The Disruptive Potential of Crypto-Technologies for M&A Markets

1. Introduction

Recently, the established German newspaper Welt published an article with the translated title: “A Dead-Certain Guide to Getting Rich”. In the subsequent text, the author speculates that “every generation has the chance to get rich within a very short period of time. Today the name of the game is blockchain – and you presumably just miss it”.¹

Bitcoin’s current all-time high, recorded in December 2017, topped out at EUR16.892,34² leaving investors with a familiar dilemma; asking themselves whether “jumping on the train” at the current level of below EUR 5,700 (as of November 17, 2018) represents their chance at a cheap entry opportunity – or the proverbial catching of a falling knife.

For deeper insight into today’s digital economics, we should consider how blockchain can add value in various economic applications, extending beyond simple currency speculation.

With that in mind, this work seeks to reason with the question of the prospective impact of cryptocurrencies (respectively crypto-technologies) on financial markets, with an emphasis on its disruptive potential in M&A business.

The second chapter deals with relevant terms and theories in the crypto-environment, while the third briefly analyzes how crypto-technologies work; mentioning main differences (respectively, advantages and disadvantages) to established technologies and currencies, including some market data. Finally, the fourth chapter aims to resolve the research question.

As this is a young topic rife with speculation and lacking in universally accredited research, particularly with regard to the aforementioned question, it should be noted that there are hardly any established theories from which further knowledge can be deduced. Therefore, the scientific approach here will be primarily induction, on a heuristic basis.

 

2. Terms and Theoretical Background

Basically a definition cannot claim truth in a scientific way.³ Definitions can only be evaluated when representing underlying processes through suitable means. As the subject in this case is budding and innovative, many of the subsequent definitions can be classified as “work-in-progress”.

• Token, or Utility-Token: Proprietary digital currency of a blockchain-project. Tokens are often treated like stocks or shares of a project. Tokens are sold during an ICO (cf. chapter 3.4) and constitute start-up capital to realize a certain project.⁴
• Proof-of-Work vs. Proof-of-Stake: Proof-of-work is a consensus-algorithm. With the aid of this algorithm, miners provide a decentralized resource to the blockchain in terms of computer capacity, in order to take part in the validity process. Proof-of-stake was introduced in 2012 by Peercoin to divert from the energy- and hardware-intensive mining process. The eligibility to validate blocks with this variant depends on the amount of own cryptocurrencies.⁵

Dealing with a theory, or at least a theoretical concept of cryptocurrencies, based on these definitions is where things become complicated. Due to the innovative status of the subject, there is no established theoretical basis so far. One possibility would be to apply money theories. But the first question that suggests itself here immediately is: Is a cryptocurrency “money”, at all?

There are three generally accepted functions of money: money serves as a medium of exchange, as a unit of account and as a store of value.⁶ If the first function is regarded with favour, Bitcoins can then be called a medium of exchange. But, this medium is generally not accepted … so does it fulfil the first function? The second function, recently resolved by a German court (Kammergericht Berlin), indicates that due to its interpretation Bitcoins are not a unit of account.⁷

The answer to third function is at very least, complex. In 1900, Georg Simmel with his publication “The Philosophy of Money”⁸ noted that everything (not only money but the economy and very nation itself) depends on trust in the intrinsic value of money. According to Simmel, money is perhaps the most concentrated form and expression of trust in the social and public arrangement of a nation; which, would only be possible in case of price stability.⁹ Neither stability, nor trust, are qualities that cryptocurrencies can claim so far. Although as history shows: this is something that neither German nor other national banks can claim themselves in a realistic way, as they have also been bankrupt several times throughout the last century. At the very least, a legal status and a generally-accepted mandatory status pretend to deliver this stability. As long as the citizens believe in the currency´s ability to store value and trust, the social and public arrangement of a nation, and as a result the third function, is fulfilled. Consequently, Bitcoins do not fulfil this third function as the necessary legal status is missing.¹⁰

