Jan Loeys Global Research

(1-212) 834-5874 J.P. Morgan Perspectives

jan.loeys@jpmorgan.com 09 February 2018

cryptocurrencies presents a challenge for regulators Allen similarly discusses various efforts under way with,
attempting to limit money laundering and terrorist- for example, a number of payment processing firms
financing activities. We review the actions that regulators increasingly partnering with technology firms/Blockchain
in various jurisdictions have taken to limit the risks providers to offer an alternative settlement engine to
associated with cryptocurrencies (Roever). various payment participants. We expect various
Blockchain-based ecosystems to coexist and compete with
What does the future bring? each other (similar to Payments networks in the current
environment), with success predicating on technology
In the early stages of innovation, usually set off by new capabilities (such as API features), number of participants
technology — in this case Blockchain (Kambo) — the on the network and ease of adoption. Given the hurdles,
market experiments with many different approaches to see CCs are more likely to be used as ancillary payment
what shape and form will stick and end up offering the methods rather than gaining traction as a primary source
most economic value-added. We would note that it is not of exchange.
pre-ordained that cryptocurrencies will succeed as there
are valid concerns about what economic value they really While seeing a potential for the deployment of the
contribute. But in a time of rapid innovation, many new underlying Blockchain technology in payments, we do not
products will are often-and-errored. We believe the see cryptocurrencies competing with central bank-issued
potential disruption from Blockchain cannot be ignored. money for lawful transactions. We note that CCs have not
attained the relative stability of value to make them useful
The excitement of innovation typically also leads to price as money for everyday transactions. As discussed in
booms and then crashes among the early movers, before Feroli and Aziz, the current set of government-issued fiat
more realistic prices emerge among the eventual currencies — such as the dollar and the euro — provide
survivors. Much of this is what we see today with efficient media of exchange, stores of value and units of
exponential price gains and losses, growth and diversity account. Some of the early buyers of CC were clearly
among cryptocurrencies. Given the amount of speculation dismayed by ballooning balance sheets of the major
in these markets, technical signals can be very useful in central banks in the aftermath of the global financial crisis
gauging market direction and they have been sending the (GFC), but the lack of any meaningful inflation since, in
right signals in recent months (O'Connor). Fundamentals both developed markets (DM) and emerging markets
are a lot less informative here, although it can be useful to (EM), has surely reduced concerns about fiat (legal tender
look at the cost of mining CCs, even as one must also issued by a central bank) money.
account for the elasticity of supply (Kaneva).
In addition, we find that local legal tender money tends to
Cryptocurrencies are both a new technology — be a natural monopoly with only extreme hyperinflation
Blockchain — and a new currency (many new ones). leading people to seek out a monetary alternative. To add,
The new shape and form of the CC market in the future Feroli and Aziz do not find that CCs are currently meeting
will likely ultimately depend on what economic value the standards of what constitutes money as the huge
they are perceived to add. We would expect the volatility of CC has made use of it as a unit of account
marketplace and regulators to ultimately weed out what impractical. Finally, given the huge returns from running a
are perceived the negative, less useful characteristics of central bank (seigniorage), governments will be quite
CCs and retain the positive elements that add economic possessive of their legal tender role and will likely put up
value. a fight if CCs were to gain broader traction domestically
(see Roever and Lei on how regulations on CCs are
As discussed more in detail below in Kambo, Huang, steadily tightening).
Allen, and Sinha, the Blockchain technology driving CCs
offers transparency to transactions and allows them to be Some EMs, such as Venezuela and Russia, appear to be
virtual and peer-to-peer. Distributed ledger technology has considering issuing CCs as a way to improve international
the potential to offer regulators greater degrees of funding and evade US sanctions. Aziz is quite dubious
transparency, higher levels of resiliency and shorter about whether any of this will work as CCs face
settlement times, reducing counterparty and market risk. regulatory headwinds and are neither better than fiat
See for example, the discussion by Sinha of banks’ effort money in establishing policy credibility nor in providing
to use Ripple to create more efficient cross-border liquidity during crises.
payments.
Several central banks, as discussed in Feroli, are
investigating whether they should issue CCs in their own

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(1-212) 834-5874 J.P. Morgan Perspectives
jan.loeys@jpmorgan.com 09 February 2018

currency, but are very far from actually doing so, as any
increased efficiency in payments technology does not
appear to be that obvious. In addition, the issuance of
crypto dollars, for example, would give non-banks access
to the Fed balance sheet, and thus could endanger the
economically and socially important financial
intermediation function of commercial banks.

