EFTA00793120.pdf

coldman bactis Investment Management Division An Overview of the Current State of Cryptocurrencies and Blockchain Technology November 15, 2017 Investment Strategy Group EFTA00793120  Investment Management tgta" Today's Discussion Division I. The Cryptocurrency Marketplace II. Blockchain Technology and Potential Uses III. How Cryptocurrencies Work IV. Is Bitcoin a Viable Currency? V. Is Bitcoin a Viable Asset? VI. Cryptocurrency Risks VII. Key Takeaways Source: Investment Strategy Group EFTA00793121  Investment Goldman Sachs Management Cryptocurrencies Have Received Enormous Attention Division 1. Bitcoin Currency Value — Through November 14. 2017 2. Cryptocurrencies with Market Capitalization over USS1 Billion 6120 107.5 7000 3100 6.590 592% 6000 YTD 302 2000 7.8 1000 3A 3.3 Is 1.8 1.7 1.7 1.8 eaccia unworn es tool nooks Dash LOSCOIn moos* NEO NEI.1 IOTA Elheteurn 0 Cash Classic 2011 2012 2013 2014 2015 2016 2017 • Bitcoin was conceived in 2008 by an anonymous inventor who is known by the pseudonym, Satoshi Nakamoto. • Since then, an estimated 2,000+ cryptocurrencies have come into existence, with a combined market cap of over $200bn.' • There are an estimated 129 focused hedge funds2 and 121 cryptocurrency exchanges globally.3 (I) (2)1 (3) htlps://cryplocciincharts.infolmarkets,inf o 2 Source: Investment Strategy Group. EFTA00793122  Investment (itfittinan Cryptocurrencies have Garnered Diverging Views Management Mchs Timeline of Statements and Measures over Recent Months Division Japan's FSA approves 11 operators of Japanese "It:s a cryptocurrency "Still thinking about "Bitcoin is 'a ponzi 1 fraud... worse than South government exchanges scheme' China tulip bulbs"' Korea #Bitcoitt. No recognizes Sept. 29, 2017 - DBS Group bans -J. Dimon bans conclusion - not Bitcoin as (David Gledhill) ICOs ICOs endorsing/rejecting " 3 legal tender Sept. 12, 2017 - Lloyd Blankfein Sept. 28, 2017 Apr. 1, 2017 Sept. 4, 2017 Oct. 3, 2017 Nov. 14, 2017 Sept 11, 2017 Sept. 17, 2017 July 24, 2017 Sept. 27, 2017 China bans BIS publishes Sept. 29, 2017 Oct. 13, 2017 US CFTC cryptocurrency report weighing "[Bitcoin is] ( SEC "Indierley approves exchanges risks and certainly more than charges two laundering." Bitcoin futures benefits of just a fad"2 ICOs with - Blackrock CEO trading cryptocurrencies - MS CEO, Gorman fraud Larry Fink (1) Barclays Investor Conference. September 12, 2017. (2) Wall Street Journal Event. September 27, 2017. (3) Twitter, October 3, 2017. (4) CNBC, November 14, 2017. 3 Source: Investment Strategy Group. public news sources. EFTA00793123  Investment Goldman Melts Management What is Blockchain Technology? Division Illustrative Schematic: Centralized Network versus Distributed Network Centralized Network Distributed Network ■ Blockchain is the critical and differentiating infrastructure that underlies cryptocurrencies. ■ Unlike most networks today, which rely on a centralized hub, a blockchain is a public distributed network whose complete database can be accessed and maintained by each member of the network. ■ The blockchain is a shared and continually reconciled database. As new transactions occur, data is quickly disseminated to, verified, and incorporated across all nodes on the network. ■ Because it has no single maintainer, the blockchain's history is resistant to editing by a malicious actor. Source: Investment Strategy Group. 4 EFTA00793124 Blockchain Technology Holds Potential for a Range of Investment Management tit* man rhti Applications Division 1. Financial Market Transactions 2. Identity Validation and Security Client XYZ Current T+ 2 State S ssi Ifft ereac iaer T+ 0 Blockchain- ILLIE Enabled • USOectlifele Settlement 410 . rrr Oelne Reale Iterat i se Secure Digital identity • Banks are focused on blockchain technology for post-trade • Potential to securely link identity and payment credentials to settlement and clearing, with aims to: a unique individual. I Streamline equities settlement from T+2 to T+0. I Benefit peer-to-peer businesses reliant on counterparty trust. ,/ Streamline compliance and anti-money laundering surveillance. • Goldman Sachs Global Investment Research expects limited blockchain adoption over the next 2-5 years, and broader acceptance after 5-10 years. — Capital market adoption may take over 10 years, given regulatory oversight and the multitude of participants. Source: Investment Strategy Group. GS Investment Research. Profiles in Innovation: Blockchain: Goldman Sachs & Co LLC, Blocchain. The