Of course, the briefly mentioned points about the money function of cryptocurrencies offer a lot of stimulation for a further theoretical discussion, and perhaps even some deductive insights based on existing theories. Also macroeconomic considerations – like the work of Koenig regarding Bitcoins, from the perspective of the Vienna School of Economics – offer interesting insights into the topic.¹¹ Theories in the fields of Behavioral Finance may also help to explain the formation of recent course bubbles within the crypto markets, but this question would compose another article entirely. In order to answer the questions addressed in the introduction, an inductive approach seems to be the more promising one. For this purpose, the operation and characteristics of crypto-technologies will be illustrated in the next chapter.

 

3. Crypto-Technologies – Operation and Characteristics

Contrary to physical goods, digital data can be copied in a relatively easy way. How can it be assured by the buyer that the seller did not generate a copy of a cryptographic currency – cryptocurrency – just before selling it, which he still owns after the sale of the original? The solution is known as Distributed Ledger Technology (DLT), and will be explained in the next subchapter.

 

3.1 Distributed Ledger

Distributed Ledgers are special data bases which execute transaction data without centralized control or authorities, or the necessity of mutual trust; but, with perfect transparency.¹² It operates by a collective booking system which adds a new position as soon as a transaction between a sender and a receiver has been received and verified.

Based on DLT, an unauthorized or unseen duplication of a digital file is literally impossible. DLT stores digital data not at one place, but rather decentralized on many peer computers (so called “nodes”)¹³ in different, independent locations spread over different countries, continents, or institutions simultaneously. Thus, the right to read a file is not only stored on one central computer anymore. All users of the file will administrate this authorization in common. Only the owner of a specific digital key is able to use the file or forward it.¹⁴

There is, however, an additional (and for many applications virtually crucial advantage) of DLT: although the participants of the peer-to-peer-(P2P) network do not know each other, and even mistrust one another by nature, a centralized administrator who executes the new entries into the data base is not necessary. After a successful verification or rather agreement new sets of data can be added by all participants of this network by their own. Due to a subsequent actualization and synchronization process, all participants will be informed about the current status of the data base – and will accordingly know who the identity of the effective owner of the original data (in a faster and cheaper way; See figure 1).¹⁵

 

Source: Sphene Capital

Depending on the access possibilities of the network participants, Distributed Ledgers can be distinguished in “permissioned” and “unpermissioned” ledger. While in the first the access to the book of accounts is regulated, the second ones are accessible for everyone. The blockchain is the most common example for unpermissioned ledgers, and, will be the subject of the next subchapter.

 

3.2 Blockchain

In order to expand the distributed book of accounts for all participants (“peers”) identically, and to assign digital data biunique, a matching-, synchronization- und validation process among the peers is necessary. For this purpose, a so-called “consensus mechanism” (e.g. proof-of-work, proof-of-stake or practical byzantine fault tolerance) comes into operation. Those algorithms exactly define, which requirements have to be fulfilled in order to add a new valid transaction to the book of accounts. The consensus mechanism guarantees that a file will not be consumed several times, e.g. by copy-and-paste (solution of the so called “double-spending- problem”).¹⁶

The most familiar consensus mechanism is the blockchain- system, that often is used erroneously as a synonym for DLT in general. The basic difference between blockchain and other available data bases is that a blockchain offers a consistent and reliable agreement for a transaction though the parties involved pursue different goals. This agreement is based on the earlier determined and immutable consensus mechanism.

