Commercial Blockchain: Objects May Be Further Away Than They Appear

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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March 8, 2018

Commercial Blockchain: Objects May Be Further Away Than They Appear

Blockchain is a technical framework for implementation-customized network protocols that enable direct trustworthy exchanges between independent members of groups. It has the potential to fundamentally change the way that value is exchanged in society, removing friction from transactions by eliminating intermediaries and bolstering security. The technology is straightforward enough for strong programming teams to implement, however, successful blockchains need all parties to possible transactions – of assets, of information, of contractual obligations, etc. – to participate in the network. This is a substantial obstacle, requiring coordination via a dominant central player, a tight consortium, or a trusted 3rd party to drive consensus on design and implementation of the blockchain. Because of this, we believe adoption will start slow, connecting pre-existing coordinated ecosystems, such as supply chains, and helping to streamline interactions, improve security and cut costs, but falling short of radical disintermediation. The beneficiaries, from a TMT perspective, will be facilitators – IT consultants helping to design and implement networks and cloud hosts providing templates and facilities on which the blockchains may operate. Longer term, truly disruptive opportunities – replacing credit cards, consolidating patient records, or establishing universal electronic IDs, etc. – will require critical masses of large groups with conflicting interests to buy in to common platforms and will likely take many years to be viable.

  • Blockchains will be customized for each use case. Created to enable the original cryptocurrency Bitcoin, Blockchain is a framework for a new type of network protocols that embed an immutable record of interactions with each exchange of a digital item of value – i.e. cryptocurrency tokens, deeds to physical assets, personal information, bills of lading, etc. The information for each exchange is noted in the record and distributed to all users in the network, ensuring trust through the open scrutiny of the records. The rules for these exchanges, the depth of the record keeping, the nature of the digital content, the process for resolving conflicts, and other definitional aspects of a Blockchain network must be agreed to by the group and built into the mechanics of a customized protocol. Think of a blockchain packet as an “interoffice mail” envelope – the contents are sealed inside, and the chronological history of where the envelope has been, where it is going, and other necessary information is marked in pen on the outside for all to add to their own master record of transactions.
  • Blockchain enables low-friction, trustworthy transactions. Transactions of value require trust that promises made can be enforced – else, they will not be completed. Traditionally, that trust is established through intermediaries that add cost and time – clearinghouses, exchanges, inspectors, lawyers, escrow, various forms of insurance, government agencies, etc. Blockchain networks establish that trust through transparency. Each network member’s up-to-date ledger is an immutable and enforceable record of all members’ obligations and the historical provenance of all digital assets conveyed by the network.
  • Scaling is the biggest technical challenge. While the concept behind blockchains is revolutionary, the software skills necessary to implement modest networks are straightforward for strong development teams. Still, with each node involved in every transaction, as the number of network nodes increases, the complexity increases geometrically. This complexity adds considerable lags in verifying transactions, already a problem for Bitcoin, where confirmation times average 78 minutes and can take hours. Innovations have reduced lag for other cryptocurrencies, but for many commercial applications, lag remains a substantial barrier for large-scale applications.
  • Coordination is a bigger challenge. To gain the benefits of blockchain, most, if not all, stakeholders in the market to be addressed must participate. Explicit buy in to the design and governance of the system is vital – coordinated via a tightly organized consortium, a dominant central player or a trusted third party – a big ask for many real-world value exchanges. As such, we believe blockchain adoption will initially be limited to pre-existing coordinated ecosystems helping to streamline transactions, improve security and cut costs. Radical change will require overwhelming support from potential stakeholders to overcome heavy resistance from intermediaries threatened by adoption.
  • Major disruption is many years away. While the hype for blockchain runs hard, we believe that the scaling and coordination challenges will keep implementations tightly focused, with networks of very high-value transactions within a limited system of technically sophisticated participants the most likely to be commercially successful. Broader and more disruptive initiatives will face obstacles that could take many years to surmount. While the technology could EVENTUALLY become a frictionless universal mechanism for exchanging value over the internet, we believe THAT is a question for another decade.
  • Few participants, high value transactions, complex settlement. Aside from cryptocurrencies, blockchain remains nascent, with many organizations investing in “proof of concept” trials but no live networks. We expect the earliest commercial successes to involve markets with – 1. A modest number of relatively tech savvy participants, 2. Regular, high value transactions, 3. Time consuming and expensive settlement procedures, and 4. A clear organizing mechanism. Financial institutions have been enthusiastic investors and participate in many markets that meet our criteria – a few settlements applications look ready for launch in 2018. Logistics applications, such as supply chain management and product tracking, are also being widely tested – Maersk’s international shipping trial with IBM is the most prominent of a long list of enterprise blockchain projects. While the interest is exciting, the difficult task of building support from a full ecosystem of stakeholders is still ahead for all these initiatives.
  • IT consultants and cloud hosts will benefit. Because each blockchain will be distinct with no tightly specified standard, and because blockchain messages ride atop existing infrastructure, there are no real opportunities for enterprise blockchain specific hardware or software products. Still, groups looking to implement one will likely need help defining the system to the needs of the application and its participants. Already, IT consultants, like IBM and ACN, have stepped into this role on high profile proof of concept trials like IBM’s work with Maersk, and they will soon support the launch of the first commercial networks. We also see opportunity for cloud hosts to provide blockchain templates and to act as an impartial platform for cross-enterprise networks – MSFT and IBM lead.

