By Kevin Dennean, David Perlman and Matthew DeMichiel
While we remain skeptical on cryptocurrencies, we still believe their underlying technology – blockchain – has promise. Also known as distributed ledger technology (DLT), we believe this new class of technology will have application across multiple industries and, one day, drive significant economic value.
That said, although we believe DLT is where the "rubber meets the road" for innovative ledger and data sharing technology, we think there could be significant friction that will likely impede widespread adoption for a number of years.
Case in point is the shipping industry, which has existed for millenniums; it is clearly an antiquated business that is ripe for modernization and digitalization. However, the path to modernization won't be easy. We believe there will be significant friction in getting the entire shipping ecosystem – including shipping companies, ports, customers, and regulators – not only to invest in new technology to support the DLT effort, but more importantly, to change long-standing business processes.
Rather than broad-based adoption that reinvents entire industries, it may be more plausible to expect incremental adoption of DLT for very targeted applications and use cases. For instance, global money center banks are looking to use DLT to improve efficiency in their swaps business. In this case, we think this could happen fairly quickly as there are only a few dozen money center banks worldwide and they have sophisticated IT departments. But this isn't as ambitious as reinventing shipping.
The possibility of a longer-than-expected adoption of DLT has not dampened investors' appetite for DLT-themed investment strategies. In fact, so far this year, there have already been three exchange-traded funds (ETFs) issued that focus on companies that have some sort of exposure to the DLT ecosystem. Two of the ETFs track indices while the other is actively managed.
When investing in a fund targeting an emerging industry, it’s important to remember that, oftentimes, pure-plays do not exist. So, to make up for this, the index methodologies (for passive products) or investment strategy guidelines (for active products) will incorporate both non-pure-play companies as well as companies within related industries.
For DLT, this seems to be taken to the extreme. The industry is so new that most companies do not have reporting guidelines that separate out revenues and spending derived from DLT. Further, the universe of companies using the technology in a meaningful way is extremely limited. So, there is no standard on what criteria to use to measure meaningful DLT exposure for inclusion in a fund.
To make up for the lack of criteria, the ETF index methodologies or investment strategy guidelines will instead rely on analyzing a company's products or services, investor resources (financial reports, earnings releases, etc.), and news outlets or industry reports that provide information on a company’s current or future plans for DLT.
Companies that directly or indirectly enable the use of DLT products and services as well as companies that could use or stand to benefit from the technology could be included. Due to this broad definition and low thresholds to satisfy the criteria, you'll see a wide range of companies within the ETFs. This may include, but is not limited to, large technology companies, semiconductors, banks, and capital markets companies. Over time, as the DLT ecosystem develops, a purer-play universe may develop.
Over the last few years, both companies and investors alike began to realize the potential of DLT. Now, in 2018, we stand at a point where key early DLT adopters will begin to transition identified use cases from 'proof-of-concept' into 'production parallel' where the goal is to scale an application while testing for shortfalls and inefficiencies, and by the end, determine whether a concept will provide increased value compared to the legacy technology.
While corporate IT spending on DLT is estimated to grow at a compounded annual growth rate of 81.2% over the next five years, according International Data Corporation (IDC), the percentage of overall IT spending dedicated to DLT will remain low with estimates of spending reaching only $9.2 billion by 2021. If we compare this against the $3.4 trillion in global IT spending as of the end of 2016, we can see that company spending on DLTs will remain just a footnote over the foreseeable future.
In sum, we do not see DLT as a meaningful driver of returns or operational efficiencies at this time. And we believe it could take years for DLT to impact the bottom lines of the world's larger, publicly-traded corporations. But the technology still holds promise.