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J.P. Morgan Perspectives Blockchain, digital currency and cryptocurrency: Moving into the mainstream?

Executive summary Blockchain evolution: Moving into the mainstream? While blockchain technology has not yet emerged into the mainstream, it has moved beyond experimentation and use in payments, with stock exchanges embracing the efficiency around settlement/clearing and collateral management.

Trade Finance and Payments blockchain solutions offer the most incremental efficiencies in the banking sector relative to other use cases, but widespread implementation is at least three to five years away.

We see the long-term potential for Distributed Ledger Technology (DLT) to transform banks’ business models by providing efficient and resilient information transfer and storage once scale has been achieved…

…but legal and regulatory frameworks and technical challenges, such as cross-platform integration, may decelerate further progress.

There is a need for verification of the information going into a blockchain; quantum computing raises security questions and poses risks around blockchain’s ability to provide an immutable record. The rise of alternative payments Asia represents the bulk of global growth in payments, driven in large part by the explosion in third-party (non-bank) and mobile providers, with the most rapid growth in China and India.

Cashless economies work and increase financial inclusion with the example of China suggesting that the transition to a mostly cashless economy can be managed at scale…

…but the rapid rise of payments-related Money Market Funds (MMFs) in China poses financial stability risks, and high-speed change requires an equally adaptive regulatory response. Are stablecoins a scalable alternative to cryptocurrencies? The crypto market continues to mature with the increased participation by financial institutions and the introduction of new contracts on regulated exchanges.

Bitcoin and other freely floating cryptocurrencies continue to exhibit extreme volatility relative to fiat currencies, which has led focus towards stablecoins to minimize price fluctuations.

Private stablecoins are likely to face technical hurdles, including the need for intraday liquidity.

Bitcoin prices have corrected much of the gap versus intrinsic value but have yet to demonstrate their value for portfolio diversification.

This is our annual update on the latest developments in the adoption, evolution and performance of blockchain technology and cryptocurrencies. We expand our report to include analysis of stablecoins and the rise of alternative noncash payments. This report is part of our J.P. Morgan Perspectives series, which brings together views and analysis from across the broad scope of J.P. Morgan’s Global Research franchise to look at big ideas and critical global issues transforming investment markets. We hope this series will both inform and foster public debate on evolving economic, investment, and social trends. – Joyce Chang, Chair of Global Research

Blockchain, digital currency and cryptocurrency: Moving into the mainstream? We expand our annual review of blockchain technology and cryptocurrencies to a broader discussion on implications of the rise of digital money.

Stablecoins have the potential to grow substantially in global transactional activity despite challenges inherent in the microstructure of operating such a payment system.

While the world is ready for private money in our view, rapid adoption and scale are hindered by the underlying technology and the need for substantial regulatory oversight.

For a stablecoin like Libra to succeed, it will likely require short-term liquidity facilities, a source of positive-yielding reserve assets, and less distributed, semi-private networks.

Blockchain has yet to emerge into the mainstream of financial services, but stock exchanges are embracing the efficiency around settlement/clearing and collateral management.

Widespread implementation of blockchain solutions in traditional banking is likely three to five years away and will be concentrated in trade finance and payments.

Asia has driven third-party (noncash) global growth in payments, especially mobile wallet, with card and e-money payments growing more rapidly than other types of noncash payments.

Online platforms have driven the growth of China’s wealth management industry, including Money Market Funds (MMFs), posing financial stability risks.

Despite the rise in cashless payments, cash use is still increasing in most countries.

Cryptocurrency trading participation by institutional investors is now significant, but volatility remains a severe impediment to broader adoption.

