The disruptive properties of Blockchain technology have the potential to transform a significant part of the financial services sector. Blockchain is a distributed database capable of holding a secure and immutable record of past transactions that is quickly adaptable to a broad range of activities and objectives. The World Economic Forum (WEF) referred to Distributed Ledger Technology (DLT) as a technology “that will form the foundation of next generation financial services infrastructure.” Data on blockchain technology collected by the WEF between 2013 and 2016 suggests over $1.4 billion venture capital investments in the industry; more than 2,500 DLT patent applications; more than 24 countries currently investing in DLT; more than 90 central banks engaged in DLT discussions worldwide; more than 90 corporations have joined DLT consortia; and 80 percent of banks are predicted to initiate a DLT project by 2017.

Financial services’ infrastructure cost savings associated with blockchain technology are significant. Although the majority of blockchain applications has been developed in the context post-trading market operations, blockchain has the potential to replace a significant proportion of existing manual processes, where information needs to be communicated and stored but is prone to human error. Facilitated by its potential to eliminate market intermediaries and create new foundations for economic and social systems, blockchain technology is an important example of a disruptive technology that can create new market structures. By 2022 Santander estimates $20 billion per year in savings for the U.S. banking system will be attributable to blockchain technology because of the reduction of banks’ infrastructure costs associated with cross-border payments, securities trading, and regulatory compliance.

Private investment funds in Europe and the United States play a major role in the evolution of blockchain technology in the financial sector. Private investment funds have invested earlier in the blockchain sector than other financial players. Because of legacy systems in the private investment fund infrastructure, the proportion of private investment funds that invest in blockchain technology is still small as a proportion of all private investment fund investments in technology. However, a growing subgroup of private investment funds is embracing blockchain and smart contracts (as well as artificial intelligence and machine learning that are beyond the scope of this article).

Private investment funds benefit from blockchain in multiple and often parallel ways. While some funds use the technology for the purpose of investing in crypto-currencies or indirectly making profits investing in blockchain start-up companies, other private investment funds are investing in start-up companies with the purpose to internalize the new technological applications within their business model. By optimizing their internal processes via blockchain technology, smaller investment fund managers gain unprecedented opportunities to compete with more established fund managers in markets that were previously dominated by larger players. Moreover, consistently with the general trends of market fragmentation and disintermediation, smaller private investment fund managers started to erode the power of established market institutions such as banks and insurance companies.

1. United States

Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model. While some funds simply focus on trading bitcoin and other cryptocurrencies to avoid market fluctuations, others invest in and/or acquire companies that use blockchain technology to provide synergies to their other portfolio companies. Yet others go much further by fully automating a hedge fund secured by blockchain technology, using blockchain technology to improve administrative procedures of private equity deal making, or using cryptocurrencies as incentives for data scientists’ competitive models that facilitate investment analysis efficiencies. Examples include private investment funds such as Polychain Capital, the Northern Trust in cooperation with IBM, Numerai, LendingRobot, and Intellisys Capital LLC, Melonport, among many others.

Several private investment funds have spearheaded and continue to expand the implementation of blockchain technology and smart contracting in their business models. In February 2017, Northern Trust and IBM entered into a partnership for the commercial use of blockchain in the private fund industry. The partnership provides an enhanced and efficient approach to private equity administration. The implementation of the Northern Trust and IBM blockchain is intended to increase the efficiency, transparency, and speed of private equity transactions, improve security, and bring innovation to the private equity market by simplifying the complex and labor-intensive transactions in the private equity market. While the current legal and administrative processes that support private equity are time consuming, expensive, lack transparency, and involve lengthy, duplicative, and fragmented investment and administrative processes, the partnership’s solution delivers an enhanced and efficient approach to private equity administration. More specifically, unlike the current deal practice in private equity, which requires parties to reconcile multiples copies of the documents that form the deals to understand the greater picture, the blockchain program announced by Northern Trust and IBM allows all involved parties in an equity deal to look at a single compiled version of the transaction and all other data relating to the deal.

Another example of the use of blockchain technology for private investment funds is Numerai. Numerai is a private investment fund with a global equity strategy that will go live on the blockchain later this year. Numerai operates on the Ethereum blockchain, utilizing a cryptocurrency called “Numeraire.” Numerai uses artificial intelligence to convert financial data into machine learning problems for data scientists. On February 21, 2017, Numerai, announced: “[Today] 12,000 data scientists were issued 1 million crypto-tokens to incentivize the construction of an artificial intelligence hedge fund.” Using data scientists for investment analysis creates efficiency through a synthesis of data. Data scientists working in this model work to solve the same problems in their own unique way with different strategies. Numerai synthesizes these models to create a meta-model out of all the predictions from the data scientists. In the Numerai model, the use of artificial intelligence ultimately helps achieve the goal of efficiency and optimum capital allocation by reducing overhead costs because there is no cost of human capital. In addition, Numerai eliminates barriers to entry because users do not need capital or any special finance or data knowledge.

LendingRobot’s LendingRobot Series is a fully automated hedge fund secured by blockchain technology. Unlike other blockchain based hedge funds that invest specifically in cryptocurrency, such as Global Advisers and Polychain Capital, the LendingRobot Series invests in lending marketplaces: Lending Club, Prosper, Funding Circle, and Lending Home. Its trading is determined by an algorithm based on the investor’s risk preferences. Once the investor has created a trading profile, LendingRobot selects and executes trades that are recorded in the blockchain public ledger on a weekly basis. Unlike traditional hedge funds that are rather secretive, the LendingRobot ledger shows detailed holdings and provides a “hash code” signature as evidence that the data is tamper-proof in the blockchain. Established private investment fund managers may consider implementing blockchain technologies in the foreseeable future. Most large fund advisers in the private equity and hedge fund industry have not yet considered implementing blockchain technology in combination with big data applications and artificial intelligence. This, however, may change in the foreseeable future if and when larger managers realize that their smaller competitors who utilize these technologies gain substantial operational efficiencies and cost savings and are able to substantially diversify their portfolio holdings via such technologies. The threshold for change for bigger managers may be dictated by the implementation cost of such new technologies.