In market economies, commercial banks manage the

largest part of what we call money through their deposit
base that they in turn lend out to the economy, after
holding back a fraction as reserves at the central bank. If
cryptocurrencies were seen as superior to bank deposits,
prompting a wholesale shift into cryptocurrencies, then a
much larger share of savings would go to the central
bank's assets (government debt) and less to commercial
banks loans, thus potentially dramatically increasing
private credit risk premia and reducing the flow of credit
to the private sector. Fractional reserve banking was a
tremendous innovation that surely contributed greatly to
global growth over the last two centuries, and we would
expect that central banks would think twice before
disturbing this source of capital to the private sector.

Normand examines the potential role of CCs in terms of

offering diversification in a global portfolio, given both
their high returns over the past several years and their
low correlation with the major asset classes, offsetting
some of the cost of high volatility. If past returns,
volatilities and correlations persist, CCs could
potentially have a role in diversifying one’s global bond
and equity portfolio. But in our view, that is a big if
given the astronomic returns and volatilities of the past
few years. If CCs survive the next few years and remain
part of the global market, then they will likely have
exited their current speculative phase and would then
have more normal returns, volatilities (both much lower)
and correlations (more like that of other zero-return
assets such as gold and JPY). Based on its historical
performance, CCs can be 10 times more volatile than
core assets like stocks, or than portfolio hedges, like
commodities. Liquidity is also well below most other
potential hedges. Extraordinary returns can be generated
in the price discovery phase, only to be followed by
several years of mean-reversion toward the eventual,
long-term average level. In the current market
conditions, we do not believe that an allocation to
Cryptocurrencies as insurance should be a portfolio’s
main or only hedge. Note that even though CCs have
improved risk-adjusted returns over the past several
years, they have not prevented portfolio drawdown
during periods of acute market stress, like the equity
flash crashes of August 2015 and February 2018.

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 Gurjit S Kambo, CFA Ravin S Mehta Global Equity Research
(44-20) 7742-0719 (44-20) 7742-4561 J.P. Morgan Perspectives
gurjit.s.kambo@jpmorgan.com ravin.s.mehta@jpmorgan.com 09 February 2018
Sterling Auty, CFA
(1-212) 622-6389
sterling.auty@jpmorgan.com

Blockchain – the technology Innovative Way of Using Existing

Technology
behind cryptocurrencies The cleverness of Blockchain is not that it is a totally
new technology, but rather it is an innovative use of three
 Blockchain (often referred to as distributed long-standing existing technologies. Basically,
ledger technology) is a secure transaction ledger Blockchain is a combination of a peer-to-peer (P2P)
database shared by all parties in a distributed network plus public key infrastructure (PKI) encryption
network that records and stores every transaction technologies plus the use of a cryptographic hash
that occurs in the network, creating an (encryption).
irrevocable and auditable transaction history.
 Blockchain can be considered a superior database
where the data and access to the data are encrypted. Blockchain = P2P Network + PKI +
The distributed nature of the Blockchain means the
master record is shared or mutualized.
Cryptographic Hash
 Blockchain is the core technology underlying
Bitcoin, but we see the potential for Blockchain to
span several industries. In our view, the biggest Each of these technologies has been around for as long as
appeal of Blockchain will be in the ability to 30 years. The P2P network was popularized by Napster
deliver efficiency gains across the value chain. in June 1999; PKI, which gives the ability to secure
transactions between two untrusted parties and provides
 We note collaboration will be key in bridging the other key elements like time stamping, has been in use
gap between the technology and the practical since the 1990s. In fact, in a 1991 Journal of Cryptology
applications for Blockchain to be widely adopted. article, Stuart Haber and W. Scott Stornetta described the
There are already a number of consortiums that process for digital time-stamping and a secured chain of
have emerged and endorsement from regulators blocks, while in 1992 Bayer, Haber and Stornetta
would also be important. There are a number of incorporated Merkle (or hash) trees as a necessary means
proof-of-concepts being tested, and whilst the full to compress the size of a historical Blockchain. Finally,
impact may not be seen for several years, we the cryptographic hash used for the consensus algorithm
believe the potential disruption from Blockchain that solves conflicts in a Blockchain is typically based on
cannot be ignored. ECC (elliptic curve cryptography), which was created in
1985, but became popular for security use in areas like
In this section, we provide a background on Blockchain, mobile devices around the turn of the century.
the technology forming the underlying infrastructure
behind cryptocurrencies such as Bitcoin. Blockchain is What is Blockchain and how does it
still an emerging technology, but momentum has been
gathering pace over the past few years as the use of the
work?
technology extends across several industries with Blockchain: A secure transaction ledger database that is shared by
potentially disruptive implications. all parties in a distributed network. Every transaction is recorded and
stored to create an unchangeable and auditable transaction log.
Summary of Blockchain The terms Blockchain, distributed ledger or share ledger are
Blockchain (often referred to as distributed ledger interchangeable.
technology) is a secure transaction ledger database
shared by all parties in a distributed network, which Simply put, Blockchain is widely recognized as a
records and stores every transaction that occurs in the superior database.
network, creating an irrevocable and auditable The simplest way to define Blockchain is as a superior
transaction history. Blockchain can be considered a database where:
superior database where the data and access to the data
are encrypted. The distributed nature of the Blockchain 1. data that is stored is encrypted;
means it has a built-in redundancy and can survive the 2. access to the data is encrypted;
loss of one node because the master record is shared or
mutualized.