Cryptocurrencies continue to have a limited role in portfolio diversification or as a hedge instrument. Moving beyond blockchain technology As emerging technologies continue to disrupt every industry and as consumer preferences evolve, modernization of payments is now a global theme. 2019 will be remembered for the rise of digital money. The groundwork is now in place for more mainstream adoption of blockchain technology at the same time that the foundation is being established for the development of digital currency and fast payments. Although legal and regulatory frameworks and technical challenges remain high, the past year was marked by a number of breakthroughs, notably widespread blockchain technology adoption by stock exchanges, the explosive growth of third-party payment systems in China, which suggests that the transition to a mostly cashless economy can be managed at scale, and the launch of options on bitcoin futures contracts on regulated exchanges. The technology challenges for bitcoin opened up the opportunity for alternative cryptocurrencies to fuel blockchain adoption. That led to a surge in alternative cryptocurrencies, many with questionable initial coin offerings (ICO). USD Coin recently launched in 85 countries. JPMC became the first national bank to create and successfully test with clients a digital coin representing fiat currency with the announcement of the JPM Coin project, which is a digital coin representing US dollars held on deposit at JPMCB, designed to facilitate payments between institutional JPM clients. China is developing its own central bank digital currency, a digital yuan or “e-yuan,” and other central bankers have started to seriously examine a supranational multi-currency-backed token as a replacement global reserve asset. But the failed release of Facebook’s Libra serves as a reminder that rapid adoption faces practical challenges to attain scale. For a stablecoin like Libra to succeed, it will likely require short-term liquidity facilities, a source of positive-yielding collateral (for those coins relying on reserve asset income), and less distributed, semi-private networks. The crypto market continues to mature, and cryptocurrency trading participation by institutional investors is now significant. Bitcoin prices appear slightly overvalued, but much of the gap versus intrinsic value has narrowed. However, Bitcoin and other freely floating cryptocurrencies continue to exhibit extreme volatility relative to fiat currencies, which has led focus towards stablecoins to minimize price fluctuations. Normand notes that developments over the past year have not altered our reservations about the limited role that cryptocurrencies play in global portfolio diversification or as a hedge instrument. He argues that crypto assets have a place in investors’ portfolios only as a hedge against a loss of confidence in both the domestic currency and the payments system. Cryptocurrency volatility has fallen, but remains about five times greater than core markets like Equities or hedges such as Commodities. In our annual round-up of the latest developments in blockchain technology and cryptocurrencies (CC) we expand our analysis to include digital currencies and the rise of alternative payments (see Blockchain and Cryptocurrencies 2019: Adoption, Performance and Challenges, 24 January 2019 and J.P. Morgan Perspectives: Decrypting Cryptocurrencies: Technology, Applications and Challenges), 9 February 2018. In this publication 30 strategists and analysts examine the evolution of blockchain technology, the cryptocurrency market, and alternative payments. We expand our research coverage universe to include an assessment of the current state of development for stablecoin-based payment systems. Joshua Younger et al. map out the technological, regulatory and practical hurdles to achieving global scale for Libra and other stablecoins, particularly those backed by assets. The IMF has laid out a tree featuring the different forms of digital money and different means of payment, mapping the type, value, backstop and technology for digital currencies, which we find useful for framing the key developments in this ecosystem over the past year (Figure 1). Figure 1. Money Trees: Mapping the New Payment Technologies Note: CBDC = central bank digital currency. Source: https://www.imf.org/en/Publications/fintech-notes/Issues/2019/07/12/The-Rise-of-Digital-Money-47097 Technology: Is Blockchain becoming mainstream? Payments, trade finance, and custodial services remain the clearest use cases for blockchain. The adoption of blockchain technology among stock exchanges to improve the efficiency around settlement/clearing and collateral management has been noteworthy. Exchanges around the world are embracing blockchain technology in their operations and seeking to launch new digital asset trading platforms. The potential beneficiaries of the new Distributed Ledger Technology (DLT)-based settlement/clearing system include banks and brokers who would see lower reconciliation costs and lower capital requirements (from potential real-time settlement), while registry service providers may be negatively impacted. Deutsche Boerse has rolled out DLT solutions for collateral management in the securities lending market. Boerse Stuttgart launched a first of its kind digital asset exchange platform BSDEX, which allows investors to trade cryptocurrencies, with plans to extend this to other tokenized digital assets designed around markets such as real estate, investment funds, and debt. The Australian Stock Exchange has plans to replace its existing settlement/clearing system, Clearing House Electronic Subregister System (CHESS), with blockchain/DLT. Switzerland’s stock exchange has been working on launching a fully integrated, DLT-based end-to-end trading, settlement and custody service for digital assets later this year. QME (the commodity trading platform of the Hong Kong stock exchange) announced a partnership with Ant Financial to create a blockchain warehouse receipt alliance to prevent fraud. Traditional capital markets are also continuing the adoption of blockchain, with more assets becoming tokenized, and asset managers are exploring the roll out of digital asset solutions (Kambo and Parameswaran). European banks continued to invest in blockchain initiatives in 2019, but we have yet to see tangible cost benefits. However, we continue to see long-term potential for DLT to transform banks’ business models and expect continued momentum in adoption in the medium term. In particular, we see Trade Finance blockchain solutions offering the most incremental efficiencies in the banking sector relative to other use cases, especially with payments largely digitalized and alternative Know Your Customer (KYC) solutions through other mediums available. The $2trn+ Traditional Documentary Trade segment has yet to achieve end-to-end digitalization, but blockchain has demonstrated its potential to materially reduce inventory lead times and lower operational costs, especially through the use of smart contracts. While we see widespread implementation of blockchain solutions at least three to five years away, challenges such as the macro-economic environment, legal and regulatory frameworks and technical challenges—such as cross-platform integration—may decelerate further progress (Sinha and Shah). Blockchain technology has been gathering interest and attention from industry players as having the potential to disrupt traditional US banking for mid- and small-cap banks, but Alexopoulos et al. find that regional banks are in the early innings of adopting blockchain technology into day-to-day banking. Commercial payments were the focus for the first use case of blockchain technology by US banks, with a mid-sized regional bank, Signature Bank, taking the lead. In addition, while large multinational banks have for the most part stayed away from providing banking services to cryptocurrency clients, smaller banks have been stepping into this opportunity to provide financial products to this rapidly-growing segment of the financial industry. Blockchain for supply chain buzz has faded as other logistics and visibility solutions, particularly automation, better meet near-term needs for productivity. In transportation, competition for disruptive freight tech has increased, with automation gaining momentum. Ossenbeck notes the potential to streamline transactions with a smart contract and isolate spoiled goods remain the most common use cases. However, the supply chain structure viewed as ripe for disruption is often a limiting factor in an industry still in the early days of leveraging data analysis, let alone applying new technologies. Specifically, digitizing information with tools such as blockchain is challenging when most of the sources are still “offline” in paper form. Instead, we see a larger potential disruption from automation. Self-driving trucks, as well as large and small drone cargo deliveries have emerged as the leading technologies for supply chain disruption. Indeed, we believe that one of the reasons we have not seen even faster mainstream adoption of blockchain is the real world realization that there is a need for verification of the information going into a blockchain. The technology is very good at creating an immutable source of truth once the information is placed into a block, but the technology itself does not validate