The concept of the blockchain – invented in 2008 by a pseudonym called Satoshi Nakamoto17 to serve as a public transaction book for the cryptocurrency Bitcoin – is a continuously growing list of data sets – called blocks – that can be linked up through cryptographic methods in a sequential way and stored locally afterwards (according to DLT). Each new block contains hash-information of the previous block (or so called “Merkle Tree”), a time seal, and the data of the new transaction. All of these single transactions are attached and stored to the end of the blockchain.¹⁷

Once recorded, the data in any particular block cannot be changed retroactively without changing all of the subsequent blocks – which would require a consensus of all of the participants of the network. Finally, there is a book of accounts consisting of interlinked blocks with transactions, the blockchain, that becomes longer with every transaction. As the book of accounts is open, it is comprehensible for every peer whether a certain transaction is valid or not. Thereby it is ensured that B (cf. figure 2) does not transfer a higher amount to C than B owns. Fraud of the blockchain should, thereby, be impossible by design.¹⁸

The next subchapter will show a further extension of this basic concept.

 

3.3 Smart Contracts

Currently there is focus is on another important function of the blockchain-technology, the so-called “Smart Contracts”. These contracts are single- or linked-programmed intelligent contracts. They are based on fixed determined sequences that are inalterable once they are published, verified, and stored within the blockchain. The terms of the contracts can now continuously and autonomously be screened if one of the ex-ante defined conditions has been confirmed, and the corresponding reaction has been executed automatically.¹⁹

 

Source: Sphene Capital, PWC*

The participants hereby expect faster and more cost-efficient contracts that additionally offer a significant benefit in legal security. For example, a chain of rules would be possible whereby B saves the bitcoins constantly transferred from A, as long as the amount of BTC 15 is not reached; from that moment on all incoming bitcoins are used to amortize a debt from C.

Smart contracts are enabled by decentralized autonomous organizations (DAOs) – long term, programmed, and intelligent applications, that contain the assets and rules of an entire organization.²⁰

To represent those DAO´s, Ethereum was developed. It expands the characteristic features of the blockchain – cryptographic security, decentralized storage and immutability – using a new component: reliable business logic. Ethereum is a blockchain based on a turing-complete programming language. This allows users to create contracts like the ones mentioned above, or, in general, that code discretionary state transition functions.²¹

Like Ethereum, EOS is a platform for other crypto-projects offering basic technologies that open blockchain technology to mass markets. EOS-Tokens certify membership rights at the EOS technology platform. As EOS is not working with a “proof-of-work”-mechanism like Ethereum, but with a “delegated proof-of-stake”- mechanism that in contrast is not creating encryption capacities via mining, EOS can overcome scaling problems inherent to Ethereum. That is why EOS is already called an “Ethereum-killer”.²² The significance of EOS cannot be dismissed, as EOS gained more than four billion US-Dollars with their ICO.

Thus, economic applications of this innovative technology are mentioned. The next subchapter deals with respective business models.

 

3.4 ICO

Initial Coin Offerings represent a connection between (crowd)funding and blockchain-technology.²³ If smart contracts enable rule-based transactions, they can be a medium to acquire capital (similar to going public for companies). At first, smart contracts notice who places which deposit, to subsequently distribute shares of the issued tokens to the participants of an ICO and supply the right to sell them.

In dependence on the term Initial Public Offering (IPO), the first sale of tokens of a new blockchain-project is called Initial Coin Offering (ICO). A usually young company or start-up creates its own cryptocurrency and sells its unities (so called coins or tokens) for a prior defined price (usually in established cryptocurrencies) to the investors. A smart contract with a programmed code for single or linked DApps defines certain rules and procedures like conditions of the ICO or token-functionalities. Afterwards this investment will be used for the operative business of the issuing company, while the issued tokens are used as functional currency units in the future.²⁴

 

Source: Coindesk, Coinschedule, EY,* Sphene Capital

Similar to an IPO the tokens are sold during a predetermined period, or so-called “public sale”. If the conception of the Smart Contract defines a finite quantity of tokens, the company cannot issue any additional tokens after public sale (creation cap). Also, the issuer must determine if the tokens can be traded in a secondary market, or a so-called crypto exchange. This occasionally raises some considerable costs.²⁵

Basically, there are the following types of coins (respectively, tokens):

