By far the most frequent question, as well as the most divisive one, that I get asked is about the future of cryptocurrencies. Spectacular gains of over 3000% in 2017 followed by spectacular volatility in 2018 make this asset class stand out. On one side, digital currency libertarians and techies herald the arrival of financial freedom from the establishment: governments, central banks and large financial institutions. On the other hand, the kings of finance criticize the space: Jamie Dimon called advocators of digital currencies “stupid,” while Ray Dalio warned against “a bubble.”
In today’s column, I wanted to share our thinking about digital currencies through the prism of disruption. In “Asset Managers Prepare to Be Disrupted,” my co-authors, David Teten and Brent Beardsley, and I argue that the investment industry has changed very little, while other industries have undergone dramatic disruption. Factors such as technological innovation, social change and political constructs often drive change in unexpected ways. Today’s viewpoints of traditional finance toward digital currency remind us of past infamous quotes from the establishment when faced with disruption. In 1977, Ken Olson, founder and CEO of Digital Equipment Corp, famously said, “There is no reason for any individual to have a computer in his home,” which has become a warning against the blind spot that prevents many successful business leaders from seeing disruption.
Bitcoin Price
Marto Research, Bloomberg
Emerging digital currency market has all the characteristics of past disruptors:
- Non-linear technology advancement makes it possible to completely re-envision an entire industry. Technology is often used to automate existing processes or to generate efficiency, such as using the internet to order DVDs. True disruption, however, occurs when new technology enables radically different business models to be created. The evolution of Netflix exemplifies that: streaming video content is a disruptive technology that has impacted the consumption of DVD video content. Similarly, the advent of blockchain technology radicalized the trading processes, thus disintermediating large financial institutions and governments. This allowed for the invention of Bitcoin, a currency that is not backed by any government or any underlying asset and is “mined” through solving complex computational riddles.
- An emerging social sub-culture is hungry for change. A new generation of avant-guard thinkers go against the status quo and embrace disruption first. During the internet boom, Silicon Valley became the cradle of an entirely new culture of irreverent techies who were not afraid to question everything and make bold moves. Today, an innovative generation that cares very little about what the established titans of our industry think constitutes “currency” have completely redefined how currency is created, exchanged and stored. It seems as though the only thing one needs for a currency to exist is buyers and sellers who want to transfer value between each other. The subculture gains momentum taking the establishment by surprise; who thought that Bitcoin would be worth over $10,000?
- Initially unsavory business interests are attracted to the space, negatively impacting the credibility of the new technology. In the case of the internet, the early entrant of users were for gambling and pornography purposes, which led some investors to stay away from the industry and shrug off its validity. Similarly, today digital currencies allow for capital transfer between individuals that is immune to government control, thus enabling possible money laundering.
Are digital currencies a scam or the holy grail of financial liberalization? If past disruptive innovations serve as an example of what to expect from digital currencies, then the answer is likely neither. The three phases of disruption that we have seen through the history of technology are likely to play out in the digital currency space:
- Creation: The innovation grows fast and moves from the periphery to the center of everyone’s attention generating great gains for early investors. The current digital currency boom is similar to the internet boom of the 1990s: As a young technology analyst, I remember valuing internet start-ups based on “eye balls.” At the time, neither revenues nor profits were considered valuation indicators. Similarly, today it is incredulous that new digital currencies are popping up with little business rational and inflated valuation. Digital currencies are likely at the end of this phase.
- Retraction: The euphoria grows to an unsustainable level and the bubble bursts. The valuation correction encourages the nay-sayers, but also sifts through the credible business models from the unsustainable ones. It is likely that the dot com bust of 2000 would have its parallel in the digital currency space, but the correction will likely be healthy for digital assets in the long run.
- Institutionalization: This is the final and most profound phase of disruption where the best of innovation embraces established best practices and common sense. During the internet boom, internet companies refocused on revenue growth and the bottom line, while developing business models intertwined with brick-and-mortar companies. The last phase of disruption created the new industry behemoths – Google, Amazon, Netflix among others. The same is likely to happen with digital currencies as survivors embrace regulation, self-regulation, and implement accountability to how initial coin offering proceeds are used and what ROI investors are looking for.
If digital currencies complete the cycle of disruption, the businesses created through the three phases of disruption will likely change the financial system as we know it, creating new sources of capital transfers, investing, and financing. The new businesses are likely to give Private Equity and Venture Capital firms, as well as banks and trading exchanges, a run for their money, but digital currencies might begin to appear in both retail and institutional portfolios.