Peak Blockchain Hype

Blockchain has caught the world’s imagination. Bitcoin prices regularly lead the news cycle, and pundits report hundreds of “proof of concept” projects by companies and consortia to trial the usefulness of blockchain networks in commercial applications. While there are enormous potential benefits to be gained, there are also considerable obstacles to successful, broad-based implementation and we believe the adoption of blockchains will start smaller and move more slowly than many imagine.

For the few uninitiated, blockchains are customized protocols designed to convey value across a network, ensuring trustworthy transactions by making all exchanges transparent to every node, each of which maintains their own up-to-date database of previous exchanges. The classic analogy for a protocol is an envelope with the content securely ensconced inside – in this case, it is akin to an interoffice mail envelope, with all the previous recipients noted in pen on the outside, along with information necessary to verify the latest transaction. Once the nodes approve it, the exchange is completed. In this, the blockchain avoids a central authority, which might be exploited, in favor of group consensus and distributed record keeping.

The general framework is straightforward and could, conceivably, be used to streamline and safeguard any exchange of items of value, from cryptocurrencies to physical assets, from personal information to legal contracts. With blockchain, intermediaries and processes meant to assure honest dealing could be eliminated, saving time and money. Still, the nature of transactions, the information needed to be conveyed, and the verification process will differ greatly from network to network – each solution must be custom developed. Moreover, as the number of users on a blockchain network grows, the complexity of the confirmation process increases geometrically. For very large networks, such as Bitcoin, this leads to serious transaction latency – the average Bitcoin exchange takes 78 minutes to validate. R&D efforts across multiple industries are looking to address this, and other scalability issues.

The most difficult obstacle for most proposed blockchains will be gaining the enthusiastic participation from a critical mass of market stakeholders – in many cases, the critical mass could be 100% participation. We see three mechanisms to drive these consensuses: 1. A powerful central player (e.g. the government, or a dominant market maker); 2. A tightly organized consortium; or 3. An impartial 3rd party (e.g. a cloud host). Even with organizing mechanisms, we believe early non-cryptocurrency blockchains will be small and focused. Logistics networks (e.g. automated supply chains, etc.) and financial clearinghouses/exchanges would seem the furthest along of the many small-scale proof-of-concept trials underway. More expansive networks will take years (and likely many misstarts) to get adequate traction. A vision of blockchain as the basis of a generalized network for the global exchange of value is likely decades from realization.

