From Bitcoin to Top Shot to Ethereum to tokenized tweets, digital assets are everywhere today. Despite their controversy, volatility, and sometimes illicit use cases, it is increasingly likely they are here to stay.

We believe it would be valuable to provide some degree of clarity about digital assets, as well as shed some light on the conversations we are having here at Manning & Napier. To be clear, we do not own any cryptocurrencies for client portfolios, but that doesn’t mean there isn’t work being done or that we aren’t monitoring the emerging field.

For investors, the questions are many: What are digital assets? How and why do they work? What are the advantages and disadvantages? Do they have merit as an asset class? In attempting to address these questions, and many others, investors can then begin to determine whether they are appropriate as an investable asset, and how these technologies may impact existing processes and business models.

Overview

Any understanding of digital assets must start with an understanding of the underlying blockchain technology. This is the foundation on which the space is built.

At its core, a blockchain is a relatively immutable distributed ledger system. We can think of this as a database stored on several different computers that is prohibitively difficult to change without consensus. The system lends itself to decentralization—though this is not always the case—and as such, it is often lacking a central authority. These characteristics are derived from several key features and it allows the technology to offer a variety of use cases across different industries and asset classes.

The functions, features, and processes supporting a blockchain can be complex, especially to those without a background in computer science. Nevertheless, we will briefly touch on some of them in order to better understand how and why blockchains function the way they do. A general technological overview will also help in understanding why cryptocurrencies may be useful either in support of an investment vehicle or as a new technology to implement in the real world.

Understanding the Fundamentals

There are three major fundamental technological characteristics that underpin blockchain technology: hashing, asymmetric cryptography, and blocks.

Hashing is the process of converting data of nearly any size into a consistent, fixed-size output, typically for encryption and/or anonymity purposes. In addition to compression and security features, hashing functions rely on statistical properties that generally encourage active users to act in ways that lead to more optimal outcomes for all parties involved.

Asymmetric cryptography uses a combination of public and private keys that allow for transactions between parties to be accepted and validated. Public keys are visible to all users of the network and generate addresses that can transfer or store digital assets. The private keys are known only to the owner and are used like a ‘digital signature’ to confirm a transaction. When a transaction takes place between users, the network utilizes the public keys to confirm each party can meet its obligation. If accepted, the transaction then enters a pool to be added to a new block and ultimately to the chain itself. Once a transaction has been agreed upon, it is broadcast to all the nodes participating in the system. These nodes are individual computers running the software that supports the network. The nodes can be either centralized or decentralized. The latter is typically associated with blockchain technology, but it should be noted blockchains can be centrally managed or contained within a private network (for example, within a company). Importantly, this does not mean that the transaction has now been recorded and added to the blockchain; rather, these transactions have been added to the ledger in a pool of candidate transactions.

Blocks are essentially a collection of validated transactions that are duplicated and distributed across the entire network of computer systems to form a blockchain. Special computers, referred to as mining nodes, ultimately determine which transactions from the pool of candidate transactions are added to blocks, and subsequently the blockchain. Once a node submits a block to the chain, other nodes can then check the validity of each transaction added to the block and either accept or reject the block based on the validity of each transaction. Finally, the block itself is hashed and added to the chain. This ensures that if any previous transaction was changed in any way, the hash itself would change, and it would subsequently be rejected by the network of nodes.

These characteristics of the blockchain give it several compelling advantages and disadvantages versus traditional data storage/verification technologies. They’re also what enables cryptocurrencies to have their unique characteristics versus traditional financial vehicles. Lastly, while the technologies may seem esoteric or complex, for those technologically savvy, they are relatively straightforward and accessible, and they have enabled a plethora of various cryptocurrencies and other digital assets to explode onto the market, each with technical tweaks or significant changes that provide unique characteristics and targeted use cases.

Advantages and Disadvantages of Blockchain Technology

As with many new, emerging technologies, the hype and optimism surrounding mainstream acceptance can detract from substantive analysis. The relative infancy of blockchain as a technology, coupled with its limited scope of use to date, make assessing its advantages somewhat theoretical. However, none of this means we can’t draw some conclusions about positive features of the technology:

• Transparent and Immutable History: Blockchains can provide users with a transparent history of transactions that can be prohibitively difficult to change.
• Trustless System: The transparent and immutable properties of blockchains enable trustless interactions between individuals or groups of individuals; this eliminates the need for trusted intermediaries to acts as brokers within a system, increasing efficiency.
• Rapid Settlement: Even though transactions are not immediately added to the blockchain, the process tends to be relatively quick and reduces settlement time.
• Accessibility: Given the inherently decentralized nature of many blockchains, they can increase accessibility to a variety of systems.
• Consensus Building: Decentralized blockchains require consensus to add new blocks, democratizing processes and in many cases ensuring that no one player can accumulate an outsized position of power.