New Technology of Trust, 5 EFTA00793125 What is a Cryptocurrency and Investment Management Goldman baits Why is Blockchain Technology Important? Division Common Features of Cryptocurrencies Common Features of Attributes Cryptocurrencies / • Coin ownership is represented by entries on a digital Digital ledger, not by a physical token. Decentralization • No single entity controls the currency. V. Open Source • All source code is available freely online. Distributed • Each cryptocurrency uses a method for obtaining Consensus consensus on ownership without a central arbiter. • Coin ownership is not linked to real-world identities V. Pseudonymity within the blockchain. Cryptography • Several cryptographic techniques are used to verify (computerized encoding) transactions, protect identities, and limit supply. • A cryptocurrency is a decentralized digital coin. It allows users to make transactions and store money in a secure and pseudonymous manner. • All cryptocurrency transactions are recorded chronologically on a blockchain, which acts as the critical infrastructure underlying a cryptocurrency. • The process of verifying transactions and ensuring the validity of the blockchain is called "mining." • Mining solves the "double-spending" problem that had plagued previous attempts to implement a digital currency. Source: Investment Strategy Group, 6 EFTA00793126  Investment I joldinan Salts Management How Do Miners Process Individual Transactions? Division illustrative Schematic of a Bitcoin Transaction Step 2: Miners Verify the Transfer Request and add Step 3: Block Containing Bob and Alice's Step 1: Bob wants to pay Alice 0.5 BTC it to the next block Transaction is Added to the Blockchain Miner B Bob Alice • • Bob owns 1BTC Bob wants to pay Previous Transaction New transaction Alice 0.58TC in wh.ch Bob was paid 1 BTC Does Bob have 1 Miner 0.58TC?? Miner A C Bob has 1BTC ecord ob s Bob owns IBTC 0.58TC Transfer 1) Before sending any bitcoins, Bob must hold bitcoins to Alice Bob wants to pay Bob wants to pay in his wallet from a previous transaction (or by Alice 0.58TC Alice 0.5BTC 1) Miner B happens to be the first to solve this block solving a block to earn the mining reward). Does Bob have Does Bob have and adds it to the blockchain. Miner B collects 12.5- 0.58TC?? O.SBTC?? bitcoin reward. 2) Bob creates a new transaction in which he pays 0.5 BTC (of his 1 BTC) to Alice. Record Bob s Record Bob's 2) If Bob's transaction is included the block. Alice 0.58TC Transfer 0.58TC Transfer becomes the owner of 0.5 BTC, which will register 3) Bob broadcasts this transaction to the network for to Alice to Alice in her wallet. validation and inclusion in the blockchain. ■ Consensus transaction validation creates a book of record for all transactions that have ever occurred. — Transactions may only occur if they are supported by evidence from previous transactions. — To send bitcoins, an owner's wallet uses its private key to prove ownership of the referenced bitcoins. ■ Transaction processing typically take 10-20 minutes, but can take up to 18 hours if the network is congested. Source: Investment Strategy Group. 7 EFTA00793127  Investment Gifitintan Sachs Management What is Mining? Division ASIC Mining Computer and a Mining Rig ■ Miners use highly specialized computers designed to run an algorithm that attempts to solve a cryptographic puzzle in order to add a new block on the blockchain. By design, a bitcoin block is created once every ten minutes. ■ The computing power required to solve the cryptographic puzzle is high and expensive; bitcoin mining consumes an estimated $1.3bn worth of electricity annuallyl—equivalent to Ireland's annual electricity consumption. ■ In order to incentivize mining, the first miner to complete a block is rewarded 12.5 bitcoins. The global supply of bitcoins is capped at 21mil (currently —16.5m) and follows a predetermined growth rate—the miners' rewards halve every four years. ■ Given -1-1.5m mining units globally, the likelihood of any one miner solving a block is low. Many miners join "mining pools," which are cooperatives which share block rewards proportionate to contributed mining power. — Mining pools are highly concentrated; the top four pools represent over 50% of total mining power. (1) Bitcoin Energy Consumption Index: htlosikkoiconomianettitcoin-enemv.consumotion 8 Source: Investment Strategy Group. EFTA00793128  Investment tiolthithit Sachs Management ICOs Fund the Development of New Currencies Division i 2. Total