the source information in the first place. In our opinion, that is where industry-specific blockchain utilizing a consortium may be needed to provide verification capability to further advance mainstream blockchain adoption (Auty). The Rise of Alternative Payments The global payments landscape is evolving, with new systems allowing near-instant person-to-person retail payments increasingly available around the world. Asia represents the bulk of global growth in payments, driven in large part by the explosion in third-party (non-bank) and especially mobile providers. The volume of cashless payments has risen sharply in recent years, especially in Emerging Markets. In China and India, for example, the volume of cashless payments increased more than five-fold over 2014 to 2018, while the volume of cashless payments in Russia has tripled. The IMF notes that the value of e-money transactions in China, such as with WeChat Pay and Alipay, surpass those worldwide of Visa and Mastercard combined. Among the various types of noncash payments, card and e-money payments have grown faster. However, we note that despite the rise of cashless payments, cash use is still increasing in most countries. Indeed, only China, Korea, Singapore, Turkey, Indonesia, India, and the US (assuming 2017 numbers)—seven countries in total—have seen an increase in the value of cashless payments per inhabitant over the 2014-2018 time period (Harano). The example of China suggests that the transition to a mostly cashless economy can be managed at scale. Younger et al. review the major third-party payments platforms in China, including business models, market structure, regulatory developments and importantly their interconnections to financial markets. Money market funds and bank wealth management products form key components of the Chinese financial system. The integration of these funds into online ecosystems (e.g., YU’E Bao and Alipay/Alibaba) helped drive explosive growth in AUM for wealth management products (WMPs) and money market funds (MMFs). YU’E Bao was briefly the largest fund in the world. The rise of digital MMFs led to outflows of personal deposits into money markets. The rapid growth of the digital MMF industry posed financial stability risks, including mismatches between assets and liabilities and redemption risks during periods of rising interbank rates. Timely regulatory intervention was key to managing this transition. Authorities introduced a temporary imposition on holdings and same-day withdrawals, which were lifted in April 2019. Digital MMF assets have stalled despite the lifting of regulatory limits, even as the money supply in China has continued expanding, likely reflecting much less attractive yield pick-up versus traditional bank deposits. Cashless payments are growing rapidly in Japan, especially since government promotion started in October 2019. The Japanese cashless rate stood at 24% (BIS basis), but at 49% with direct debit/bank transfers. Credit card payments are driving the rise, and QR code payments are growing the most. Loyalty programs are also growing rapidly, supported by platformers’ reward ratios as high as 20% and the negative interest rate environment in Japan. Platformers’ loyalty points, with currently modest market size, could be used as an alternative payment measure as their ecosystems expand. It could bring issues for monetary policy/financial stability in the medium term (Nishihara). Are stablecoins a scalable alternative to cryptocurrencies? As Bitcoin and other freely floating cryptocurrencies continue to exhibit extreme volatility relative to fiat currencies, there has been much greater focus on stablecoins designed to minimize these price fluctuations. Younger et al. provide a primer on stablecoins and discuss key stability risks introduced by some designs. First, they argue that high-turnover payment systems require short-term liquidity facilities, particularly daylight overdraft provided by a non-economic central authority, to avoid gridlock—especially under stress. Second, the underbanked populations likely make up a small fraction of global payments volume, even after folding in the shadow economy. This means a world in which Libra or another stablecoin is successful is one in which its activity is dominated by developed markets—and by extension business-to-business (B2B) transactions with their associated reliance on intraday liquidity. Third, any system that relies on reserve asset income to fund operational and other ongoing costs becomes unstable in a negative yield world. Younger et al. also examine the scalability of Libra and other stablecoins, particularly those backed by assets. They believe that the world is ready for private money, as most of the money in the world already comes from private issuers. However, private stablecoins are likely to face technical hurdles, including the need for intraday liquidity. If the experience of traditional banks is any guide, the institutionalization of stablecoins will come with significant regulatory oversight and costly compliance obligations. Second, they argue that given that DLT protocols are very energy intensive, less distributed, semi-private networks likely will be required. Third, they note that sourcing positive-yielding collateral may be difficult since a significant fraction of short-term high-quality sovereign debt is locked up in central bank balance sheets. The rise in negative-yielding debt poses a significant challenge to Libra and other fiat-backed stablecoins. While global financial markets are awash in high quality short-term government debt suitable as stablecoin collateral, only half offer positive returns. In our most recent J.P. Morgan Perspectives publication, What if US yields go to zero?, 16 January 2020, we outline why the persistence of very low nominal policy rates is here to stay. Valuation: Far from institutionalized, but gap closing between market and intrinsic value for cryptocurrencies The market capitalization of cryptocurrencies recovered from around $125bn a year ago to around $235bn, with Bitcoin increasing its dominance by accounting for nearly two-thirds of the total. Once ‘fake’ trading volumes such as wash trades are adjusted for, participation by institutional investors is now significant. In addition, the crypto market continues to mature with the introduction of new contracts on regulated exchanges, most recently with the launch of options on futures contracts in regulated exchanges. Panigirtzoglou and Inkinen find that the gap that opened up between Bitcoin’s market price and their estimate of its “intrinsic” value has narrowed substantially, largely due to declines in the market price. Its market value continues to trade above their estimate of intrinsic value, suggesting some downside risk remains. However, volatility remains a severe impediment to broader adoption of cryptocurrencies. The IMF notes that the standard deviation of day-on-day changes in Bitcoin prices is roughly 10 times higher than in most G7 currency pairs, and even a little higher than in the Venezuelan Bolivar to US dollar exchange rate. That being said, we have seen some integration into mainstream apps and scaling. For example, we have seen companies like Square announce that they are working on a Lightning Development Kit to help integrate the Lightning Network into bitcoin wallets. Moves like this utilizing open source tools can help alleviate some of the scaling issues with bitcoin allowing the cryptocurrency to finally move into the realm of use for everyday payments (Auty). Cryptocurrencies have yet to demonstrate their usefulness for hedging extreme macroeconomic environments and geopolitical flashpoints. The appeal of crypto assets for investors has been their low correlation to traditional asset classes, which has usually improved portfolio efficiency. However, even miniscule allocations remain impractical as long as the lack of legal tender status limits their transactional use and in turn their liquidity. While cryptocurrencies might serve some retail investors with a small asset base as one of several hedge instruments, it could not serve all retail investors nor institutional ones and corporates due to a liquidity constraint that is tough to circumvent without legal currency status to convey scale. Crypto assets are also still failing to rise as consistently as Bonds, the Yen, and Gold when Equities incur large drawdowns. Thus, Normand argues that crypto assets should form part of an investor’s long-term hedges, but more for the ability to hedge an environment that most countries have never experienced—entailing a loss of confidence in both the domestic currency and the payments system—because they still fail to deliver the same protection as more liquid defensives. Venezuela’s Petro—supposedly the first sovereign cryptocurrency, and apparently backed by oil—was introduced with much fanfare, but it has gained little, if any, international traction. Instead, the Petro has thus far served as a reference price for domestic transactions inside Venezuela, and more recently as a vehicle to distribute social spending, pensions and bonus payments to government employees. In the end, the Petro has so far looked more like another (hyperinflationary) fiat currency (Ramsey). Joyce Chang AC joyce.chang@jpmorgan.com J.P. Morgan Securities LLC Kimberly Harano AC kimberly.l.harano@jpmorgan.com J.P. Morgan Securities LLC