• “Currency coins” are designed exclusively as virtual currency. As a digital payment instrument currency coins are mostly based on its own blockchain. Examples for currency coins are Bitcoin, Litecoin, and Ripple.²⁶
• “Utility tokens” can be used for the upcoming application of a product or the claim to a service of the issuers. In this case tokens imply the function of a “digital voucher”.²⁷
• Equity tokens represent rights on the issuing company, for example a participation at the economic success of a company. They come as close as possible to shares or stocks.²⁸

ICOs are a highly-hyped way of venture financing. During the first half of 2018, more than double as much capital was placed by ICOs in comparison to the entire previous year. Figure 3 shows the development of the ICO-market for the last three years and figure 4 breaks the ICOs down to the countries of origin.

Now the requirements for dealing seriously with the research question are on hand. The next chapter attempts to give the answers from the author´s perspective.

 

4. Further Development of Crypto-Technologies for M&A

Given the same data and experiences so far there is diametrical disagreement about the evaluation of cryptocurrencies, even among people dealing with this topic in a professional or scientific way. On the one hand there are people like Brian Kelly who concede them no less than to change the world (in a positive way).²⁹ One the other hand, representatives like Nouriel Roubini seek to speculate an imminent crypto-apocalypse, referring to Bitcoin as “Shitcoin”, and marking blockchain as the least useful technology in the history of mankind.³⁰

As briefly mentioned, the challenge here from a scientific standpoint is the lack of a theoretical model so that no “what-if”-statements can be dedicated in a strictly deductive way. Thus, the explanations during this chapter will not raise a claim of impeccability. Nevertheless, heuristic techniques like conjectural conclusion based on the given empirical data, and experiences in similar issues as well as interdisciplinary transfer of knowledge, grant interesting insights and perception about realistic and recurring tendencies.

The mentioned advantages of the blockchain-technology such as decentralization, cyptographic security, transparency, immutability of data, same rights and obligations for every user, automatic settlements or reduction of know-your-customer costs (respectively cost at all) identify it as a disruptive technology, meaning that it may have the potential to change the existing rules, substantially.

 

Source: Coindesk, Coinschedule, EY,* Sphene Capital

“Give me control of a nation’s money and I care not who makes its laws.” – This famous quote, attributed to Amschel Mayer Rothschild around 1790³¹ visualizes that activities surrounding the question of who controls money are very “sensitive”. In Germany for example, there are about 30 regional currencies. Their legal status is at the least unclear, but they are nevertheless tolerated. The question is: what would happen if they would achieve real significance?

In 1932, in the midst of the Great Depression that was swashed from the US to Europe, there existed a little village in the Austrian Alps named Wörgl which issued its own money, the so called “Schwundgeld”. Despite the surrounding economic infirmity, Wörgl experienced a remarkable boom.³² But, as soon as around 200 other communities tried to copy this model, the national bank forbade the development of any additional local currencies. The concern for the citizens’ welfare was obviously an argument that had to concede to other interests.

One must not be a conspiracy theorist to acknowledge that not only the economic benefit but the absolute control of power as described by Mr. Rothschild bundles the interests of actors in the financial market with an enormous strength. So, if the conviction of Brian Kelly that alternative currencies can change the world really should become true, how likely does it seem that those who currently have the power would tolerate it? The NGO “Corporate Europe Observatory” counted nearly 1,700 lobbyists of the financial industry in Brussels at the EU government. This number excels, by far, the number of lobbyists of other industries, to include the pharmaceutical industry.³³