From the TMT side, most of the near-term opportunity of blockchain will fall to IT consultants, which are already working with enthusiastic early investors, such as financial institutions, heavy manufacturers, and transport networks to develop their customized trial solutions. We see IBM and ACN as particularly advantaged. As commercial blockchains begin to go live, perhaps within a year or so, we see opportunity for cloud hosts to provide turnkey nodes and secure networking. While the disruptive potential of blockchain may open huge new markets to TMT company in the intermediate to distant future, we believe that the near-term impact will be modest compared to AI and the cloud.

Exh 1: The Gartner Hype Cycle for Emerging Technologies

Yet Another Blockchain Primer

Blockchain, blockchain, blockchain! The hype is deafening –Gartner’s famous hype cycle currently positions blockchain just past the peak of inflated expectations and heading for the trough of disillusionment. (Exhibit 1). By now, most investors have seen more than a few primers on blockchain. If you are confident that you know what it is and how it works – feel free to skip ahead. For everyone else, we will take crack at a simple explanation, relatively free from technical jargon. Here goes …

Blockchain is not a single network standard specification, but rather a framework for customized specifications to be developed for specific networks intended to facilitate the secure transfer of digital items of value. Like other network protocols, the most apt analogy is of an envelope containing digital content to be delivered. Most protocol/envelopes are thin, with a bit of information – sender, receiver, instructions for delivery. Blockchains are thick envelopes – think of those interoffice mail envelopes with fifty boxes on the front showing everyone who had the envelope before you, except there is explicit information about each exchange in every box and copies of the envelope get delivered to everyone in the company simultaneously. The contents of the envelope are private – secured by cryptography for blockchain and by that wrap-around twine on the interoffice mailer – but the transaction records are transparent and every member of the chain copies down the new information in their own comprehensive ledger of network transfers. For each new transaction, all the network nodes will check their ledgers and confirm that it is valid by the rules of the blockchain. In this way, no single entity can manipulate the market and attempts to “cheat” are flagged by the community. Everyone can trust the system, even if they don’t trust (or even know) the individual members (Exhibit 2).

Exh 2: Blockchain Transaction Confirmation and Broadcast Workflow

The blockchain concept was created to support the launch of Bitcoin in 2009 (Exhibit 3), the first and largest of the world’s cryptocurrencies. While the Bitcoin blockchain secures the transfer of that digital asset between parties on the network, the technology can be adapted to support the exchange of any digital object of value – e.g. financial instruments, claims on physical assets, information, etc. – there doesn’t have to be any sort of alternative currency or digital “mining” involved.

Exh 3: Blockchain Ecosystem Development Timeline

A Separate Blockchain to Every Purpose

Every blockchain is customized for its application. The data to be shared to the distributed ledgers, the rules by which transaction requests are distributed, reviewed and confirmed, the process for resolving discrepancies, the methodology for encrypting packet contents, and many other design considerations must be proposed, agreed to by all participants, written into software and implemented. A blockchain to settle trades at an exchange will be very different from another designed to convey patient medical records to healthcare providers. Moreover, blockchain is a higher-level protocol (Exhibit 4)– its “blocks” are meant to be chopped up and carried in the simpler envelopes of lower level protocols, like the Internet’s TCP/IP, to be reassembled on the other end – and its workings are not directly dependent on a specific hardware platform. (N.B. crypto-mining relates to the payload of a blockchain, cryptocurrencies, and is not involved in the network itself). Because of this, there will be no “blockchain boxes” to sell, and generic “blockchain templates” sold as a service will still require significant customization to adequately serve the needs of necessarily focused applications.

Exh 4: Blockchain vs. The World Wide Web Architecture Comparison

Why Blockchain?

