A new paper by Wulf A. Kaal, an Associate Professor at the University of St. Thomas in Minnesota, looks at the proliferation of blockchain-related innovations in the world of private investment funds. In an earlier paper, Kaal discussed the impact this is having on the fee structure of that industry. But in the newer paper his attention is on innovation itself, and the ways in which it generates benefits for the industry’s clients. Blockchain, which Kaal defines in standard fashion as the use of a distributed ledger “where all participants are equal and verification and validation of each transaction is provided by all parties in the network,” certainly has had other enthusiasts. Kaal cites John Naughton, who in The Guardian a year and a half ago referred to blockchain as “the most important IT invention of our age.” But it is Kaal who makes a niche for himself among the enthusiasts by looking at the benefits blockchain offers the trading, as well as the middle and back offices, of asset managers. Lawyers out of the Loop One of the benefits of blockchain technology is that it in turn enables smart contracting, and smart contracting allows parties to cut out the lawyers from the productivity loop. A blockchain can transfer value and represent title to property, in ways that require virtually no human mediation or counterparty risk. In a description that Kaal borrows from Ethereum, smart contracts are “applications that run exactly as programmed without any possibility of downtime, censorship, fraud, or third party interference.” Indeed, Kaal cautions that the legal profession, whether in service to affected clients or in self- preservation, may take to the argument that “smart contracts” are void and unenforceable. In now-standard business management theory, the disrupting innovations are said to come from marginal players and start-ups. Clayton Christensen, back in the 1990s when the internet itself was the hot new disruptive influence, wrote The Innovator’s Dilemma. He explained why great companies become locked into doing things the way that has worked for them, and how it becomes virtually impossible for them to innovate – the torch of innovation passes to the marginal. That is precisely what Kaal describes in the asset management industry. Various startups “attempt to replace intermediaries in many types of transactions, including and most notably contracts analyses, real estate, and intellectual property.” There is a platform (clause) for self-managing legal contracts; one (binded) for tracking and enforcing copyright and yet another one (ascribe) to establish digital ownership of art and other creative works. Robotic Trading One investment fund that intrigues Kaal is LendingRobot, which invests in lending marketplaces such as Prosper Funding Circle and Lending Home. What fascinates him is that its trading is automated, an algorithm based on investor risk preference. Due to blockchain technology, all transactions are a matter of public record, in compliance with best execution obligations. This facilitates the location and auditing of trades, internal investigation, and reporting to regulators. Kaal also writes admiringly of Numerai, a global equity hedge fund which has issued its own cryptocurrency, Numéraire, on the Ethereum blockchain. This involves the combination of blockchain technology with other cutting edge developments of our time, Big Data and artificial intelligence. Numerai’s blockchain cryptocurrency “increases efficiency and optimum capital allocation by reducing overhead costs.” Banks Out of the Loop Blockchain might very well diminish the role of banks in the asset management industry. As Kaal writes, banks charged $1.7 trillion in processing fees in 2014. But with blockchain “financial transactions can be executed instantaneously at near zero transaction costs, increasing the efficiency for businesses and individuals exponentially.” Banks and related institutions have lately become big investors in blockchain. Kaal postulates that this investment arises out of their sensible fear that they are being outflanked. Blockchain isn’t solely good news for fund managers. After all, it increases competitive pressures in their own industry (and here Kaal reconnects with the subject of his earlier article, on the fee structure). This of course is good news for their investors/clients. It isn’t just fees, though but liquidity as well, where investors in funds receive benefits from this increased competition. LendingRobot’s investors “can withdraw funding on a weekly basis at no additional cost.”
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