Blockchain evolution: Moving into the mainstream? Blockchain starts to emerge to the mainstream.

Bitcoin further solidified as platform of choice.

Hurdles remain: garbage in, garbage out.

Quantum computing raises future security questions. It is often difficult to determine whether a new technology will catch on, and especially difficult to determine when a technology will go through its inflection point to really see mainstream adoption. But what has been consistent through the years are the phases that technologies must go through to reach that point of inflection. Notable technology writers including Geoffrey Moore (Crossing the Chasm) and Rita McGrath (Seeing Around Corners) use similar phases of hype, disillusionment (when the naysayers take over the message), emergence, and maturity. We believe the latter part of 2018 and beginning part of 2019 represented the timeframe when naysayers were owning the message that Blockchain and cryptocurrencies would not be successful. In the second half of 2019 and heading into 2020 we believe the groundwork has been laid for more mainstream adoption of the technology/cryptocurrencies. Integration into mainstream apps and scaling are good signs. We have seen companies like Square announce that they are working on a Lightning Development Kit to help integrate the Lightning Network into bitcoin wallets. Moves like this utilizing open source tools can help alleviate some of the scaling issues with bitcoin allowing the cryptocurrency to finally move into the realm of use for everyday payments. Currently, transactions are limited to a maximum of around seven per second for bitcoin, and that is why in 2018 the Lightning Network was created as an off-chain peer-to-peer layer two payments protocol. Scaling remains one of the biggest hurdles to future adoption, but the level of activity in terms of research to solve the issue is very encouraging. Payments remains one of the clear use cases for blockchain, as does smart contracts, supply chain (companies like Cargill and Bumble Bee Foods are utilizing), secure transfer (medical records for companies like CVS), and custodial services (biggest being the DTC that supports the investment industry). Bitcoin solidified as platform of choice. The technology challenges for bitcoin opened up the opportunity for alternative cryptocurrencies to fuel blockchain adoption. That led to a surge in alternative cryptocurrencies, many with questionable initial coin offerings (ICO) making it challenging for companies to understand where to focus. One could argue the peak was the 2019 failed release of Facebook’s Libra. All in all, we believe this has further emboldened bitcoin as the platform of choice and motivated the increase in research to solve challenges like scaling. Garbage in, garbage out. One of the reasons we believe we have not seen even faster mainstream adoption of blockchain is the real world realization that there is a need for verification of the information going into a blockchain. The technology is very good at creating an immutable source of truth once the information is placed into a block, but the technology itself does not validate the source information in the first place. This is where building processes that in some cases are manual, or in the best case utilize real-world sensors to validate information, are needed to ensure accuracy of information going into a blockchain. In our opinion, that is where industry-specific blockchain utilizing a consortium may be needed to provide verification capability to further advance mainstream blockchain adoption. Quantum computing raises security questions. Some of the most important characteristics around the use of blockchain as a technology include the security and ability to provide an immutable record. The security aspects are centered around encryption (cryptographic hash) that potentially could be put at risk from the power of quantum computing. Unlike today’s computers where information can only exist in two states 1 or 0 (binary computing), quantum computing uses quantum bits (qubits) that allow it to store a huge amount of information rather than just 0 and 1. This provides the capability to complete what today’s computers would consider massively complex calculations in a fraction of the time. Today’s encryption standards using traditional computing methods would take an unreasonable amount of time or resources to crack using force methods. However, there is an argument that quantum computing would be able to break the encryption in a matter of minutes. We are still in the early stages of seeing the capability of the first generations of quantum computers, but it could require a fundamental change to the encryption foundation being utilized in blockchain and bitcoin. Sterling Auty, CFA AC sterling.auty@jpmorgan.com J.P. Morgan Securities LLC