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 Gurjit S Kambo, CFA Ravin S Mehta Global Equity Research
(44-20) 7742-0719 (44-20) 7742-4561 J.P. Morgan Perspectives
gurjit.s.kambo@jpmorgan.com ravin.s.mehta@jpmorgan.com 09 February 2018
Sterling Auty, CFA
(1-212) 622-6389
sterling.auty@jpmorgan.com

3. the distributed nature of the Blockchain means that it In the diagram below, we summarize the main
has a built-in redundancy and can survive the loss of components of the Blockchain or distributed ledger as it
one node because the master record is shared; is often referred to. Ultimately, we see Blockchain
improving efficiency, which, through the mutualization
4. transactions are immutable, in that it is impossible of processes, should lower costs.
to alter historical records, thus creating a credible
audit trail.

Figure 1: The key components of Blockchain

Source: J.P. Morgan

Wikipedia definition of Blockchain Distributed ledgers – A type of database architecture whereby all
nodes within a system cooperate to reach a consensus on the
“A block chain, or Blockchain, is a distributed database
accurate state of a shared data resource.
that maintains a continuously-growing list of data
records hardened against tampering and revision. It Decentralized – Eliminates the need for a central authority to process,
consists of data structure blocks – which hold exclusively validate or authorize transactions.
data in initial Blockchain implementations, and both Centralized – Control under a single entity, which leaves the system
data and programs in some (for example, Ethereum) of exposed to a single point of failure.
the more recent implementations – with each block
Benefits of distributed ledgers
holding batches of individual transactions and the results
of any Blockchain executables. Each block contains a Secure and consistent – The database is an irrevocable and
timestamp and information linking it to a previous irreversible record of all transactions. Data stored cannot be tampered
block.” with or revised. This creates an auditable transaction history.
Trusted – Computer servers within the network must reach a
consensus, which in turn allows for transactions to take place between
otherwise unknown parties.
Real-time data store – All nodes within the system store an identical
copy of the ledger, which is updated almost automatically.

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 Gurjit S Kambo, CFA Ravin S Mehta Global Equity Research
(44-20) 7742-0719 (44-20) 7742-4561 J.P. Morgan Perspectives
gurjit.s.kambo@jpmorgan.com ravin.s.mehta@jpmorgan.com 09 February 2018
Sterling Auty, CFA
(1-212) 622-6389
sterling.auty@jpmorgan.com

What is a distributed ledger? Figure 4: Distributed ledger approach

The Blockchain, as previously mentioned, is a digital,
distributed ledger. Each block within the system is
generated once multiple nodes reach a consensus and
validate the transactions. This is where the distributed
nature of the Blockchain stems from, a concept that we
illustrate below based on a study into the benefits of
adopting a digital data communications system integrated
with a distributed network framework.

Figure 2: Distributed network infographic

Source: “On Distributed Communications Networks”, Paul Baran, 1964.

As a distributed database, multiple copies of data exist

across multiple computers, which together create a peer- Source: J.P. Morgan. For illustrative purposes only.
to-peer network. Hence, rather than a single centralized
server or database, the Blockchain captures an entire Shortcomings of the centralized ledger driving
decentralized network of machines, with each one acting interest in the distributed ledger
as a node within that specific network. This ultimately Existing practices of data management, particularly of
serves to reduce the need for central authorities to clear personal data, encompass vast legacy IT systems
transactions and certify ownership. typically located within a single institution. An array of
networking systems are then layered over to facilitate
Figure 3: Centralized ledger approach external communications, resulting in added cost and
complexity. Such a centralized system thus presents a
high-cost single point of failure, with data that are often
outdated and out of sync, which may be exposed to cyber
crime.

Given the distributed ledger platform comprises multiple

shared copies of the data, the ledger is inherently harder
to attack, as an attack would have to simultaneously
target all copies in order to be successful. In addition, the
technology is resistant to any suspected malicious
tampering or unauthorized database changes as network
participants will notice any change to an isolated part of
the ledger. However, we should note that Blockchain is
not completely immune to cyber crime: collusion among
users could result in modifications to all copies of the
ledger at the same time.

In our view, completely moving away from the

established centralized model may be viewed as too
Source: J.P. Morgan. For illustrative purposes only.
risky, and therefore, a solution could be for the existing
centralized authorities (central securities depositories or
custodians) to support the implementation of distributed
ledgers. In such a scenario, there could be a period over
which existing infrastructure would need to coexist and

10

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