Because blockchain’s transaction transparency and distributed ledgers dramatically reduce the potential for fraud and other malfeasance through public scrutiny, other mechanisms intended to provide the same protection may not be necessary. These mechanisms – brokers, insurance, escrow, clearinghouses, settlement systems, inspectors, arbitrators, court-enforced contracts, and other intermediaries – may be substantially reduced in importance or even eliminated with blockchains covering transactions that they used to oversee. This has three obvious benefits: 1. Reduced costs by eliminating payments to middlemen, 2. Reduced friction for transactions, including the elimination of delays introduced by intermediaries, and 3. Improved security through transparency, user control, and encryption (Exhibit 5).

While the original application for blockchain was to create a trustworthy mechanism for completing transactions using cryptocurrency, the concept has broad applicability to exchanges of value. Financial services have myriad obvious applications, and financial institutions have been big early investors in the technology, building “proof-of-concept” trial networks alone and in consortia. Estimates for the potential annual savings for financial services approach $50B. Logistics, broadly defined, is the other major area of early investment. Maersk’s project with IBM to demonstrate end-to-end tracking for shipping is an excellent example – the company estimates that each container ship generates $5.4M in paperwork costs that could be eliminated by maintaining the chain of custody via blockchain. While we see these arenas as the most promising, companies in a variety of other businesses – e.g. health care, retail, real estate, etc. – are also investing in proof-of-concept blockchain networks. Together, research has identified roughly $450B in annualized savings that might be realized across industries through commercial blockchains, with transaction costs down as much as 75% in some cases. (Exhibit 6-9).

Exh 5: Key Benefits of Blockchain Technology

Exh 6: Estimate Costs of Closing on Real Estate Addressable by Blockchain Tech

Exh 7: Global Logistics Costs Addressable by Blockchain Forecast, 2017-2025

Exh 8: International Payment Infrastructure Costs Comparison

Exh 9: Potential Industry-wide Cost Savings from Blockchain Implementation

Yes, But …

Bitcoin was launched in 2009, giving the world more than 8 years to apply the underlying blockchain technology to other commercial purposes. The basics of blockchain – those distributed ledgers, thick protocols, transaction confirmation mechanisms, hard encryption for digital assets, etc. – are complicated but well within the reach of competent software development organizations. Why, then, has it taken so long to take blockchain beyond cryptocurrencies?

It turns out, there are obstacles (Exhibit 10). On the technical side, the big sticking point is scalability. The confirmation process in blockchain involves each node comparing the proposed transaction against its own stored ledger, reporting any discrepancies to the full group, attempting to reconcile those discrepancies with the group, then giving approval if appropriate. As the number of nodes increases, the process to reconcile discrepancies becomes geometrically more complex and the time and resources needed to confirm transactions increases. For example, the Bitcoin blockchain currently has just under 12,000 active nodes and the average time to validate an exchange is 78 minutes, with delays of several hours during busy times possible (Exhibit 11). Researchers are considering alternatives that might allow accelerated confirmations without compromising the security of the blockchain, but solutions are at nascent stages (Exhibit 12).

This issue may restrict commercial blockchains to smaller implementations (where scalability won’t be too much of an issue) and to applications where transaction latency is not a major drawback (paperwork and human intermediaries can certainly impose much greater delays than a blockchain confirmation). We also note that the privacy implications of open distributed transaction ledgers may require layers of permission for certain information that could create additional issues for scalability and latency for many implementations.

Exh 10: Highlight of Factors Hindering Blockchain Adoption

Exh 11: Existing Payment Channel Tx Time, Throughput and Costs

Exh 12: Top Candidates of Possible Approaches to Scalability Problems

Herding Cats

Blockchains are networks, purpose built to transmit value amongst a group of participants. As such, the benefits of the network are dependent on the participation of its intended constituents. Unlike cryptocurrencies, where joining the network is voluntary and the rules of engagement are well established, most commercial blockchain projects intend to address existing markets and replace traditional mechanisms for assuring trustworthy interchanges. Success in these applications will require nearly unanimous acceptance – if major partners refuse to play, cost savings will be elusive, and the effectiveness of the system will be compromised. Membership will require investment in new processes and training, along with implicit trust in the fairness of the system itself – the rules of the blockchain might be interpreted to favor some members over others, or to offer insufficient security or transactional privacy. How, then, to build a coalition of the willing?