Blockchain adoption in US financial services: Early innings but Signature Bank stands out Commercial payments a focus for first use case of blockchain technology by US banks as a mid-sized regional bank takes the lead.

Large banks shy away from banking cryptocurrency companies, but smaller banks have stepped in to fill a gap in providing banking services.

A handful of smaller banks step out from the pack, with Signature Bank an early mover. Early use cases of Blockchain at regional banks focused on commercial payments As emerging technologies continue to disrupt every industry on the planet, the US bank industry remains fully ripe for disruption. In particular, blockchain technology has been gathering interest and attention from industry players as having the potential to disrupt traditional banking. Looking across our US mid- and small-cap banks universe, we find that regional banks are in the early innings of adopting blockchain technology into day-to-day banking. In fact, most regional banks are in a wait-and-see mode to observe what larger banks or fintechs end up developing before potentially investing in the technology. This fast follower approach is largely due to limited technology budgets at smaller regional banks when compared to the largest US banks in the country, which have annual technology budgets in the $10+ billion range. However, we would note that there are exceptions for regional banks as some smaller players are going head-to-head with some larger banks. Banks developing use cases for Blockchain have initially been around the commercial payments space to reap the benefits of blockchain technology in the form of lower cost, faster and around-the-clock settlement, fewer errors, and other benefits. First movers developing blockchain use cases include J.P. Morgan’s JPM Coin and Wells Fargo’s Digital Cash. In February 2019, J.P. Morgan announced plans to launch JPM Coin, which is a digital coin representing US dollars held on deposit at JPMCB, designed to facilitate payments between institutional JPM clients. In September 2019, Wells Fargo announced the testing of Wells Fargo Digital Cash, an internal platform to support real-time payments processing and settlement for cross-border payments. Meanwhile, a mid-sized regional bank, Signature Bank, was the first to reveal its blockchain-based Signet payments platform in December 2018. Signature Bank first to market with Blockchain-based payments platform On 1 January 2019, $49 billion asset size Signature Bank became the first US bank to launch a blockchain-based proprietary payments platform via partnering with trueDigital Holdings, a fintech focused on blockchain-based infrastructure, exchange, and settlement technology. The Signet platform was approved by the New York State Department of Financial Services, making Signature Bank the first bank to receive regulatory permission to use blockchain in this capacity. Signet allows Signature Bank’s commercial clients to make real-time payments in US dollars to other Signature commercial clients at no cost, eliminating the need for a third party to facilitate the payment. This new vertical should provide a steady stream of low-cost deposits as customers sign up for the service. Clients using Signet are required to maintain minimum deposit balances of $250,000 that are FDIC-insured. Signet allows commercial clients to make payments in US dollars 24/7, which compares to traditional corporate payments using the SWIFT interbank platform or the Automated Clearing House (ACH) network, which can take as long as three days and are generally not available on weekends. In January 2020, Signature Bank announced its partnership with Prime Trust, a fintech providing infrastructure solutions for the digital economy. Prime Trust’s Prime Settlement Network will leverage the Signet platform to provide real-time payments and settlement services to Signature and Prime Trust’s institutional clients. In this use case, the first customer to sign up was power supply company American PowerNet, which chose to use Signet to facilitate real-time payments within the renewable energy sector and to purchase power for Pennsylvania. Signet would allow American PowerNet to settle with power generators on a daily basis once schedules are confirmed, as compared with the traditional 30-day payment structure that has long been the industry standard. The Commonwealth of Pennsylvania, through its electric supplier relationship with American PowerNet, is the first entity in the country to purchase its power using Signet. Additionally, the Lancaster County Solid Waste Management Authority has also begun to incorporate Signet into its regular transactions of buying and selling power via American PowerNet’s Verde Blocks platform, a blockchain technology that provides large retail electric buyers direct access to sustainable power generators. This use case displays the potential for clients in all industries to leverage the bank’s blockchain platform to improve the flow of money. Small banks step in to bank crypto-related businesses, as large banks shy away While large multinational banks have for the most part stayed away from providing banking services to cryptocurrency clients due to the ambiguity on how they are regulated, as well as a volatile trading market, smaller banks have been stepping into this opportunity providing financial products to this rapidly-growing segment of the financial industry. Top concerns are around anti-money laundering regulation that require banks to identify customers and the flow of funds. Today, there are only a handful of small banks in the US that operate in this space, including New York-based Signature Bank (SBNY) and Metropolitan Commercial Bank (MCB) within our coverage universe, as well as California-based Silvergate Bank (SI), which serves over 750 digital currency clients. While some money-center banks have announced intentions to offer some form of digital currencies (JPM Coin and Wells Fargo Digital Cash, for example), beyond that, large banks’ involvement in this space has been very limited. Silvergate Bank has the highest exposure to cryptocurrency clients Although Silvergate Bank was founded in 1988, its push into becoming a prominent player in providing digital currency products did not begin until 2013. Today, $2.1 billion asset size Silvergate provides to its 750+ fintech clients various banking solutions including real-time 24/7/365 settlements for currency transactions (through its no-fee Silvergate Exchange Network), support services for digital currency exchanges including cash management products, and traditional bank accounts (with online banking and debit card functionality). Silvergate’s fintech clients include cryptocurrency exchanges, large institutional investors that hold positions in digital assets, and blockchain miners and service providers (that hold a combined $1.3 billion in deposits, primarily non-interest bearing, at Silvergate). In 3Q19, Silvergate’s Exchange Network processed over $10 billion of USD transfers across 12,000 unique transactions, and the company has 250 prospective digital currency customers in its pipeline. The value proposition in the network is that it enables its participants to transact US dollars at any time, even outside of regular market hours, with funds clearing immediately, compared to a legacy process that can take anywhere from several hours to several days to complete. On the deposit accounts that the company provides to its digital currency clients, today Silvergate is one of only a handful of financial institutions that has the ability to open these accounts in a way that is regulations-compliant. Metropolitan Commercial Bank banks cryptocurrency clients, but a small contributor to overall banking Another small-sized bank that banks cryptocurrency clients is New York-based $3.1 billion asset size Metropolitan Commercial Bank, although at a smaller scale than Silvergate. As of 2Q19, Metropolitan Commercial Bank held $213 million in deposits from digital currency-related customers, or 9% of total deposits at the bank. Not only does Metro gain access to low-cost funding from banking digital currency-related clients, but it also earns fee income from these relationships by providing services such as wire transfers, ACH, and foreign exchange conversion at the same fee as is charged to digital currency-related clients. The niche client base includes cryptocurrency exchanges, hedge funds, and other cryptocurrency investors that seek to move money and use other banking services. We note that deposit balances for digital-currency clients have been on a decline every quarter since 2Q18 and therefore this activity has been a smaller driver of deposit growth. Steven Alexopoulos, CFA AC steven.alexopoulos@jpmorgan.com J.P. Morgan Securities LLC Alex Lau alex.lau@jpmorgan.com J.P. Morgan Securities LLC Anthony Elian, CFA anthony.elian@jpmorgan.com J.P. Morgan Securities LLC Janet Lee janet.s.lee@jpmorgan.com J.P. Morgan Securities LLC Nikhil Potluri nikhil.potluri@jpmorgan.com J.P. Morgan India Private Ltd.

