Reality Shares CEO Provides Insights on Blockchain ETFs

Here’s a previous Q&A we’ve done with Eric Ervin about smart-beta dividend ETF investing.

ETFdb.com: Can you describe the kinds of companies that are in the newly launched Reality Shares NASDAQ Next Gen Economy ETF (BLCN C)?

Eric Ervin (E.E.): We believe that blockchain and the technology supporting it is going to impact all the different sectors of the economy. So, we wanted to look at a comprehensive methodology that would pick companies using the technology, either in their business or actually selling and advising on it.

IBM, as an example, is invested heavily in the space. It started with just a couple of engineers and then pretty soon became a full pivot for the giant company.

Another company in the ETF is HIVE Blockchain Technologies, which is a bit more speculative. What they’ve done is a reverse merger as a roll-up, where they’re buying assets from Genesis Mining to do cryptocurrency mining.

So the holdings in the ETF go from one extreme to the other; you have IBM all the way down to this tiny company like HIVE.

Accenture (ACN) is another company in the ETF that’s advising the Singapore Central Bank on creating its own digital currency. This translates into a lot of consulting revenue. Any time there’s a new technology that’s so disruptive, there will be a lot of traditional industry people who need to pay for advice. That’s where Accenture, IBM and a lot of these other companies provide blockchain as a service, similar to software as a service.

It lends itself toward a company like Intel. Intel’s Xeon chip that’s coming out is able to process transactions. A user is able to send it encrypted data and then the chip will decrypt it, process the transaction and then send out encrypted data. So a company like Amazon, for example, can’t look at what the processing is. As a result, you’re able to do cloud computing on the blockchain. That could potentially be almost a 25% revenue increase for a massive company like Intel.

Because the index rebalances, we could potentially add companies like Walmart, which would be using blockchain in their business to reduce infrastructure costs on the supply chain. In a store like that where every margin counts, saving even 1 percent would significantly improve their earnings.

So, the blockchain could impact so many different types of businesses.

ETFdb.com: There was another similar ETF that launched the same day. The Amplify Transformational Data Sharing ETF (BLOK B-), which is an active ETF. As opposed to BLCN, which is passive. What makes BLCN unique or better?

E.E.: We’re friends with the Amplify team, and we think the world of them. But, my thought is, anytime you can take the human out of the equation, you’re generally better off. I have a computer background and I prefer taking the rules that the human is working with and putting them into a process and an index, which is why I like passive investing. But there are times when you can’t. So, when you can’t, maybe you can put the humans into the process, and that was what we wanted to do. So we needed technologists who absolutely understood the blockchain space. We went out and selected this board of advisors and the leading experts in the industry:

• Erik Voorhees, who’s ranked number eight on CoinDesk’s list of the most influential blockchain experts.

• Jeff Garzik was one of the original five core developers on the bitcoin protocol. He worked with Satoshi Nakamoto. Jeff is also one of the original Linux core developers. He’s on the board of Linux to this day with Linus Torvalds. He worked with Linus to actually build Linux. Jeff is able to look at some of these companies like, say, Kodak, and analyze their underlying source code. He knows that’s just a copy of an ICO that was trying to go public about three months ago. All they did was just package up some other ICO that was on the shelf and now they’re coming out with it. It’s not really a robust process or white paper. All they did was change the name and say they’re conducting this new initiative.

• Dr. Garrick Hileman, who’s a researcher at the University of Cambridge and prolific author on the space. He also supervises a number of colleagues who constantly do research on blockchain technology, industry impacts and cryptocurrency.

• Marco Santori is the president and chief legal officer of Blockchain.com. He’s known as the “Dean of Digital Currency Lawyers” in the industry and is a recognized authority in the law and policy of blockchain technologies.

Matthew Roszak, Steve Beauregard and Derin Cag are also on our board. We have these experts and what they do is vote or essentially score each company based on this blockchain economic impact and the blockchain viability of the products. Then that goes into our process to arrive at an ultimate blockchain score, which we then utilize to rank companies and determine which ones make it into the index.

It’s kind of one-part passive because it’s a full rules-based system, but there’s also a human element that’s evaluating each business and whether or not they’re actually involved in the blockchain technology.

Therefore, a company like Kodak isn’t going to make it into our index until they actually have a robust product.

Another example is XNET, which is in the BLOK portfolio. They are currently under investigation by the securities commission in both China and the U.S. for an illegal ICO – illegal securities offering – because they allegedly tried a backdoor way to conduct an ICO. That doesn’t pass our screens because it’s a hype machine. It’s not an actual robust technology solution.

Therefore, our process is a little bit more rigorous but also a bit slower. It won’t have as much volatility, both to the upside and downside. Whereas the Amplify product will probably have a lot more booms and busts.

Check out our list of Blockchain ETFs.

ETFdb.com: Why did the SEC encourage you not include the word “blockchain” in your newly launched ETF?

E.E.: The process for the SEC is rule 35D. It came a long time ago for international and intermediate bond funds to address the question of whether this fund really has 80% of its assets invested in intermediate bonds, for example. If it’s a technology or something, the issuer has to say, “Well, how can we prove it?”

