Perspectives

Blockchain’s power revolutionizes M&A

Trust is the cornerstone of every transaction, whether it is buying a book online or selling shares of stock on an exchange. Transactions often rely on intermediaries such as real estate agents and stock brokers to facilitate trust between the parties.

Without these intermediaries, or “trust vendors,” many markets would simply not exist. Hence, these trust vendors act as market makers. In return, they are able to command a high price for their services; for example, average fees for a real estate broker can equal up to 6% of the transaction value.

This high price does not guarantee fast and efficient service. Some financial transactions can take up to 20 days to clear, and purchasing a house is a complicated, months-long process. Although there are ways to optimize the current framework of intermediation, the most revolutionary of these lies in the blockchain, the technological infrastructure that underlies bitcoin.

A blockchain is a fast, decentralized and irrefutable ledger of transactions that is maintained by the participants in a system, thereby eliminating the need for an expensive intermediary. As an agent of trust, a blockchain has the power to (i) expand current “transactional” markets through infusion of trust and reduction of transaction costs, and (ii) create new markets through capabilities enabled by the blockchain.

Major players supporting blockchain

Across industries, players are racing to tap into the market-making power of blockchain technology. Big banks like Goldman Sachs, JP Morgan, Credit Suisse, and Barclays have joined forces to construct a blockchain architecture for financial transactions that could replace intermediaries like exchanges and clearinghouses.1

The Government of Honduras is exploring putting its entire real estate ledger on a blockchain. In order to achieve its potential, the blockchain still has to overcome the technical and psychological barriers that confront any technology in its infancy.

Assuming the blockchain’s current limitations will be addressed, we believe that thousands of public, private and hybrid blockchains will emerge — handling everything from selling stock transactions to paying for energy credits. By adding trust and reducing transaction costs, the blockchain has the potential to revolutionize existing markets, as well as create new growth sectors.

Trust: the cornerstone of every transaction

To fully understand the value proposition of the blockchain, we must first establish the rules of engagement that govern transactions.

We posit that trust is a crucial component in determining the value of a transaction. Increasing trust and security — which are currently rare, valuable and expensive — in a transaction reduces the transaction costs. Additionally, lower transaction costs generate a higher volume of transactions across markets, creating a driver for growth across entire industries.

Take the example of private automobile transportation. Passengers arriving at an airport are often approached by private drivers (who don’t own taxi medallions) who offer rides to the passengers’ final destination. Passengers are hesitant to engage these unlicensed drivers because they don’t have the information needed to trust that the driver will get them to their final destination in a safe and cost-efficient manner.

In circumstances where passengers do engage with these unlicensed drivers, they may take the effort to ensure that the unlicensed driver delivers them to their destination efficiently and safely (for example, by closely monitoring the driver’s route, informing a family member of the driver’s license plate number, etc.). These inconveniences are some of the “transaction costs” of purchasing the services of an unlicensed driver.

Now introduce popular private car-sharing applications (such as Uber or Lyft) into the mix. That same unlicensed driver has to undergo a background check before being able to offer rides on the mobile application. Prospective passengers can also view the driver’s rating from other passengers to draw conclusions about the driver’s track record of private rides, including cost and time of delivery.

Additionally, passengers know that the application offers customer service should something go wrong during or after the ride. As a result, the app increases the passenger’s trust in the unlicensed driver.

The passenger therefore may not feel the need to closely monitor the driver’s route or share the driver’s information with an acquaintance or family member. Thus, by increasing the trust between the passenger and the driver, the application has reduced the risk and transaction costs of hiring a private, unlicensed driver.

The explosive growth of private car-sharing applications proves that increasing trust not only reduces transaction costs, but also increases the volume of transactions. Private car-sharing applications have not only eaten into the market share of licensed taxi companies and other car services; they have also expanded the market for rides through innovations such as shared rides and the ability to request a specific type of vehicle (utility vs. luxury, sedan vs. minivan, etc.).

Trust has therefore served as a growth driver in the ride-sharing market and, once supported by blockchain technology, could do the same for other industries as well.

Figure 1: Net benefit with decreasing transaction costs

Increasing trust can rapidly increase the value from a transaction.

Understanding blockchain

Simply defined, a blockchain is a continuously growing ledger of transactions (financial or nonfinancial) that is shared among all of the participants in the blockchain network. Updates to the ledger are constantly being made through a digital appending of new “blocks” of aggregated transactional data to the current blockchain.