Blockchain adoption in European financial services: Exchanges embrace settlement and clearing efficiencies Blockchain technology has the potential to drive efficiency gains across the sector especially in areas of settlement and clearing.

Exchanges are embracing blockchain technology in their operations; seeking to launch new digital asset trading platforms.

Traditional capital markets are continuing the adoption of Blockchain, with more assets becoming tokenized.

Asset managers are exploring the roll out of digital asset solutions. Blockchain adoption: Stock exchanges The adoption of blockchain technology among stock exchanges offers scope to improve the efficiency around settlement/clearing and collateral management. Settlement in the exchanges space is currently typically T+3 days, but the delay is principally due to market practices, financial industry laws, and regulatory requirements and not necessarily to current technological infrastructure. The industry has discussed the potential to reduce settlement time, and the implementation of Blockchain could act as a catalyst to drive down the settlement period towards T+0 over time. Deutsche Boerse has rolled out DLT solution for collateral management Following Deutsche Boerse’s investment in technology firm HQLAˣ in early 2018, in December 2019 Deutsche Boerse and HQLAˣ launched their jointly developed Distributed Ledger Technology (DLT) solution for frictionless collateral swaps in the securities lending market, with live transactions executed by Commerzbank, Credit Suisse and UBS on the Eurex Repo F7-trading system. The HQLAᵡ operating model leverages distributed ledger technology to enable atomic Delivery versus Delivery (DvD) for baskets of securities residing at multiple custodians. DvD enables capital savings by reducing the consumption of intraday credit and liquidity. Australian Stock Exchange advancing in implementation of blockchain technology In the exchanges universe, the Australian Stock Exchange is at a relatively advanced stage to embrace Blockchain/DLT as it seeks to replace its existing settlement/clearing system (Clearing House Electronic Subregister System (CHESS)); however, we note that the planned implementation has been delayed from late 2020 to early 2021. ASX management has indicated that their version of DLT would involve a private permissioned ledger with key benefits including reduced costs for participants, continued trust (with the ASX being the single source of truth), and the availability of real-time data on settlements. ASX management believes that there will be no computational issues with using Blockchain technology to replace the CHESS system, as ASX will be the only entity who needs to verify the chain, unlike a public ledger which requires verification by multiple participants within the blockchain system. The ASX initiative has attracted complaints from a range of current system users including Chi-X (which processes one-fifth of the Australian trades and relies on ASX’s clearing system) which joined share-registry firms, Computershare and Link Administration, in raising concerns over the CHESS overhaul. While ASX already has a monopoly on clearing and settlement, the firm believes that they will experience disruption and an unfair disadvantage as a result of the new system introduction. ASX is proceeding with the system rollout, while the debate on the financial benefits of the new system, as well as the security offered by a non-consensus algorithm-based ledger continues. Swiss Stock Exchange working towards SIX Digital Exchange rollout Switzerland’s stock exchange has been working on launching a fully integrated, Distributed Ledger Technology-based end-to-end trading, settlement and custody service for digital assets. The new platform, known as the SIX Digital Exchange (SDX) was expected to launch in H1 2019, but was delayed into H2 2019 and now further into 2020. The delays are reportedly caused by the changes to the legislation required to accommodate digital exchanges and assets. The service will provide a safe environment for issuing and trading digital assets, and enable the tokenization of existing securities and non-bankable assets to make previously untradeable assets tradeable, as well as to reap the benefits of nearly instant settlement and the potential for fractional ownership. SIX trialed the first prototype in late 2019, aiming to demonstrate the integration of a distributed CSD (central securities depository) with the conventional model of a stock exchange. The prototype featured digital security token issuance, live trading, and instant settlement. The second prototype, due to be released in the coming months, will feature asset servicing and post trade services. Boerse Stuttgart launched a digital asset exchange In September 2019 Boerse Stuttgart launched a digital asset exchange platform BSDEX, which allows investors to trade cryptocurrencies, with plans to extend this to other tokenized digital assets designed around markets such as real estate, investment funds, and debt. The platform is regulated and is the first of its kind in Germany offering investors a modern and transparent way to directly trade digital assets by avoiding time and costs associated with intermediaries such as brokers. The potential beneficiaries of the new DLT technology based settlement/clearing system include banks and brokers who would see lower reconciliation costs and lower capital requirements (from potential real-time settlement). Registry service providers may be negatively impacted as they will lose interest income on cash balances, and the service of providing ownership information may become redundant since exchanges will have access to that information quite readily. In the long run, as the pool of tokenized securities grows, we believe digital exchanges could put pressure and increase competition among the traditional brokers and asset managers. Blockchain adoption: Capital markets Fidelity expanding digital asset custody and trading Fidelity announced in October 2018 that it would be launching Fidelity Digital Asset Services (FDAS) to offer as institutional-grade digital asset custody, trade execution, and dedicated client service. Since then the company noted a “significant interest and engagement by the institutional community, which show no signs of slowing,” and in December 2019 formed a UK subsidiary to formalize the provision of digital asset services in Europe. State Street collaborates with Gemini on reporting In December 2019 State Street announced it will collaborate with the Cryptocurrency exchange and custodian Gemini Trust to integrate Gemini’s digital asset custody solutions into State Street’s investment reporting, enabling investors to have an integrated interface for investment reporting spanning their digital and traditional assets. QME and Ant Financial launched a blockchain warehouse receipt alliance to prevent fraud QME (the commodity trading platform of the Hong Kong stock exchange) announced a partnership with Ant Financial, to integrate warehousing and logistics, using blockchain technology to provide transparency for the entire lifecycle of a commodity. Warehouse receipts, which can be used as collateral for finance, have been subject to widespread fraud in recent years, and blockchain technology allows a receipt to be better tracked and authenticated, hence preventing potential for double financing. Blockchain facilitates the debt issuance process Blockchain technology has been used to improve the process of bond issuance by enabling more efficient bookkeeping, underwriting, pricing and allocation of bonds. Blockchain is also seen as enabling better transparency in the allocation of debt securities by issuers, an area where, in some instances, a conflict of interest could exist. 2019 saw an increasing number of blockchain bonds being issued. For example, the Bank of China completed the issuance of 20bn yuan ($2.8bn) of bonds using its proprietary blockchain system. In addition, Santander issued a tokenized $20mn bond on the public Ethereum Blockchain. BBVA has completed a number of loans ranging between €35mn and €1bn using its Blockchain loan platform, which also won it the Bankers Tech Projects Award in 2019. Following its launch of bond-I (the world’s first bond to be created, allocated, transferred and managed through its life cycle using distributed ledger technology) the World Bank announced in 2019 it has raised an additional A$50mn, and the second tranche has taken the total capital raised by bond-I to A$160m. The bond is part of a broader strategic focus of the World Bank to harness the potential of disruptive technologies for development. In June 2017, the World Bank launched a Blockchain Innovation Lab to understand the impact of Blockchain and other disruptive technologies in areas such as land administration, supply chain management, health, education, cross-border payments, and carbon market trading. Gurjit S Kambo, CFA AC gurjit.s.kambo@jpmchase.com J.P. Morgan Securities plc Siddharth Parameswaran AC siddharth.x.parameswaran@jpmorgan.com JP Morgan Securities Australia Ltd