Funds Raised by Month (US$ Millions): Angel and Seed Stage 1. Approximate Funds Raised by ICOs by Calendar Year (US$ Milllions) Internet VC versus ICO $4.000 900 a Mgel & Seed VC Funding (Internet) • 1CO Fundraising 839 $3.461 800 Approximate Annual Funds RetsedThroughICOs (Smil $3.500 700 $3.000 638 ssoo 2 $2.500 49 500 $2.000 cc e 400 U. 346 $1.500 3 ° 300 262 256 259 235 $1.000 207 200 190 $500 loo $26 514 12 [ 19 2 so 0 2014 2015 2016 2017 YI'D 7/16 8/16 9/16 10/16 11/16 12/16 1/17 2117 3/17 4/17 6/17 6/17 7/17 8/17 9/17 • New blockchain-related projects are funded via an Initial Coin Offering (ICO). This process raises capital through token sales. • In an ICO, the object offered is either a new digital coin or a yet-undeveloped concept in search of funding. ICO investors purchase an ownership percentage of a future money supply or functionality. • While many ICOs support legitimate use cases, Autonomous Research asserts, "unfortunately, many ICOs arefraudulent."' • Rather than raising fiat currency, ICOs primarily raise capital in the form of Bitcoin and Ether, driving additional demand for the cryptocurrencies. (1) #Token Mania. Autonomous Research. July 2017. Source: Investment Strategy Group. Bloomberg. Goldman Sachs Global Investment Research. 9 EFTA00793129  Investment Goldman Nuts Management Why Have Cryptocurrencies Rallied So Much? Division 1. Shooin Supply Over Time (Million Tokens) 2. Currency Composition of Bitcoin Purchase Volume • US Dollar • Japanese Yon SotAh Korean Won • Chno:o Poem la Euro = Polsh Zloty • Omen Pound 100% 90% 20 80% "E• Current Supply 70% 2 4 IS 60% a a 50% N E 10 40% 30% 20% 10% S.IthcIMAS 3°,11 qq Sgi"MISIZRSSItha1 /4X01 0% 2011 2014 2017 1i12R2222222222222221icmcmcmcmcmcmcmcm 2012 2013 2015 2010 • In addition to speculation, which has been the biggest driver of cryptocurrency appreciation, other drivers include: • Perceived Scarcity: Bitcoin's 21 million token cap is expected to be reached in 2140 (16.5 million today). Many of the over 2,000 other cryptocurrencies, however, do not have a capped supply. Further, while unlikely, bitcoin's token cap could be raised if a consensus of programmers decided so. • Desired Safe-haven: Increased global participation reflects desire for an asset independent from governments or central banks ("digital gold"). Many governments from which investors have sought diversification, however, have recently banned domestic crypto-exchanges. Source: Investment Strategy Group. Bloomberg, 10 EFTA00793130  Investment (inktinan satins Management As Bitcoin Ownership is Not Anonymous, Illicit Use has Fallen Division Larry Fink on Bitcoin's Illicit Use "Bitcoin just shows you how much demandfor money laundering there is in the world. That's all it is. It's an index of money laundering." — BlackRock CEO Larry Fink, October 13, 2017 ■ Because bitcoin is pseudonymous, not anonymous, users' real-world identities are ascertainable once the individual converts bitcoin to fiat currency. ■ Digital intelligence companies continually scan the blockchain to identify suspicious transaction activity. ■ The Blockchain Intelligence Group estimates that illegal transactions in bitcoin fell from -50% of total volume in 2015 to -20% in 2016, and represent "significantly less than that" today. ■ As law enforcement has become better able to track bitcoin ransom, cybercriminals have begun to favor currencies that allow anonymity, such as Monero and Zcash, and even Ether. Source: Investment Strategy Group, Blockchain Intelligence Group, 11 digital-currencies.html. EFTA00793131  Investment Management Qglga" Sovereign Currencies Meet Three Criteria Division 1) They are used as a medium of exchange. — To represent a medium of exchange, an instrument must facilitate the transaction of goods or services between parities (US$ are used to buy a barrel of oil). 2) They serve as unit of account. — A unit of account is a measurement which allows value to be accounted and compared (a barrel of WTI is worth -$55). 