Let’s take, for example, gender equality or a lot of these ESG (environmental, social and governance) type products. There’s no way you could prove that a certain percentage of revenue comes from that item and that you are being a green company. You have to come up with your own tests, which was why we were so proud of our methodology. As we talked to the SEC, they pretty much agreed that we had a robust methodology for the tests; any company with a blockchain score that meets the criteria of 50 or higher can be in the index. As long as the index and the ETF are called the blockchain score leaders, which is what we had kind of agreed with the SEC on, then we met the test.

Legally, I think we were on very good footing, and we could have just launched if we’d wanted to. But at the last minute, they came in and asked if we could come up with a different name or spend more time talking with them about our test. So we could have either delayed the launch or come up with a different name, and we chose the latter. I think there was just some lack of comfort at the top. And rightfully so because of the blockchain hype.

It’s ironic, though, that Long Island Iced Tea can change their name, yet we have a valid methodology of picking out blockchain companies. I think over time though, they’ll get more and more comfortable, and this hype will all die down and then it’ll be no problem to change the name.

ETFdb.com: You think you’ll change the name in the future potentially?

E.E.: Yes, just to be more descriptive.

ETFdb.com: The industry allocation of your new ETF is pretty diverse. Which sectors do you think have the most benefit from blockchain technology?

E.E.: Well, tech and info tech are probably some of the biggest beneficiaries early on. Then the advisory opportunities, because there’s going to be a lot of revenue generated there. The more nuanced piece of it, though, is that financials could potentially be a huge beneficiary, which is what makes this space so interesting and fascinating. But they also could be completely disrupted and would potentially have to change their business entirely because they would lose one of their largest sources of revenue, which is fees for processing transactions.

Visa, as an example, is either going to be wiped out because of blockchain technology or it will figure out a way to revamp its whole internals to offer blockchain solutions to the economy.

I bet you in 10 years, half of the companies that are currently in our index won’t be and maybe half of those won’t even exist because they didn’t “figure it out.” They were playing around with the technology and thought, “Oh, maybe this is something interesting.” Some are going to embrace it wholeheartedly and just change their business model, and others are going to get totally wiped out, like Barnes & Noble. They said, “Oh yeah, we have a dot-com site,” but they didn’t really embrace the internet early on, so Amazon has transformed them from a big company into a tiny company.

Netflix is probably the best example of somebody who came in and disintermediated by getting rid of the DVD business and going to a digital platform. They chose to adapt versus other companies that might not and that’s kind of how I view a company like JPMorgan; they’re playing around with Quorum, their own blockchain. And so, we’ll see if they actually embrace it fully or just hold out a little bit longer.

We’re not worried about these cases because we rebalance every six months, adding companies that are embracing the technology and removing companies that are not using a rules-based methodology. This way, you don’t have to worry about some person making a bad decision with the ETF holdings.

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ETFdb.com: What are the implications of blockchain technology? What kind of future implications do you expect to be created using this technology?

E.E.: Micropayments are one of the most interesting pieces of blockchain. For example, anytime someone reads an article, they pay for that article instead of paying for a whole subscription to The New York Times. Steem is really big in that. Then you have songs. Imogen Heap is a popular artist and musician. She’s been really vocal in promoting this solution for a problem that has plagued the music industry for a long time. The average artist spends almost 60 percent of their profit or revenue on agents and all these intermediaries.

In the future, you’ll be able to embed a smart contract in your MP3 file. Kodak actually has an interesting business proposition related to this. So, you can embed a smart contract where anytime a song is downloaded to a personal computer it can be played for free, for example. Or if it’s played on a radio station, then automatically it’s a penny per song. Then if it’s played more than 100 times, the person has to pay 20 cents for it. And this way, you could actually sell a song. For example, if I bought an MP3, I could sell it because I own it, and that’s the beauty of the blockchain. No one can own two pieces of the same entity, so you can’t just copy it.

If I try to offer it to someone, they can buy it from me for a discount, but I still own it. Or maybe they tailor the smart contract to say this can’t be sold for value. That’s just one example of smart contracts, and autonomous vehicles is another one that I’m sure you’ve heard a ton about. Imagine going to work and your autonomous vehicle starts ‘Ubering’ people around for you and making income.

ETFdb.com: Oh, I see. I heard of that. There’s a Tesla Network that Elon Musk’s trying to build. Not sure if he was going to use the blockchain technology.

E.E.: I don’t know if he is but someone will. Let’s take it one step further and take the example of your car being parked in a zone where a street sweeper is going to come. Your car automatically talks to the street sweeper over the blockchain and then parks itself in a different area during that time. The street knows it and makes a micropayment for that service.

Another great example: In the Australian outback, there are telephone lines that go across thousands of miles. Anytime there’s a storm or one of these telephone lines goes down, humans have to go out and find them, which takes a lot of time. So, a company has made sensors that go on each of those telephone lines. They talk to each other and no one sensor can go very far but they’re very cheap. So, you essentially have Wifi going out thousands of miles because of these sensors and if a pole goes down, you instantly know the location because it provides feedback to the network.