If and when the long-term benefits of using the technologies exceed the implementation cost, which are much larger for larger managers than for the smaller managers who are currently experimenting with such technologies, larger managers are incentivized to start the innovation process as well.

2. Europe

In Europe, venture capital funds are the most engaged asset class in blockchain technology. European venture capital funds are engaged in building new blockchain applications and platforms. A group of the U.K.’s biggest asset management companies (Schroders Investment Management, Aberdeen Asset Management, Columbia Threadneedle Investments, Aviva Investors and Henderson Global Investors) partnered to invest in a secret project on blockchain, in particular to test if blockchain can be used to cut trading costs, by removing intermediaries and reducing manual processing of trades, and intervening in the direct trading of illiquid securities. Moreover, Neufund (participated by the Atlantic Fund), is building a blockchain-based and investor-directed platform, whose main purpose is to bridge the world of blockchain and venture by enabling the creation of a new kind of VC fund. The fund attempts to unlock the resources of cryptocurrency and blockchain to fund startups and any form of technological innovation and disruption.

Similarly, Bigchain DB, financed by Anthemis (London) and Early Bird (Berlin), attempt to support developers and enterprises to deploy blockchain proof-of-concepts, platforms, and applications with a scalable blockchain database. Bitbond (financed by Point Nine) is a global marketplace lending platform for small business loans who attempts to make investing and financing globally accessible. Point Nine has also invested in Chainalysis, to manage the security of digital assets. Coinsilium, venture capitalist based London, invests in the development of blockchain companies through a consortium of investors. Among others, Coinsilium has invested in SatoshiPay, a company that “is developing a two-way payment platform, which enables online content providers to monetize their digital content through the acceptance of nanopayments.”

The venture capital firm Blockchain Capital is raising capital through an Initial Coin Offering (ICO), a new form of crowdfunding based on cryptocurrency tokens, selling its own Ethereum-based smart contract digital token for its venture fund, where they represent an indirect fractional non-voting economic interest in Blockchain Capital III, Digital Liquid Venture Fund, LP. Started as a phenomenon that is revolutionizing the way start-up companies investing in blockchain raise capital (in the last 12 months ICOs have raised $331 million, overtaking venture capitalists’ investments), it may become an alternative method for many traditional companies.

The implementation of blockchain technology often goes hand in hand with the use of big data applications and artificial intelligence, also by established larger managers. The abovementioned examples refer all to the implementation of blockchain and smart contracts. A similar trend is the one of investment fund managers implementing AI and machine learning technologies. This is the case, among others, of Aidyia, a Hong-Kong based hedge fund, trading in U.S. equities, or Bridgewater, building an algorithmic model to automate the firm’s management.

3. Trends

The analysis in this article suggests that the market for private investment funds who invest in- and utilize blockchain technology appears to be near equally divided between the U.S. and the EU with Russia and China playing a significant role. We interpret parts of the data as suggesting that larger private investment fund advisers in Europe may be more willing to make the required investments into blockchain infrastructure whereas in the U.S. the legacy systems utilized by larger private investment fund advisers create barriers to entry for larger private investment fund advisers to invest in and utilize blockchain technology. On the other hand, the data also seems to suggest that the larger European fund advisers use the technology predominantly to invest in- and secure crypto assets whereas American fund advisers appear to use the smart contracting features of the technology more frequently to build more advanced crypto businesses and business structures via blockchain technology.

While the overall proportion of strategies of private investment funds that utilize modern technologies, including blockchain technology, is still small, as the private investment fund industry’s use of blockchain technology grows and accelerates, the innovation benefits for private investment funds and their clients promise lasting change for the industry.

Private investment funds’ bank disintermediation through the implementation of blockchain technology will depend on their ability to find scale opportunities. Future bank disintermediation via private investment funds also depends on the funds’ ability to participate in the technological integration of blockchain systems with other technologies such as artificial intelligence, machine learning, and big data.

The full analysis by Wulf A. Kaal and Marco Dell’Erba, Blockchain Innovation in Private Investment Funds – A Comparative Analysis of the United States and Europe (July 14, 2017). U of St. Thomas (Minnesota) Legal Studies Research Paper No. 17-20 is available at SSRN: https://ssrn.com/abstract=3002908

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Wulf A. Kaal

Wulf Kaal is a tenured associate professor of law at the University of St. Thomas School of Law in downtown Minneapolis. He is a leading expert on hedge fund regulation in the United States and the European Union.  Before entering the academy, Kaal worked for Cravath, Swaine & Moore LLP in New York and Goldman Sachs in London.  Kaal has published more than two dozen articles in the United States and Europe. His articles were published in leading peer reviewed law and finance journals and in American law reviews such as the Minnesota Law Review, the Washington & Lee Law Review, and the Wake Forest Law Review, among others.  Kaal’s study on the effects of hedge fund registration requirements under Title IV of the Dodd-Frank Act has gained national attention and was covered in a Business Week article and other journals. He is the author of a book chapter on Investment Advisers and Investment Companies in the Securities Law Handbook published by Edward Elgar.
He has also been a consultant to major corporations and hedge funds regarding various aspects of financial markets and regulation.

 Wulf A. Kaal
Associate Professor
University of St. Thomas School of Law
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Minneapolis, MN 55403
United States
 

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