A spectre is haunting the financial world. It is not as 170 years ago the spectre of communism that threatens the establishment in Europe. The ghost today is called “bitcoin”, and it threatens the entire power structures in the global financial industry. The similarities with the Communist Manifesto of Karl Marx and Friedrich Engels are not exactly obvious, since even the strongest apologists of global finance capitalism have discovered bitcoin for themselves. Even the investment banks have jumped on the band wagon of cryptocurrencies. The similarities lie rather in the promises of salvation we hear from the proponents of the new digital currencies: the overthrow of the banks' traditionally untransparent, corrupt, and overpriced business model, more democracy in businesses and governments, fairness in global trade, the promotion of social justice, and a turbo booster for prosperity for the world’s poorest.
But it is not political idealism or the prospect of a fairer society that drives the current hype around bitcoin. Rather, it is the same outcry as the one heard from San Francisco in the very year in which Marx and Engels announced the coming of communism: "Gold! Gold! Gold from the American River!" It is the sound of quick money that, even 170 years after the California Gold Rush, has lost none of its appeal. Bitcoin's 15-fold increase in price over the past year has reached those who are otherwise indifferent or even distance themselves to what is happening in the world of finance. Who can ignore the fact that, with bitcoins, millions can be made in almost an instant? And today one does not have to travel thousands of miles any longer in order to "mine" the new gold, but simply access the Internet. And “mining” is indeed what the process of acquiring new bitcoins with one’s own computer is called. In China and Iceland there already exists entire bitcoin mining farms, the computers of which - and this is a less well known side effect of the bitcoin hype - consume a massive amount of electricity and thus leave a significant global carbon footprint.
Meanwhile, the hype has turned into a true bitcoin mania that drives even the unsuspecting (and especially those) to the completely unregulated, and often anything but transparent, bitcoin exchanges. "The biggest speculative bubble in history," critics describe the recent performance of cryptocurrencies. And bitcoin is just the most well-known. There are many more of them. In fact, anyone who wants to can create his or her own digital currency. This is reminiscent of the nobility’s right of minting in the Middle Ages, with which every nobleman who possessed it was allowed to coin his own currency. Comparisons to the tulip mania in Holland of the 17th century are already frequently made. On February 3, 1637, the price of a single tulip bulb was more than 5,000 guilders (in today's prices almost 100,000 euros). By way of comparison, the painter Rembrandt only received 1,600 guilders for his painting The Night Watch. It is a sobering thought but at least the investor still had a bulb from which a beautiful flower could grow – even after the tulip bubble burst. Bitcoin is clearly a different case altogether.
On bankers and economists bitcoin has long produced only a mocking smile. The regulatory authorities have watched the crypto currency already for a while, but mainly for the purpose of curbing its criminal uses. And these continued to make headlines in 2017: money laundering, ransom-hacking, embezzlement, arms trafficking in the so-called darknet, etc. But now the overseers have begun to evaluate the mainstream capability of bitcoin. We can observe parallels to the development of the internet in the early 1990s, which bankers and large corporations - traditionally laggards in adopting technological change - initially eyed with equal scepticism, before jumping on the bandwagon and integrating it into their own business models. Is bitcoin, or more generally the technology behind it ("blockchain"), facing a similar development? Or will bitcoins become the tulips of the 21st century and no longer play any role in the real economy after the bubble has burst? (And even the most enthusiastic bitcoin apologists are convinced it will burst). In order to answer the question ‘what follows next?’ it is well worth having a look at the historical relationship and interaction of scientific / technological progress with speculative financial bubbles.
The first major technological revolution, also called the (first) "Industrial Revolution", was based on the utilisation of steam power in the first half of the 19th century. Economically, its result was the creation of vast fortunes, especially in the form of shares in railway companies (which accounted for half of the stocks listed on the New York Stock Exchange back then). A huge speculative bubble around these stocks began to form before finally bursting spectacularly in England in 1847 and the US 26 years later - even before the railroad technology had reached its full impact as a mass product.
The second major wave of technology was based on the use of electricity as well as the development of the automobile (both were connected: electric cars were among the first models ever and in several respects technically superior to their competitors with combustion engines). Once again, the enthusiasm of investors surged to the sky and with it the stock prices of electric and automotive companies. The result was the crash of 1929, which led to the worst economic crisis of the 20th century. With the electrification and the mass production of automobiles, the true breakthrough of the technology into people’s everyday lives did not occur until 25 years later.
The third major technological development most contemporaries surely still remember: the digitisation that brought us the internet and mobile communication. The accompanying dot-com bubble of the 1990s finally burst spectacularly in the early 2000s. This did not detract the triumphal march of the internet and the smartphone, which subsequently only took 5-10 years to materialise, rather than the earlier precedents of a quarter of a century.
It appears that speculative bubbles are somehow a necessary condition for meaningful technological developments, while the intervening time span between grows increasingly shorter. This does not, however, mean that every financial crash is preceded by a technological revolution. In 2008, for example, it was the banks’ ominous derivative and structuring operations that preceded the real estate and stock market downturn. No real new technologies were behind these, it was rather more a case of bankers coming up with new ideas to skim as much money as possible.
Now the question arises: Is the currently developing speculative bubble around bitcoin and its upcoming bursting such a forerunner of a new revolutionary technology? That is by no means out of the question, as blockchain, the technology behind bitcoins, does indeed have the potential for another technological overthrow. And this threatens to completely exterminate an important group of central agents in the global economy, the so called intermediaries. Today, intermediary institutions such as banks, stock exchanges, notaries, auditing firms, as well as numerous government institutions (eg central banks, tax authorities and regulators), collectively control a large part of our economic life. They guarantee a central condition for the smooth functioning of all economic activities: trust.