In the meantime, for 99 years out of 100, those sensors would be unnecessary and just sit there. So, in the future blockchain world, the company that installed those sensors can sell data. You can sell Wifi to that house directly beside those sensors because it’s getting the network access and you can just pay on the blockchain. Or sell weather data, so they can start providing that service to people.

There are also all the smart refrigerators and devices now. They don’t need a ton of memory to run and be on the network, but we can’t make memory small enough anymore. So, there’s no sense in making, for example, 128-kilobyte memory chips. We just put a megabyte memory chip in there. Then you have all this extra space and capacity on all these smart devices where you could store information in a distributed way.

This is like what Filecoin is potentially doing, and then you would get paid for storing distributed data on that network. You’d be using all of your own devices to earn money.

The first industries to be impacted are financials and supply chain. Supply chain was one of the first products that IBM had kind of built out solutions for. The beauty in supply chain is, let’s say you buy a product in China and it comes from a factory then is loaded onto a truck, travels to the distribution center and each point along the way, there’s a different company handling this product. You can have a GPS sensor tag in the package and instead of invoices being handled and payments happening three or four days later, you can use a smart contract, which would automatically make the payment before the pickup transferred hands.

All of these payments can happen if everyone’s on the blockchain. And so you no longer need to pay all those back-office support people because it’s just automatic. Then you have trade finance because now a bank can finance that receivable since they know it’s coming. It’s on the way and they can see it on the blockchain, so you can give them access. Then they have the ability to say, “Okay, we know you’re going to get paid for this because we see it on the truck, and you just sold it and we know it’s going to hit here.” You just open up that blockchain to your different counterparties and everyone provides data to it. So, that’s probably one of the most interesting real-time examples happening.

ETFdb.com: Was it harder from an ETF regulation perspective to launch an ETF that seeks to track blockchain companies or companies that own the blockchain technology, given the controversial nature of the technology?

E.E.: I think it’s harder not so much because of the controversial nature other than just differentiating and saying, "Wait, understand that it’s an underlying technology. It’s not bitcoin, its blockchain.” Once they get their brain around some of these stories and use cases, then instantly they say, “Oh, I’ve got to learn more about this.”

It’s at the point that everybody gets really excited, and so that’s kind of where we’re more focused. It’s just education and that was another part of bringing on this advisory board. We really want to use them to post webinars and get on conference calls. We want to help advisors potentially talk to their clients and enable them to understand what blockchain is, how it works and what the difference is between cryptocurrency and blockchain. The idea is to have industry experts help educate the market because we see it as such a cool opportunity.

ETFdb.com: Reality Shares ETFs are considered smart beta, including the latest (BLCN C) ETF. What is the reason for that? Aand are you bullish on the prospects of smart-beta investment?

E.E.: I am bullish on the prospect of smart beta because I do view it as just a more systematic version of active management. It’s taking active management, putting it in a rules-based process, getting rid of the human element wherever you can, and then offering the same value for half the cost or less. That’s what I think is really the next wave. All these trillions of dollars that are in mutual funds and active management are going to continue to flow not all the way to straight beta, but to this place in between where you can actually have alpha with a more intelligent approach than a human saying: “Today’s the day to buy.” You just take the human element out of the equation. With artificial intelligence and technology, it’s just a matter of time before we will completely remove the human from that piece of the investment process. There’s just very little need for humans if you can systemize it.

Check out our complete list of smart-beta ETFs.

ETFdb.com: Many issuers are cutting management fees, including big names like BlackRock and Vanguard. Where do you see this “fees war” heading? Do you see these fees being lowered only for the major high AUM ETFs?

E.E.: I think there’s going to be pressure on fees certainly for the straight beta products, but then it’ll creep into more and more of the smart-beta products. The real fee pressure, ultimately, is going to hit the active mutual fund managers. That’s where the more egregious fees are.

The fee war internally in the ETF industry is just there so that it can capture those flows coming from mutual funds into the ETF space so that they go into that lowest-fee product. But who’s really going to suffer from it is the mutual fund industry.

It’s good for the consumer. It’s tough for the ETF issuers because it’s very hard to fight that battle. But there’s value, where you can add value and get paid for it, but it’s harder. It’s harder to stand out.

Being aware of risks and costs is important regardless of your ETF investing strategy. Read The Hidden Risks and Costs of ETFs to find out more.

ETFdb.com: Last question here. What are some of the key insights from the Inside ETFs Conference?

E.E.: It’s great to see so many people interested in the space and in the industry. I get so excited about blockchain that I kind of forget that we’re in the hottest industry in the investment management business. This really is an exciting time right now. We’re reinvigorating the asset management business and it’s like asset management 4.0. I think that’s the real takeaway here – there’s a lot of interest and enthusiasm, which just continue to grow.

Eric Ervin, president and CEO of Reality Shares, believes that blockchain technology is going to have a great impact on different sectors of the economy. This represents a massive opportunity for investors. That’s where Reality Shares NASDAQ Next Gen Economy ETF (BLCN C), which was recently launched, can help investors who want to invest in the emerging world of blockchain technology.

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