The blockchain is different from a conventional, centralized ledger system such as those used by banks or clearinghouses because it leverages individual actors, or “nodes,” as opposed to a central authority, to validate transactions within a network. Updates to the blockchain must be agreed to and recorded by a majority of these users, thereby establishing an irrefutable chain of transactional data and preventing one user from unilaterally altering transaction records.

The blockchain has rightfully been compared to other groundbreaking standards and protocols, such as TCP/IP. TCP/IP is a set of standards that dictates how computers should pack, address, transmit, route and receive data.

These foundational rules have facilitated the creation of the internet and the applications/activities we can perform online (such as browse websites, send and receive email, etc.). The blockchain can similarly be thought of as a set of standards that establishes trust between unconnected parties by recording transactions in a practically immutable, public ledger.

The existence of this public ledger has allowed for innovations such as bitcoin and other cryptocurrencies that rely on the blockchain as a reliable record of all transactions.

To understand the role that trust plays in facilitating and enhancing the value of a transaction, we have developed The Parthenon-EY Trust Framework. For a rational actor, the decision to engage in a transaction is governed by the transaction’s net benefit.

Net benefit of transaction = Total benefit from transaction – Total cost
Where:

    • Total benefit from transaction = Utility derived from consumption of good/service being transacted
    • Total cost = Price paid for good/service + transaction cost

An actor proceeds with the transaction only when the net benefit is greater than or equal to zero. In this case, the total benefit from the transaction is assumed to be fixed: the rational actor already knows the utility of what he or she is buying.

Within the total cost, the price of the good is also assumed as fixed. The only variable factor is the transaction cost. An example of a transaction cost is when an individual who buys a watch from a pawn shop, engages a third party, say an appraiser, to verify that the watch is authentic.

The cost of the appraiser is a transaction cost that the purchaser incurs to convince himself or herself that the good is authentic (and that the net benefit from the transaction is positive and acceptable)

Figure 2: Net benefit with a lower transaction cost curve

The blockchain ensures trust but at a lower transaction cost than other intermediaries.

The exact position of the total cost curve is a function of the mechanism used to ensure trust. When a trust-securing mechanism (or intermediary) is expensive and slow, the transaction cost for securing trust (say, shifting from “I don’t know you” to “I know you”) is higher (red line in graph). An efficient and cheaper intermediary can secure the same level of trust (moving the users from “I don’t know you” to “I know you”) but with a lower total (transaction) cost. This is where the blockchain comes in.

The blockchain is such a powerful facilitator of trust because it allows the users to shift their total cost curve down and to the left (dashed red line). Shifting the total (transaction) cost to the left not only increases the net benefit of every feasible transaction, but increases the pool of feasible transactions.

For example, the transaction denoted by the blue star in the chart above would not be feasible if the total cost curve was the solid red line. Because the blockchain makes it cheaper to enforce trust, the blue star transaction now becomes feasible.

Therefore, introducing the blockchain not only makes it cheaper to enforce trust in a transaction, but also increases the universe of feasible transactions.

Blockchain’s potential to revolutionize transactions

Although the blockchain is an early-stage technology, the outlook on its growth and impact is bullish. The two most active development areas are evolving blockchain technologies and (ii) developing applications to run on top of existing blockchains. Blockchain applications include:

Record of transactions

The obvious and most widely utilized application of the blockchain thus far has been its use as a record or ledger of transactions. With its guarantee of accurate authentication and minimal transaction costs, the blockchain has the potential to completely revolutionize how transactions are made by reducing transaction costs and replacing slow and costly mechanisms like clearinghouses and middlemen.

Examples include online and retail purchases, payments, invoicing, payroll, etc.

Identity verification

The irrefutability of the blockchain makes it an effective tool to verify identities of individuals quickly, accurately and inexpensively. Contrast this with conventional processes of identity authentication, such as ID cards or fingerprints, which are costly to implement, susceptible to fraud and don’t employ universal standards or protocols that can increase acceptance.

Examples of identity verification applications that blockchain technology could enable include financial settlements, birth and marriage certificates, academic records, car leasing and sales, business licenses and property titles, among others.

Tracking

Because of its universality and speed, the blockchain can be an effective tool to track movements of physical goods, and possibly even people. Items being tracked can check in and check out of locations tagged on a blockchain, a feature that can find applications in supply chains and logistics. A blockchain can supplement current tracking systems, such as radio frequency identification (RFID), which are not as accurate and require significant investments in infrastructure, technology and training.

By doing so, blockchains will help with speedier, accurate tracking of global supply chains across industries.

Smart contracts

A blockchain can serve as a medium to enable smart contracts. Smart contracts are analogous to regular contracts that we encounter in many aspects of daily life, except that they are virtual, more efficient to execute, secure, universally accessible and accepted, and less expensive than their non-virtual counterparts.