Banks guarantee my financial assets, a "banknote" offers a (in most cases) reliable storage device for value. A notary guarantees the legal certainty of a contractual agreement, while central banks determine that the paper notes in our hands possess a value. In addition, government authorities ensure that players in the international banking business comply with the rules. All these are “agents of trust”. However, even these agents are not 100% trustworthy and can themselves get into a state of distress and this is proven by the various banking and government crises of the past years and decades, with effects ranging from hyperinflation, bank failures, credit crunches to dysfunctional (failed) states.
The blockchain technology provides completely new solutions to the challenge of building trust within an economy. Perhaps the most prominent example is a new transparent and decentralised way of defining the central unit of economic exchange: money. Economic processes hereby take place in decentralised ("peer-to-peer") networks instead of by exchanging a government regulated currency. There is no need for trust and a central bank currency to process payments.
The way blockchains work is as simple as keeping a business journal, but with a lot more entries as well as decentralised and global management: blockchains are electronically stored journals ("blocks"), which - hence the name - are linked in a chain, stored on many computers in parallel, and are accessible to anyone. The property of the money corresponds to the possession of a secret digital key, which enables access to a digital wallet. This is then used to transfer money to somebody else for the sake of making a payment. This process is then registered in the global blockchain.
We usually need to trust a bank or another facilitating entity when making a transaction, which guarantees the security of the transaction. However, in a blockchain, this is the task of the community of all stakeholders. A payment will be approved by the majority of the participants upon presentation of the correct key. Corrections to the system are only possible if the majority of the participants agree. Due to their high number this is hardly possible after a short while. The entries of the blocks into the blockchain are performed by decentralised nodes, for which their owners are rewarded (this applies to the bitcoin blockchain, other models exist, however): They receive new currency units for their activity. This is the process of "mining" new bitcoins. In order for everyone to participate and have a chance of successfully mining, and thus to make the net as broad as possible, miners must solve increasingly complex mathematical problems, before they can make an entry and receive bitcoins (in technical language: miners must show a "proof of work”, which requires CPU and the cooling of the computers - significant costs on their part).
The blockchain technology has thus the potential to replace intermediaries such as money, banks and government agencies by a community of numerous users. It could put commercial transactions and organisations on an entirely new footing. Money, as we know it today, could disappear completely. Instead of using such a state-regulated intermediary for business transactions, people could make all their payments directly and digitally, registering them in blockchains. The lawyer, who buys bread from the baker, pays by enabling a transaction (eg through the use of a cell phone) which is then immediately added to the blockchain. Similarly, the lawyer receives compensation for labour directly from customers into a digital account, which is equally stored in the blockchain. Money as an intermediary for various economic agents and their purchases and sales is then simply no longer needed. No wonder the technology is arousing the enthusiasm of those who want to withdraw economic processes from any government control.
However, the potential applications of blockchains go far beyond monetary transactions. Blockchains enable people who do not know each other to keep an accurate and true record of who owns what. It is not necessary for them to trust each other, because the blockchain itself guarantees the integrity of the transactions. Most generally, blockchains enable the recording and preservation of "truths" (eg property rights) that cannot be manipulated by a corrupt state or by private interests, as such manipulations must always be decentrally confirmed by the majority of the users. According to forecasts from the World Economic Forum, the first governments will collect payroll taxes using the blockchain technology by 2023. And, by 2027, at least 10% of total world gross domestic product will be stored on block chains (WEF, Global Agenda Council on the Future of Software and Society, Deep Shift Technology Tipping Points and Societal Impact, 2015). Decentralised land register accounts based on blockchains are already being discussed, which could have a significant positive impact on society, especially in countries where public registers are unreliable or do not even exist. The central land register, as we know it today, could become obsolete. Developing countries, such as Honduras and Georgia, but also maturing economies eg Sweden have already signalled interest in using blockchain technology for this purpose. And in March 2017 Dubai announced a major blockchain initiative aimed at empowering all government entities and the entire public administration to use the new technology from 2020 onwards.
With high probabilities, many people will soon lose a lot of money once the bitcoin bubble and that of other crypto currencies burst. But the really interesting questions relate to what happens thereafter. What will become of the underlying blockchain technology in the medium and long term? Blockchain’s much bigger technological potential, which extends much further than bitcoin, is the real reason why it is worthwhile following its developments very closely.
About the author: Dr Lars Jaeger is Head of Alternative Risk Premia within GAM Systematic, primarily responsible for risk premia research and portfolio construction. Before joining GAM in November 2014, Lars Jaeger was the founding partner and Chief Executive Officer of Alternative Beta Partners AG. Prior to that, he was a partner of Partners Group where he was responsible for the hedge fund business and initiated the alternative beta business. Before Partners Group, Lars Jaeger co-founded and was a partner of saisGroup, a hedge fund asset management firm established by the former alternative investment strategies team at Credit Suisse Asset Management, where he was responsible for risk management. Lars Jaeger holds a doctorate degree in theoretical physics from the Max-Planck Institute for Physics of Complex Systems, Dresden, and a master’s degree in physics from the University of Bonn. He is a CFA charterholder, a Financial Risk Manager (FRM) and the author of several leading books on hedge funds. He is based in Zurich.
