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Industry Voices

Commentary: Institutional grade — the distributed ledger

New technology is frequently born into the arms of intensely enthusiastic communities of early adopters. These folks generate the energy, enthusiasm, initial resources, time and care that incubate and accelerate opportunity. If the affection and vision of this early circle is merited and sufficient, we see a period of explosive growth. This is the story of the distributed ledger — or blockchain — over the past few years. While 2017 was a fiscally explosive year, 2018 followed with growing regulation. This year also saw clarity and the emergence of calming voices, which continue to bring larger degrees of certainty to blockchain operations.

Ultimately, the question remains: "How should the institutional community understand blockchain?" The initial draw to blockchain was that all information is stored in an immutable ledger without the need for a central authority or intermediary. However, the allocator and fund manager community has yet to find a way to integrate blockchain into its decision-making, namely finding a way to validate the information entered into the blockchain. Early reports of blockchain as, primarily, a financial technology have been poorly borne out as it has affected the world beyond finance. Other industries are relying on blockchain, which means the financial world eventually will have to expedite full adoption.

Blockchain has altered return expectations, generated new millionaires, and has led to new wealth platforms, banks, OTC desks, advisers and funds jumping in. Yet like all creative explosions, the distributed ledger world still experiences shakeouts.

The immutability and power of blockchain that the institutional community can rely on has costs, in other words, keeping information with everyone forever. Writing into blockchain means waiting and paying for irreversibility. Even if the speed and transaction costs fall, institutional investors will wait to rely on blockchain for their operations. They might delay allocations to external fund managers that invest in this platform until several points are cleared up, namely surrounding scale and regulations. Institutions have processes, protocols and committees that exist to centralize authority and accountability over their activities, but the blockchain relies on a decentralized system of inputs to streamline information flow and transactions. Down the line, investors should find a way to verify these transactions and operations to ensure blockchain activities are accurate.

Institutionalizing the blockchain

Blockchain will be better received by Wall Street and by the institutional investors once the scalability question is answered — can this platform be successful in shouldering growing demand? Even if blockchain meets the demands of an ever-growing number of sectors, what about the issue of speed? Will blockchain be able to execute operations at a profitable pace? These questions must be dealt with.

Further adoption by institutional investors will be accelerated by clearer regulation, which is not now consistent in the U.S. and overseas. Yet this year, the jurisdictions with regulatory clarity will likely witness the highest inflows of capital and blockchain adoption, according to a report from PwC Strategy and Crypto Valley, a trade organization. Blockchain's proof of concept, which the institutional community seeks, will be tested in regulatory-certain environments.

Implications for money managers

Institutional managers will face increasing pressure to learn and allocate to firms using blockchain and rely on this technology for other research and activities. Top venture capital and quantitative funds are the pioneers in this regard.

Managers wishing to be blockchain pioneers can create several advantages. They should seek legal teams who are well versed in tech compliance. There will also be a requirement to hire technology teams with the subject matter expertise to operate in the blockchain and enhance a firm's blockchain activities. On the flip side, allocators should seek managers that combine both regulatory compliance with technical know-how, for ultimate operational efficiency.

Moreover, blockchain-related asset exposures already are in portfolios. Managers might be shorting the sector accidentally by being invested solely in legacy technologies that are vulnerable to the changes likely to come from blockchain. To mitigate accidental shorting, managers should examine the leading industries witnessing large blockchain participation and then avoid betting on a sector's legacy technologies that will be disrupted by blockchain.

Blockchain is here to stay. Movements of wealth across borders, growing demand for international trade finance and explosions of fintech innovation all provide entryways for blockchain integration. The institutional community is already feeling the impact. The more blockchain wealth is created, the more the next generation of investors and entrepreneurs will start to rely on cryptocurrencies as an alternative way to achieve funding for enterprises. The asset management community must have a role in directing this capital. There have been downside records for this asset's performance, namely in 2017. As a result, blockchain assets should be reserved for high risk, high return portions of portfolios only.

Will McDonough is CEO of iCash Ltd., based in Bermuda. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.