We see three main paths to gain critical mass for blockchains (Exhibit 13): 1. A Dominant Central Player – a single large company might use its influence over smaller ecosystem partners to mandate compliance with a group blockchain. An example would be Walmart’s proposal to build a blockchain for its grocery suppliers to track the provenance of perishable items – the retailer may have enough power to demand adoption of the blockchain. 2. A Tight Consortium – Companies with shared interests may be able negotiate a cooperative solution developed jointly through a formal arrangement. An example would be the Digital Trade Chain, launched by 7 European banks to build a network to facilitate cross-border trade for small businesses. 3. A Trusted 3rd Party – A neutral 3rdparty may play an important role in organizing a network of participants that might otherwise be wary of the potential dominance of larger companies. At the recent FinTech confab hosted by SWIFT, IBM announced a blockchain network to facilitate international payments. It is running in trial mode in the Pacific Island region, but IBM will look to recruit global participants from its many central and commercial bank clients.

Each of these paths has potential pitfalls. A dominant player may force compliance on its ecosystem, but it would be difficult to extend that solution beyond those cowed by the organizer. Consortia have a long history of falling apart, as peers jockey for influence. 3rd parties lack skin in the game and must rely on salesmanship to build group consensus around a solution. These difficulties are probably the best explanation as to why no major commercial blockchains yet exist, despite the steady drumbeat of industry hype (note the Gartner hype cycle chart back on page 4). While momentum has picked up, we expect that the projects that will be successful in the near-term will be modest in their ambitions (Exhibit 14).

Exh 13: Necessary Mechanisms for Critical Mass Adoption of Blockchain

Exh 14: Leading Enterprise Blockchain Consortiums and DLT Platforms

Vision Quest

The most expansive visions of Blockchain see it as the World Wide Web version 3.0, a generalized mechanism for frictionless transactions of all types over the Internet. Such a world would eliminate fraud, bureaucracy and other elements of transaction friction that dampen economic activity. Like information flowing around the world today, this version of the web would do the same for trade.

This vision is of the very distant future – decades, not just years, away. With today’s technology, the scaling issues of such a network are overwhelming. Someday quantum computers might be up to the challenge, but the current infrastructure is unable to confirm Bitcoin transactions amongst 12,000 nodes in less than an hour. Imagine billions of consumers on a global system. Moreover, the challenges for security in a world with quantum computers will also be substantial – we are optimistic that they will be solved, but there is an enormous amount of research ahead.

Like commercial blockchains today, the global consumer blockchain of tomorrow will face big challenges in gaining critical mass. Governments will be opposed to technology that enables transactions that transcend physical borders. Privacy issues – remember those shared ledgers – and system governance issues will also be major impediments. We note also that a generalized system would need to interface with the myriad of market specific and not-at-all interoperable commercial blockchains that will come into play, another huge challenge. While we are optimistic for the future of blockchain, our optimism has its limits.

Who Will Get Paid?

We see a lot of project work underway, with “proof of concept” blockchains being built on behalf of companies, consortia and “on spec” by interested 3rd parties. A Juniper Research survey of 400 global companies revealed 43% are considering or already investing in blockchains (Exhibit 15). Most of these companies also reported working with IT consultants on their projects, with IBM, Microsoft and Accenture well in the lead with both active engagements and commercial interest. Some of these projects will be successful, and while the hit rate is almost certain to be far short of 100%, these companies will gain important experience in facilitating the technology for commercial applications. We see all three as substantial winners from the expected growth of this technology, with the investment in proof-of-concept trials already delivering meaningful upside for all three (Exhibit 16, 17).

Exh 15: Blockchain Leadership Rankings Survey Results

Exh 16: Top Cloud Platform Hosts with Blockchain-As-A-Service Offerings

Exh 17: Top IT Consultants with Blockchain Related Service Offerings