Notwithstanding, the probability does not appear to be very high that a technology that is utilized with great advantages and benefit in one industry can be banned for another one. In a likely scenario, the advantages of the blockchain (like cost reduction in particular areas) will be implemented in the current frame, while the system threatening aspects will be regulated. There is already some evidence in this direction as international regulating authorities are warning of ICOs in the meanwhile. The European Securities and Markets Authority (ESMA), European Banking Authority (EBA) and European Insurance and Occupational Pensions Authority (EIOPA) have all published a common statement to alert consumers of the dangers of buying cryptocurrencies or participating in ICOs.³⁴ The German BaFin reserves the right to examine ICOs and to intervene in case of legal violation.³⁵ Already in 2011 the BaFin has classified cryptocurrencies as financial instruments, and has claimed reservation ofauthorisation.³⁶ Thus the area of application of the German Banking Act, and based on it a respective certification, may be exercised at any time. Recent cases of fraud with cryptocurrencies facilitate any action in this direction on the pretext of consumer protection.

Consumer protection is an important aspect and has to evolve as new facets of this developing technology arise. According to CipherTrace, a cyber security company, there is an increase in cyber criminality in 2018 of 250 percent so far, compared to 2017. The harm in 2018 up to now is valued at about one billion US dollars. In addition, cryptocurrencies appear to be an attractive variant for money laundering.³⁷

The fact that landscapes in the banking industry may change dramatically as a result of new global players like Google, Apple, or PayPal, in conjunction with the slow but consistent abolition of cash money does not change this estimation as long as these new players operate in compliance to the traditional currency system. There must be a differentiation between crypto- technologies and cryptocurrencies. But, there are also tendencies to integrate crypto-financial services into the regular, current financial markets.³⁸

In Switzerland the Crypto Fund AG was recently licensed as an asset management company.³⁹ Those companies are usually under the supervision of self-regulating organizations in Switzerland, below the surface of the Swiss authorities for the financial markets (Finma). But there is also the Seba Crypto AG, which received 100 Mio SFR in private placement and has since applied at the Finma for a “real” banking license.⁴⁰ Now, not only for blockchain technologies but also regarding cryptocurrencies, there appears to be ways (or loopholes) providing access to the established financial system. As per a report of Krypto Fund Research, about twenty percent of the newly issued hedge funds in 2018 will be crypto funds.⁴¹

Until now, the US exchange supervision authority (SEC) had declined applications for Crypto ETFs (Exchange Traded Funds).⁴² The solution for admission to exchange markets seems to be so-called “Stable Coins”. Stable Coins are characterized through their coupling with the course of a real currency. In fact, The New York Department of Financial Services (NYDFS) recently approved two stable coins for the New York Stock Exchange. The Gemini Coin for example is one type of stable coin allowing users to send and receive US dollars on the Ethereum blockchain.⁴³ It will be strictly pegged to the U.S. dollar on a one-to-one basis, and through this assimilation of stable coins it appears that these coins may very well find their way into legality.

One specific sector of the financial industry, specifically investment banking, deserves special attention: M&A. In this case, established financial theories in the form of new institutional economics⁴⁴ can absolutely be applied. If there is no secondary market, such as exchange markets where fungible securities can easily be traded, there are three basic disadvantages. Firstly, it takes a lot of time. The necessary time to buy or sell a stock highly corresponds with the “booting time” of a computer and the necessary time required to login to an online broker software. If you talk with experienced people working in the M&A industry, you will hear that the time to sell a company that is not listed at an exchange market is six to twelve months on average.⁴⁵ Secondly, a lot of expenses tied to the transaction will incur, supplying lawyers with different backgrounds, auditors, tax consultants, business consultants, HR specialists, M&A consultant and all other temporal resources that the involved parties have to invest.

Thirdly, the risk combined with a non-listed company is evaluated higher by the financial markets – and therefore its price will be lower. A publicly-listed company has to disclose more data in a standardized way than the ones who are not listed. These publication duties are not only based on the formalities of the specific exchange markets; primarily, these are laws. Taking Europe as an example, these are not national laws but EU-laws (e.g. for the prime or the general standard at the Frankfurt exchange). The lack of this information poses a serious risk for the buyer. And, since Harry Markowitz, it is now common wisdom that risk and return go hand-in-hand in financial markets. This means that in order to achieve more return with the same operative result, the input must be reduced. As a consequence, there are studies that the purchase price of a company that is not listed in an exchange market is between twenty and thirty percent lower than the one of a listed company,⁴⁶ but only after six to nine months…and a lot of exhausting effort.