Blockchain technology can help enable contracts from the momentous to the routine, from enabling faster and secure mortgage applications and approval, to hosting your contract for a gym membership.

Cybersecurity

Cyber attacks are a constant and ever-growing threat for businesses, governments and, increasingly, individuals. By exploiting vulnerabilities in our cyber infrastructure, attackers can gain access to critical information that can endanger our security, our finances and our data.

Blockchains reduces the conventional cybersecurity risk by removing a critical weakness in our infrastructure: the need for human intervention. If individuals are able to directly upload an authorization to a publicly available ledger that is instantly verified and confirmed by numerous nodes in the system, this dramatically lowers the odds that a single rogue human actor can manipulate the authorization.

Internet of Things (IoT)

Another exciting new prospective technology on the horizon is the Internet of Things, or a world in which all devices are connected and communicative. IoT could make our lives more seamless by, for example, enabling a washing machine to order detergent before we realize it’s running low, or empowering an air conditioning unit to file a service request when it senses a malfunction.

Current IoT infrastructures still rely on central actors to control and monitor the entire system. A blockchain, on the other hand, could enable a decentralized IoT in which devices communicate directly with each other instead of having to rely on a central administrator to relay a message.

Some challenges do exist before blockchain technologies and services present the significant market opportunities many business executives expect and are currently investing in. Changing records in a blockchain requires a significant amount of computing resources, and there can be disruptions in the timing and execution of transactions.

Performance risk has been a contentious issue impacting the technology’s ability to scale. Questions remain about privacy and information disclosure needed for verification and security of transactions, which leads to uncertainty around regulatory considerations and possible hurdles with governments.

We posit that the industry will address security and regulatory concerns through innovation and education, thus paving the way for widespread adoption of blockchains in multiple applications. Indeed, the trust barrier is already being crossed, as is evidenced by the joint venture between the major banks (that are extremely sensitive to issues of security and reliability) and initiatives such as the one by the Government of Honduras to place its entire real estate ownership ledger onto a blockchain.

Figure 3: How the blockchain stacks up to popular trust-based businesses

An intermediary's ability to extract transaction costs varies by the tools it employs to secure trust in the transaction.

Blockchain’s applications across industries

Many industries are already exploring the use of blockchains in various applications:

Financial services

In September 2015, a consortium of nine major banks (including Goldman Sachs , JP Morgan, Credit Suisse, and Barclays) launched an initiative in collaboration with financial technology firm R3 to explore how the blockchain can be used in financial markets.2 Banks believe the blockchain could make their operations faster, more efficient and more transparent by replacing archaic settlement processes that, in some cases, can take up to 20 days to settle a trade.3

Analysts estimate that switching to blockchain technology could save major banks $15b-$20b on cross-border payments, securities trading and regulatory compliance by 2022.4 Interest in the blockchain isn’t limited to private sector participants: the Bank of England has identified the blockchain as a “key technological innovation” and has a team dedicated to the subject.

A major advantage of the blockchain as a protocol is that it can be tailored to suit the needs of specific applications. The open source nature of the technology, which lends itself well to transparency and decentralization, is anathema to big banks, which want to protect proprietary and client information.

One potential solution is a “permissioned blockchain” that is accessible only to a select group of participants.5 The ability to make such modifications makes the blockchain a versatile solution for the challenges of recordkeeping not just in financial services, but in other industries as well.

Real estate

A blockchain can be used to record and verify ownership of a physical asset. Real estate ownership information can be stored on a publicly shared blockchain, thereby doing away with the need for a central recordkeeping authority whose records can be difficult to access and are vulnerable to being manipulated.

There are two ways in which property ownership can be recorded on a blockchain: (i) the property itself could be registered as an asset on the blockchain, or (ii) a coin in a cryptocurrency (such as bitcoin) could be linked to that property and the ownership of that coin in the cryptocurrency universe would signify ownership of the physical asset.

The Government of Honduras has recently engaged Epigraph, an Austin, Texas-based title registry company, to develop a blockchain-based system of land registration. Historically, land has been transacted in Honduras through settlements and payments that are not recorded in any official governmental database.

The Government has attempted to address this problem by instituting a countrywide system of land registration. However, the system is riddled with corruption, allowing the well-connected to steal land and extort the poor. Epigraph plans to work with the Government to place the land registry system onto a blockchain.

By doing so, the database of land ownership can be shielded from fallible bureaucratic processes and tracked on an immutable ledger.