Banks’ adoption of Blockchain: Latest developments in distributed ledger technology Banks have continued to invest in blockchain initiatives in 2019, but we have yet to see tangible cost benefits. However, we continue to see long-term potential for Distributed Ledger Technology (DLT) to transform Banks’ business models, and expect continued momentum in adoption in the medium term.

We see Trade Finance Blockchain solutions offering the most incremental efficiencies in the Banking sector relative to other use cases, especially with Payments largely digitalized and alternative KYC solutions through other mediums available.

While we see wide-spread implementation of blockchain solutions at least three to five years away, challenges such as the macro-economic environment, legal and regulatory frameworks and technical challenges, such as cross-platform integration may decelerate further progress. Developments in Blockchain applications for the banking industry Following on from our Blockchain and Cryptocurrencies 2019: Adoption, Performance and Challenges, J. Loeys et al., 24 Jan. 2019 report, we look at the progress that the Banking sector has made in 2019 on blockchain initiatives and our expectations for the medium term. While we continue to see wide-spread Blockchain adoption at least three to five years away, progress has been made in 2019 with a growing number of Banks’ supported Blockchain platforms in live operation across key business segments such as Trade Finance and Payments, inter-operability solutions piloted across platforms with the same underlying technology, and a growing awareness across the financial community (Global Banks, Regulators and other stakeholders) of the potential benefits of blockchain adoption. We continue to see significant long-term potential for Blockchain to transform Banks’ business models once scale has been achieved, but we also see near-term headwinds outside of Banks’ control, which may impede progress We expect continued momentum in the medium term, particularly in areas such as network expansion for Trade Finance platforms, but we also outline several challenges that could negatively affect further progress: 1) With the macro-environment more dovish compared to a year ago, we see Global Banks responding to increased revenue pressures through cost-cutting and a reduction in discretionary investment programs, which could directly impact funding into Blockchain consortiums and programs, resulting in slower progress and operational challenges; 2) The legal and regulatory framework for Blockchain/Crypto globally remains incomplete resulting in a deficient ecosystem, hindering widespread adoption in our view—although we note that Central Banks have paid close attention to developments, particularly around Payment systems (e.g., Facebook’s Libra); 3) Technical challenges remain including cross-platform integration and a lack of standardization resulting in hurdles when upscaling platforms. We continue to see Blockchain’s long-term potential, once scale has been achieved, through the transformation of manual/cost-intensive processes that could drive more efficient business models in the Banking sector. Since the cryptocurrency boom in 2017, expectations of the transformative qualities of Blockchain for the Banking sector and the time horizon of development and adoption of initiatives have rebased. We note that PWC’s 2017 Global Fintech Report surveyed >1.3K executives and showed 55% of respondents planned to adopt Blockchain as part of processes by 2018 and 77% expected Blockchain to be a common element found in business processes by 2020, but we see this unlikely to materialize. We continue to see wide-spread Blockchain adoption at least three to five years away, but see progressive development across various initiatives. See our previous Blockchain reports from 2018 J.P. Morgan Perspectives: Decrypting Cryptocurrencies: Technology, Applications and Challenges, J. Loeys et al., 9 Feb. 2018) and from 2019 Blockchain and Cryptocurrencies 2019: Adoption, Performance and Challenges J. Loeys et al., 24 Jan. 2019, which address key use cases of Blockchain in the Banking sector, and expand on below. Trade Finance represents one of Blockchain’s key opportunities where significant progress has been made to provide end-to-end digitalization Trade Finance, and particularly the $2trn+ Traditional Documentary Trade segment, has yet to achieve end-to-end digitalization with Blockchain emerging as a potential solution to materially reduce inventory lead times and lower operational costs, especially through the use of smart contracts. Blockchain initiatives in Trade Finance have seen significant progress relative to other use cases with an increasing number of global Banks participating in pilot programs and some offering live solutions to clients (e.g., Societe Generale, HSBC, UniCredit, Know Santander, and UBS). In our view, given the palpable benefits to clients, we see Banks’ participation and investments into Trade Finance-related Blockchain initiatives both as defensive over market share and ultimately customer relationships, and geared towards new growth opportunities (e.g., products/clients/markets). KYC Blockchain solutions offer the potential for significant cost-saving, but well-developed alternatives such as SWIFT’s KYC registry already exist Blockchain offers a potential solution to reduce duplicative Know Your Client (KYC) processes performed by Banks and significantly reduce the on-boarding time for clients—which can take up to one month and in many cases, longer—reducing the overall KYC cost base. A Thomson Reuters survey in 2016 showed that the average firm paid $60mn a year for KYC compliance, with some spending up to $500mn annually. Such Blockchain solutions are still in production phases including Dubai’s KYC data-sharing consortium partnering with KYC blockchain developer ‘norbloc,’ which is planned for 1Q20, with several successful trials including R3’s KYC application partnering with 39 firms concluded. Blockchain technology for KYC processes has the potential to produce the most time efficiencies relative to other use cases. However, we expect progress on blockchain KYC projects to continue to be challenged in areas including multi-jurisdiction hurdles on data sharing and privacy, lack of network effects, and concerns around transferring KYC responsibilities, but not liabilities to third parties (i.e., other institutions on the Blockchain). Further, the availability of alternate solutions such as SWIFT’s KYC registry, which is already used by more than 5k financial institutions and provides substantial time efficiencies, may hinder widespread adoption of a blockchain solution (even if incrementally more efficient)—although we note underlying differences in the technology such as the responsibility of validation. Syndicated Lending offers high margin potential, but is still reliant on manual processes, with Blockchain a potential solution to digitalize Syndicated Lending offers Banks high margin potential, but is still reliant on manual processes with 20+ day settlement cycles due to the quantity of information exchanged, lengthy reviews and the paper forms of communication between parties. Blockchain offers a potential solution to digitalize this process, reducing complexity and operational risk. Finastra is one of the companies at the forefront of Blockchain-based Syndicated Lending with its Fusion LenderComm platform partnering with multiple banks such as RBS, BNP Paribas, HSBC and ING. However, given the larger volume of transactions in Trade Finance relative to Syndicated Lending, and hence the greater potential to reduce aggregate inefficiencies, we see Trade Finance Blockchain solutions and partnerships as more of a focus for Banks, in our view. New use cases such as document management, Blockchain mortgages and custody platforms are in development, driven by the continuing need to digitalize processes While much of the Blockchain attention in the Banking sector is drawn toward developments in Payments and Trade Finance, new initiatives are emerging for other Banking processes. Poland’s Alior Bank announced plans to use a public Blockchain for client document management, allowing clients to verify and authenticate their documents by matching hash codes—a notable difference to other initiatives that use private Blockchains. RBS is also working on a Blockchain solution for the mortgage process to enable background data to be shared with relevant parties (e.g., lawyers, conveyancers), giving clients more transparency with the process. Further, HSBC has plans to shift $20bn of assets to a Blockchain-based custody platform (“Digital Vault”) by March, giving investors real-time access to records of securities bought on private markets. We also note that Citigroup and Goldman Sachs recently completed the first total return swap transaction using DLT on Axoni’s Blockchain platform to process trade data, which allows for continuous reconciliations between parties during the trade lifecycle. Widespread adoption for Trade Finance Blockchain solutions remains three to five years away Network expansion through organic and inorganic means is the key next step to drive participation in the supply chain. Through 2019, Banks have featured in pilot programs globally across multiple Trade Finance Blockchain platforms, producing evidence that Blockchain technology can provide efficiency gains (e.g., costs, time) to the supply chain. In our view, the next key step for Banks and consortiums towards the ultimate goal of full-scale Blockchain adoption is network expansion, as this provides scalability and wide acceptance across supply chains. We expect network growth to be achieved organically (i.e., new Financial Institutions and their client networks joining as participants in programs) or inorganically (i.e., consolidation of Blockchain projects where Banks are mutually inclusive or inter-technology/cross-platform integration between programs). The number of participants in Blockchain projects provide an indication as to the level of adoption seen—which we expect to grow in the medium term through positive feedback loops Below, we highlight the scale of current Blockchain programs within the Trade Finance and Payments segments—we focus on these segments as this is where we have seen the most progress and where Blockchain technology could be significantly impactful on Banks’ business models. While we note that each project offers different solutions and may be geared towards a particular geographic region, the number of participants provides an indication as to the level of progress made by each program given the importance of network expansion. The Interbank Information Network® has the highest level of adoption so far with 400 Global Financial Institutions having signed letters of intent to join, of which over 90 are live participants, followed by Marco Polo and the Letter of Credit Network programs, which have core Financial Institution members. Komgo has cross-industry uptake with shareholders that include banks like Citi, BNP Paribas, and ABN Amro, alongside trading houses like Koch and Mercuria, and energy majors like Shell. Vakt is an example of an industry-specific network with over a dozen energy market investors as network participants. We expect continued growth in the participant base in the medium term, particularly as programs mature and the number of successful transactions increase, creating positive feedback loops. Successful pilots show platform inter-operability is achievable where the underlying technology is consistent, but cross-platform integration remains a challenge Inorganic network growth with programs using the same underlying technology (e.g., Marco Polo and Letter of Credit Network using R3 Corda) is relatively easier from an operational and governance perspective compared to the challenges faced with cross-platform integration. We note that HSBC has successfully piloted a Letter of Credit in 2019 using inter-operability between two Blockchain programs: Letter of Credit Network and ReChainME, both on R3 Corda technology. Similarly, multiple Asian banks also trialed a shipping trade finance transaction in 2019 using eTradeConnect and Global Shipping Business Network programs, both operating on Hyperledger technology. However, we are beginning to see pilots demonstrating successful, cross-platform integration. A prototype network, using the underlying technology developed by J.P. Morgan, and announced by the Monetary Authority of Singapore and Temasek, as part of Phase 5 of Project Ubin, demonstrated a Quorum-based payments network that provided interfaces for other non-Quorum blockchain networks (such as Hyperledger, DAML) to connect and integrate to support use cases such as Delivery-versus-Payment (DvP) settlement with private exchanges, conditional payments and escrow for trade, as well as payment commitments for trade finance. Table 1: Key Blockchain Initiatives Name Number of Participants (JPMe) Underlying technology Application Stage in cycle Contour (formerly Voltron and Letter of Credit Network) 8 Financial Institutions and the R3 consortium R3 Corda Letters of Credit Expected to go live in 2020 We.Trade 15 European Financial Institutions IBM Blockchain Platform using Hyperledger Fabric Open Account trade and Trade Finance for SMEs Live Marco Polo 30 Financial Institutions and the R3 consortium R3 Corda, Trade IX Open Account trade Expected to go live in 2020 komgo 15 core shareholders (o.w.10 Financial Institutions) and 2 non-shareholder members Quorum, a permissioned-variant of the Ethereum blockchain Letters of Credit, Open Account trade, KYC solutions, Certification processes Live VAKT 12 members (o.w. 3 Financial Institutions) Quorum, a permissioned-variant of the Ethereum blockchain Post-trade management in commodities trading Live eTradeConnect 7 initiating Financial Institutions and 5 member Financial Institutions – Asia focused IBM Blockchain Platform using Hyperledger Fabric Open Account trade and Trade Finance Live Interbank Information Network® 400 Global Financial Institutions have signed letters of intent; 90 are live currently Quorum, a permissioned-variant of the Ethereum blockchain Information sharing related to global cross-border payments Live Axoni 15 Financial Institutions Variant of the Ethereum blockchain Equity swaps Live Source: J.P. Morgan estimates, Company reports. R3 Consortium contains >300 members. Raul Sinha AC raul.sinha@jpmorgan.com J.P. Morgan Securities plc Sheel Shah AC sheel.shah@jpmorgan.com J.P. Morgan Securities plc Distributed ledger technology/Blockchain Distributed ledger technology (DLT) has the potential to disrupt payments, clearing, settlement and related activities. Distributed ledger technology draws on well-established technologies, as well as newer technologies like blockchain technology to operate a set of synchronized ledgers managed by one or more entities. In many financial markets there is a central ledger managing certain risks on behalf of participants. Distributed ledger technology could reduce the traditional reliance on a central ledger managed by a trusted entity. Distributed ledger technology may substantially change how assets are maintained or stored, obligations discharged, contracts enforced and risks managed. The key potential positives include: Reduction of complexity