3) They are a store of value. — A store of value is an asset that can be saved, stored, and exchanged in the future for a predictable stable value (with 2% annual inflation, a nominal dollar today will be worth 820 in 10 years). Source: Investment Strategy Group. Do Digital Currencies Pose a Threat to Sovereign Currencies and Central Banks?. Daniel Heller. PIIE. 12 EFTA00793132  Investment Goldman Do Cryptocurrencies Meet the Criteria for Currencies? Management Sachs 1) Bitcoin is an Inefficient Medium of Exchange Division Average Transaction Fees (USS Monthly Average) 6- 5 4 C 0 S34 co a C a. N 2 $2.1 0 • Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 • Processing is expensive. The average transaction cost is —$3.40, rendering transfer of small fund balances uneconomical. • Processing is slow. Transaction processing typically takes a minimum of 10-20 minutes, but can take up to 18 hours if the network is congested (Visa and Mastercard authorize transactions in -20 milliseconds). • Bitcoin is not broadly accepted. A mere 9k merchants accept bitcoin, compared to the 37mi1 that accept Visa and MasterCard, and the billions of merchants and people globally that accept US dollars.' • Further, the IRS considers all cryptocurrency gains a taxable event (including for de minimis purchases). (1) Do Digital Currencies Pose a Threat to Sovereign Currencies and Central Banks?, Daniel Heller, PIIE. Source: Investment Strategy Group, Bloomberg, 13 EFTA00793133  Investment Goldman Do Cryptocurrencies Meet the Criteria for Currencies? Management Sachs 2) Bitcoin is an Unreliable Unit of Account Division Illustrative Pricing: US$ vs. Bitcoin as a Unit of Account January 2nd 2017: November 14th 2017: 1 Bitcoin 1 Bitcoin $1,012 $6,590 r. 1 Bosch Dishwasher ($1.079) 6 Bosch Dishwashers ($6,474) C ■ Bitcoin's rapid appreciation makes it an unsatisfactory candidate as a unit of account. ■ In January, one could have purchased a dishwasher for one bitcoin. Today, it would cost 1/6th a bitcoin to buy the unit, implying severe deflation over the past several months. ■ In deflationary environments, people hoard their money in order to buy goods more cheaply at a later date, which has prompted most people to hoard their bitcoin. Source: Investment Strategy Group. Bloomberg. 14 EFTA00793134  Investment Do Cryptocurrencies Meet the Criteria for Currencies? Management Sachs 3) Bitcoin is an Unstable Store of Value Division 1. Volatility: Bitcoin versus Most Volatile EM Currencies 2. Bitcoin, Ether and Ripple versus 500 Historical Drawdowns 100% • Bitcoin Ether • Ripple • El 500 (Over Bitcoin's History) NMI 500 (Since 1945) 95 Or: 60 47 47 40 33 75% S 20 ■ 1 22 SS -20 40 26% 15.6% 16.1% 16.7% 60% 11.7% 11.9% 12.9% -60 -57% • r 69% 63°:' 09% -80 Turkey Mexico Colombia South Africa Brazil Argentina Russia Bitcoin Count of Drawdowns of 15% or More Worst Historical Drawdown (TRY) (MM) (COP) (ZAR) (BR1-) (ARS) (RUB) tXBT) (Left Axis) (Right Axis) • Bitcoin's annualized volatility of 95% dwarfs even the most volatile of EM currencies. • Bitcoin's volatility is 8x the volatility of US equities. In terms of both count and magnitude, Bitcoin, Ether and Ripple have all experienced more severe drawdowns over their short histories than the 500 has since 1945. • Bitcoin exchanges have thin liquidity, which plays a role in driving enormous price movement—so far to the upside, but which could cause a flash crash upon a large sell order. A -$30 million sell order would likely move the market by 5%. • A store of value should predictably preserve wealth. Bitcoin is unable to do so, as it neither generates income nor grows with earnings. Source: Investment Strategy Group, Bloomberg, 15 EFTA00793135  Investment G011101811 Compared to Commodities, Bitcoin's Market Price is Dislocated Management SUMS Relative to its Marginal Production Cost Division Oil. Gold and Bitcoin: Marginal Production Cost versus Current Market Price • Marginal Production Cost •Cirrent Market Price (% above marvel production cost, 56.517 (.350%) • 400D 51,278 $1200-1700 (.5016) 557 ses • o (.8%) $52.5 CrudeOil (WTI) Gold &coin • Bitcoin tokens possesses no physicality, a criteria for traditional commodities. • Compared to other commodities, Bitcoin's market price stands far above its marginal production cost. — Gold miners' and oil drillers' revenues stand 50% and 8% above their marginal production costs, respectively. — Bitcoin miners' revenue per bitcoin stands approximately 350% above their electricity expenditures. (1) Peter C.B. Phillips, Shu•Ping Shi and Jun Yu, "Testing for Multiple Bubbles: Historical Episodes of Exuberance and Collapse in the• 500,International Economic Review. Oct 28, 2015. Source: Investment Strategy Group, Bloomberg. 16 EFTA00793136  Investment Goldman Bitcoin's Market Cap is Dislocated Relative to that of Payment Management Sachs Processors Division Relative Transaction Volume and Market Cap • 12m Transaction Volume ($Trillion) 96.8% $10 • Market Cap as %of 12m Transaction Volume (Right) 100% •