this is true of legacy digital assets like Bitcoin that employ a proof-of-work approach requiring substantial amounts of energy, it is not the case for blockchains like Ethereum that have adopted an environmentally sustainable solution. The recent upgrade to ETH 2.0 marked an important transition from Ethereum’s existing proof-of-work mechanism to a proof-of-stake approach to compensate network participants for validating transactions. To use a simple analogy to explain the difference between the two mechanisms, we can compare it to the two ways a household generates income: 1) working household members can get paid a wage in return for their time and labor (i.e., miners/proof-of-work); or 2) the household can invest their savings and earn a return on their investment (i.e., validators/proof-of-stake). Much like the time and energy expended working at a full-time job, there is a significant amount of computing power consumed by mining under a proof-of-work approach. In contrast, proof-of-stake drastically reduces energy consumption by pledging capital rather than using computing power to validate transactions on-chain. Ethereum is the leading blockchain platform used by developers; as such, the proof-of-stake upgrade is an important step towards creating a more efficient, sustainable and environmentally friendly method to execute and record transactions on a blockchain network. 

Blockchain’s Role as a Tool to Improve Sustainable Business Practices

Blockchain is emerging as an elegant solution to enhance sustainable business practices and improve environmental, social and governance (ESG) disclosure and outcomes for enterprises across industries in both the private and public sectors. Global asset managers are increasingly taking account of ESG risk analysis in their investments. To respond to this secular trend, public companies are turning to blockchain solutions to improve disclosure and promote sustainable business practices and environmental and social outcomes. Below are a few examples of how blockchain is being used to promote sustainability.

Supply Chains

We have written extensively on the use of blockchain technology to increase the efficiency and transparency of supply-chain ecosystems. Blockchain infrastructure can be used to more accurately track, measure and ultimately reduce a supply chain’s carbon footprint. Additional benefits include digitization and automation of paper-based workflows, sustainable and ethical sourcing of raw material inputs, and verification of product quality and provenance.

Access to Finance

Blockchain can reduce the cost, increase the speed and improve the accessibility of financial products and services.  In lending and insurance, smart contract automation reduces costs by eliminating manual processes, and improves operational efficiency by eliminating friction associated with centralized ledgers. Financial transactions recorded on blockchain networks are immutable and cryptographically secure, which reduces fraudulent activity and improves data privacy and security. Decentralized ledger technology is also being used to reduce the high cost of remittance and cross-border payments, which remain stubbornly high owing to the operational inefficiencies of existing centralized bank-based platforms like the SWIFT payment network.

Health Care

Blockchain has several potential use cases in the health-care industry. A number of blockchain consortiums have been formed to break down barriers among providers and improve patient outcomes while protecting patient privacy. Pharmaceutical companies are using blockchain to address key operational risks such as counterfeiting, recalls, raw-material sourcing and product contamination.

Blockchain’s Emerging Opportunity in the Metaverse and Web 3.0

We are often asked about the relationship between blockchain, the metaverse and Web 3.0. In a nutshell, blockchain provides the decentralized infrastructure for these emerging technologies. The convergence of these themes is worth exploring in detail as both the metaverse and Web 3.0 are secular tailwinds that have the potential to drive incremental investment in blockchain projects.

To provide some context, the metaverse is essentially a virtual representation of the internet, where users can interact in an immersive, three-dimensional environment. While the metaverse is still a nascent technology, online games that incorporate augmented reality provide a glimpse of what metaverse environments may look like in the future. Like the metaverse, Web 3.0 also represents an evolution of how users interact with the internet. At its inception (Web 1.0), internet functionality was a one-way road—users could consume virtual content (i.e., reading a newspaper online) but two-way communication was essentially non-existent. Web 2.0 added another lane to this road by enabling two-way traffic between internet users and providers for consumption of content as well as goods and services. Engaging in online commerce is a good example of Web 2.0 functionality. Web 3.0 takes this evolution a step further by allowing users to own the vehicle that they use to navigate their online experience. Specifically, Web 3.0 represents a further decentralization of the internet where individual users own and monetize their digital identity, data, and content. This transformation has the potential to disintermediate or even eliminate those centralized providers who currently store and profit from this data and content.

Where does blockchain fit among these emerging ecosystems? Very simply, blockchain technology is the digital substrate upon which metaverse and Web 3.0 applications are built. For the metaverse, blockchain provides the digital infrastructure for the ownership, record keeping and exchange of virtual goods (non-fungible tokens) and value (digital currencies). Building on the gaming example highlighted earlier, blockchain provides the immutable and verifiable ownership of virtual goods such as avatar skins earned or purchased by players. Similarly, digital currencies built on blockchain permit the transfer of value among users within virtual gaming environments.

Blockchain is also the decentralized backbone of Web 3.0 applications. In the existing environment, internet users and content creators rely on centralized intermediaries to store and manage their content and data. Blockchain eliminates the need for centralized architecture by solving the dual issues of trust and security while adding functionality in the form of portability and monetization of data and user-created content. It is worth noting that the recent regulatory focus on consumer privacy and ownership of personal data are driving investment in blockchain technology that underpins the Web 3.0 ecosystem.

To summarize, we are still early in the adoption curve and ubiquity of blockchain technology. Opportunities like sustainable enterprise solutions and thematic correlation with the metaverse and Web 3.0 underscore the evolution, breadth and durability of the blockchain theme beyond early speculation in cryptocurrencies. Aided by active portfolio management and a dedicated thematic focus, we believe Blockchain Innovation is well positioned to identify and invest in those public companies that stand to benefit from both existing use cases and future applications of blockchain technology across industries and geographies.

Authors

Jonathan Piskorowski

Research analyst, portfolio manager