Two variants of the new institutional economics are relevant here. The principal-agent aspect means that there are different asymmetries in the relation between a principal and an agent, especially information asymmetries. The higher the asymmetry the more risk in a M&A situation for the buyer, and consequently, the lower the price of the company. This is beneficial for all the mentioned service satellites surrounding – but neither the buyer nor the seller.

The goal, hence, is to lower the risk. This does not necessarily have to happen by decreasing the information asymmetry.

In a debt situation, a borrower may have the worst rating available but nevertheless receives a credit. The solutions are collaterals. A bad rating is usually a high risk for a lender; but if there is a collateral, he does not have to care about who the borrower is because he can exploit the collateral in any case. So, there is basically no risk – despite a high information asymmetry. A similar result may be achieved with the introduction of smart contracts in the M&A industry. Maybe companies have skeletons in the cupboard; but, things like this could be integrated in the blockchain utilizing automatic consequences – specifically, without long-lasting law suits and uncertain outcomes, and again massive resources that have to be invested. Additionally, if the purchase of a company happens via tokens, they can be sold much easier through digital trading platforms afterwards. Thereby, it is not necessary anymore to find one big investor – instead, the sale can happen on the mass market with innumerable small investors.

The next aspect of the new institutional economics is the transaction-cost theory. According to this theory, a transaction is becoming cheaper the more often, and safer, and less specific it is.⁴⁷ Now, it is thinkable that on the Ethereum platform a standardized blockchain for company acquisitions is available, as an example. This blockchain could be interpreted as equipped to deal with different standardized challenges of every M&A transaction, such as the assessment of pension accruals or the correction of the EBIT by extraordinary results. With a coordinated blockchain, matters like this would not be relevant anymore. The given EBIT from the income statement could be used, and if afterwards certain ex-ante fixed conditions would occur – automatic corrections of the multiplicator and the consequences within agreed periods of time would be initiated. Of course, there should be interfaces to adjust these standardized blockchains by the needs of the individual transaction.

Even if the technological development is just at the beginning,⁴⁸ its further development in this direction would turn M&A coherent services inside out. On the latest imaginable level services like tax consultancy, audit or legal advice would largely be obsolete. There would be a standard smart contract with optional modules that can be added individually. The task of an M&A consultant would then merely be to tailor the standards to the needs of the respective deal and parties. Even the sales function could be omitted to a large extent by inserting smart contracts by prospective buyers or sellers in M&A databases. The search for matches and their mutual proposal would be fulfilled by software. Confidentiality or other requirements could be ensured on sanctions based on smart contracts and thus fair dealing could be achieved on a higher level. Most of all the time needed for a transaction could be reduced to weeks. The new focus of companies in the M&A business would be to provide the respective IT services.

Based on these considerations, it appears in summary that crypto-technologies would be disruptive for the M&A business as previously mentioned. Risk could considerably be reduced, as well as the time required. And according to the principal agency theory and rules of the financial market, the risk discount for transactions beyond exchange markets could eventually be erased.

After a project with the Deutsche Bank the Deutsche Börse communicated that blockchain-technologies are appropriate for the operation of a financial market´s infrastructure.⁴⁹ During the World Economic Forum 2017 in Davos, it was prognosed that until 2027 not less than 10% of worldwide gross domestic production will be stored in blockchains.⁵⁰ As explained, we cannot predict to which extent this number will also be valid for the M&A business. Ultimately, due to all the arguments listed, we claim that it will at least be a good idea to keep track of upcoming developments in this area – and to be prepared in case of a disruptive change in the name of the game.