Pharmaceuticals

The pharmaceutical industry has long struggled with the issue of counterfeiting. Interpol estimates that 10% of medicines sold globally are counterfeit, a situation with potentially life-threatening consequences. Interpol has pushed partnerships between member governments and stakeholder organizations like the WHO to tackle this problem.

However, the lack of a universal tracking system has hindered this disjointed effort. A blockchain could be used to accurately track medicines along the supply chain and verify the authenticity of a drug.

An additional use could be in preventing prescription abuse. Currently, there is no mechanism for medical professionals and pharmacists to track prescriptions from multiple sources in the licit pharmaceutical market, allowing consumers to fill multiple prescriptions that are later resold, often for recreational use.

Companies such as Prescriptchain are working to tackle prescription fraud by giving medical professionals and pharma companies the ability to track and record prescriptions on a blockchain.

Crowdsourced delivery

Blockchains can increase the security and reliability of crowdsourced delivery mechanisms. Leading e-commerce players are developing applications that will permit a user to collect a package from a holding facility and deliver it to another user.

This mechanism could greatly reduce shipping costs while increasing delivery speed. The challenge, however, is how to track whether the right user has collected the right package and delivered it to the intended recipient.

The blockchain offers a solution. By placing the fulfillment details of a given product on a blockchain, e-commerce platforms can easily track any package from warehouse to recipient, thus making it possible to determine whether the correct person has signed for and received a package.

Since the blockchain is a virtually incorruptible ledger of transactions, no third party can change the details of a transaction and make it appear that a package has been delivered correctly when, in reality, it has not. This application can also be extended to drone-driven fulfillment processes to ensure accurate delivery of packages by drones.

A call to action

While the blockchain is an emerging technology, business leaders would be well served by understanding its revolutionary potential and the wide-ranging impact it could have on their industries. And first movers on this nascent technology can be market makers in their industries.

The first financial institutions that can successfully establish a cost-effective, efficient and secure marketplace that is run using blockchain technology could steal share from existing marketplaces for financial transactions. Countries and municipalities that can successfully transition real estate records to a blockchain could improve the transparency, efficiency and integrity of their real estate markets, improving sentiment among owners and prospective buyers.

In the same way that ride-sharing applications have upended the traditional taxicab model, the blockchain can change how industries operate.

Questions to consider 

Business leaders should be asking the following questions to understand the potential impact of the blockchain on their respective industries, and how they can influence it:

  • Do functions like transaction recording, identity verification and tracking, where the blockchain has already demonstrated potential, play a critical role in my value chain? Are there additional functions in the value chain that the blockchain could replace or improve?
  • Are current mechanisms to address these functions doing an effective job at fulfilling the needs of my employees, customers and suppliers?
  • How, if at all, could the blockchain address these needs?
  • What investments will I need to make (in capital, human resources, technology) to bring a blockchain-centric solution from concept to execution?
  • Can I scale the blockchain-centric solution in a way that is disruptive or gives me a distinct competitive advantage?

Blockchain’s growth based on reliability, speed and efficiency 

It is clear that the blockchain provides unique benefits of reliability, speed and efficiency at a lower cost than existing intermediaries. By doing so in a scalable manner, the blockchain can expand current “transactional” markets through infusion of trust and reduction of transaction costs and create new and bigger markets through more points of exchange and additional capabilities enabled by the blockchain.

An ecosystem of blockchain-focused start-ups and established companies are already working to remove obstacles to the blockchain’s growth and to invent unique solutions tailored to needs of different industries. These developments, and the underlying promise of the technology, make the blockchain an undeniably attractive opportunity for future investment and research.


 

About the authors

Barak Ravid is a managing director of the Parthenon-EY practice of Ernst & Young LLP and is co-head of the Parthenon-EY technology group. Based in San Francisco, Barak has 20 years of experience in providing strategic and advisory services to corporate, financial and institutional investors and in helping to solve their most complex business challenges.

Vidur Sehgal is a consultant of the Parthenon-EY technology group practice of Ernst & Young LLP based in San Francisco. He has extensive experience advising technology clients on strategic business issues, and working with private equity firms focused on mid-market technology investments.

Clark O’Niell and Sam Wang also contributed to this article.


 

Footnotes

  1. Jemima Kelly, “Nine of world’s biggest banks join to form blockchain partnership,” Reuters, 15 September 2016.
  2. Ibid.
  3. Edward Robinson and Matthew Leising, “Blythe Masters Tells Banks the Blockchain Changes Everything,” Bloomberg, 31 August 2015.
  4. Ibid.
  5. Ibid.