The above list is purposefully brief and far from exhaustive, but it touches on some of the main advantages offered by blockchain technology. Conversely, the system presents a number of challenges that will either be difficult to overcome or require further development and refinement:

• Inefficiency: Adding new blocks to the chain can be an inefficient process, particularly in a system where miners compete for the right to add the next block (a ‘proof of work’ model); it is this dynamic that drives the conversation around the energy inefficiency of Bitcoin.
• Scalability: Some blockchains lack the capability to process very large amounts of transactions rapidly and at a minimal cost.
• Asset Security: Individuals and groups need to have their private keys to access their assets. One option is to store these on a central server (like an exchange); however, some believe that this is not the most secure option. An alternative is to store your own keys, but if they are lost then your assets will almost certainly be lost as well.
• Upgrades: Upgrading software can be very challenging given the need for consensus across the nodes in the blockchain.
• Interoperability: Communication between legacy systems and other blockchains is extremely difficult at the moment.

Despite these challenges, blockchain technologies continue to grow in popularity. Development efforts have targeted some of these challenges, and we would expect that many of these problems will eventually be solved to enable broader and more effective use of blocks.

Potential Uses

Blockchain technologies have the potential to be used across nearly any industry in the world. But just because blockchain could be used, doesn’t mean it should be. In our view, the most pertinent question is: Where are the features unique to blockchain most capable of having a meaningfully positive impact?

As an investment manager, we recognize the importance of understanding how this potentially disruptive technology can reshape industries and sectors. Consider the following potential uses:

• Money and Finance: Features such as an immutable history, secure and trustless transactions, and rapid settlement lend themselves well to financial transactions. There are real world applications for the technology in combination with traditional fiat currencies and capital markets.
• Supply Chains and Logistics: Supply chains and logistics lend themselves incredibly well to being able to track the exact path of different goods and services. From documenting and effectively communicating places of origin, to value-added transformations, to proof of carbon-offsets, this industry could potentially be transformed by blockchain technology.
• Medicine: Blockchain technology could help to transform the way that medical professionals document procedures, bill patients, file insurance claims, and quickly view and understand a patient’s entire medical history.
• Recordkeeping and Auditing: There are several industries burdened by significant documentation needs that stand to be upended by blockchain technology. Past transactions, such as title transfers, could be quickly viewed and verified before completing new transactions, simplifying recordkeeping and auditing procedures.

These are just a small number of industries that could be reshaped by the introduction and adoption of blockchain technologies. As the challenges associated with blockchains are addressed, more rapid adoption is certainly possible.

Investment Implications

So what does all of this mean for investors? It’s a complicated question with no easy answer.

As it pertains directly to digital assets, cryptocurrencies are the most obvious investment vehicle. It is helpful to distinguish between those that are more akin to a currency and those that confer to the owner some sort of utility or function on a network.

Bitcoin is an example of a cryptocurrency that has features similar to other traditional currencies thought to be a potential store of value, hence it’s moniker ‘digital gold.’ Conversely, a token like Ethereum provides users with certain rights or access to a network. Still another example of a digital asset is a non-fungible token, or NFT. These are essentially the hashed output of any number of things, such as videos or pieces of art, that are then put onto a blockchain. Individuals can purchase these tokens to either keep them for themselves or transfer them to a new owner on the blockchain at a later date.

The potentially disruptive nature of blockchain technology may also lead to investment implications beyond solely the digital asset space, particularly for its potential commercial uses. We believe broader acceptance will lead certain industries to see reduced costs and increased efficiencies, while other industries lose share as the technology changes the traditional ways of doing business.

As an asset manager, we remain keen observers of the ebbs and flows of the cryptocurrency space and blockchain technology. While these are some of the issues we are thinking about today as we evaluate cryptocurrencies, we have not made the decision to invest. Nevertheless, we are cognizant of the possible impacts that a technology as potentially disruptive as blockchain can have on our existing holdings, and how they could reshape the sectors and industries we’ve covered for decades.

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This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. The reader should not assume that investments in the securities identified and discussed were or will be profitable.