Improving processing speed, and thus speeding up the availability of assets and funds

Reducing the need for reconciliation across multiple record-keeping ledger infrastructures

Increasing transaction transparency

Improving network resilience through distributed data management

Reducing operational and financial risks A key property of distributed ledger technology is the distribution of responsibilities for updating the ledger or transactions to multiple nodes. These nodes can be deployed across multiple sites, institutions and jurisdictions. This is depicted in Figure 1. Depending on the rules implemented, changes to the ledger are reflected in all copies in a certain time span. Figure 1: Ledgers distributed across multiple nodes Source: Bank for International Settlements Typically in order to maintain a synchronized ledger, a number of protocols are used for communication between the nodes and for facilitating consensus among nodes about the current state of the ledger and the historical record. Cryptography tools play an important role in DLT in terms of authenticating approved participants, confirming data records and facilitating consensus. As part of the protocols, different nodes in the system may play different roles. These roles in a particular protocol may include, system administrator; asset issuer; proposer to update the ledger; validator to update the ledger; auditor of the ledger etc. Figure 2 shows an example payment transaction using DLT: To initiate a payment, Entity A uses cryptographic tools to propose an update to the shared ledger that would transfer funds from its account on the ledger to Entity B’s account on the ledger.

Upon receiving the request, the other nodes authenticate Entity A’s identity to makes sure Entity A has the requisite permissions. Then verification to make sure Entity A has the requisite funds. Nodes agree on the consensus process about which transactions should be included in the next update to the ledger.

After the update has been accepted by the nodes, the properties of the asset are modified so that all future transactions on that asset must be initiated using the cryptographic credentials of Entity B. Figure 2: Process flow for a distributed ledger technology-based payment system Source: Bank for International Settlements For the full report, see Primed for payments: Growth and consolidation go hand in hand, Sandeep Deshpande and Varun Rajwanshi, 9 September 2019 Sandeep Deshpande AC sandeep.s.deshpande@jpmorgan.com J.P. Morgan Securities plc Varun Rajwanshi, CFA AC varun.rajwanshi@jpmorgan.com J.P. Morgan Securities plc

Blockchain in Transportation: Hurdles persist to widespread adoption Competition for disruptive freight tech has increased, with automation gaining momentum.

Other collaborative logistics and visibility solutions meet near-term needs for productivity.

Several hurdles remain for widespread adoption including standards and government integration. Commercial viability remains a challenge Use cases remain unchanged, still in proof of concept. The potential to streamline transactions with a smart contract and isolate spoiled goods remain the most common use cases. However, the supply chain structure viewed as ripe for disruption is often a limiting factor in an industry still in the early days of leveraging data analysis, let alone applying new technologies. Specifically, digitizing information with tools such as Blockchain is challenging when most of the sources are still “offline” in paper form. Other hurdles include adoption models, complexity. Data quality is a concern for Blockchain if records are truly immutable, given the likelihood for entry errors. Dynamic networks would also have a difficult time maintaining Blockchain if updates are required but no longer centralized. Lastly, the path toward greater adoption is not clear and split between industry-led (push), or start-up-created (pull), to gain critical mass. Competition has increased in freight tech Larger potential disruption from automation. Self-driving trucks, as well as large and small drone cargo deliveries have emerged as the leading technologies for supply chain disruption. Recent testing in real-world applications with broadly supportive regulations have elevated the competition for Blockchain as a strategic imperative. Moreover, the potential long-term economic benefit of automation is more readily quantifiable after successful pilot programs even if it remains several years away from implementation at a larger scale. Competing visibility and collaboration tools are in use. Logistics platforms such as Turvo (a real-time collaborative logistics platform) are already driving collaboration with existing systems and across different supply chain partners. Other hardware and software solutions have improved track and traceability beyond just “dots on a map” and extended the business case to working capital savings. These offerings are low friction software and can also rely on data gathered from existing assets or a low level of investment with IoT sensors. Companies investing more in near-term productivity. Amid the recent volatility in global trade and US freight rates, public companies will make targeted efforts to drive cost savings with “low tech” applications. Process automation and leveraging internal data to improve asset utilization and freight visibility will likely remain focal points for companies looking to offset the challenges of a weaker freight market entering 2020. Governmental agencies play a significant role Cross-border trade integrates customs officials. Accelerating and streamlining customs clearing is a commonly cited use case for Blockchain. However, adopting this system would not only require shippers and carriers to join, but also governmental agencies from multiple countries. As noted in a recent paper from George Mason’s Mercatus Center, “rent seeking behaviors” could work against Blockchain adoption in instances of significant bureaucratic corruption. Federal approval required for new consortiums. TradeLens, a Blockchain initiative for ocean shipping started by Maersk and IBM, signed up other global container vessel carriers, but will require US regulatory approval for cooperation amongst competitors. One railroad (CSX) joined TradeLens in November 2019, but could also attract similar scrutiny should other US railroads look to join the consortium. On the back burner, but not going away Blockchain for supply chain buzz has faded. After dominating the freight tech world in 2017/2018, Blockchain for the supply chain has fallen down the “Gartner hype cycle” and was not a key topic at the recent freight tech conference we recently attended. The lack of substantive progress with use cases and the rise of competing technologies with a larger potential for long-term disruption are part of the declining interest level. Standards are critical and still under development. The Blockchain in Transportation Alliance (BiTA) formed in 2017 has ~500 member companies in 25 countries, including blue chips and tech-enabled “disruptors.” BiTA is facilitating common standard development and hosting education sessions. The lack of standardized data interchanges and software in legacy supply chains reinforces the need for an organization like BiTA to introduce a new framework, but the process will likely take a significant amount of time. Brian P. Ossenbeck, CFA AC brian.p.ossenbeck@jpmorgan.com J.P. Morgan Securities LLC

The rise of noncash payments globally The volume of cashless payments has risen sharply in recent years, especially in Emerging Markets…

…but the value of cashless payments has been more mixed; in several countries, the value of cashless payments adjusted for GDP declined over 2014-18.

Card and e-money payments have grown more rapidly than other types of noncash payments.

Despite the rise of cashless payments, cash use is still increasing in most countries.

The 2019 Federal Reserve Payments Study shows similar trends for the US, with noncash payment growth accelerating in 2015-18. The volume of cashless payments has increased sharply in recent years The global payments landscape is evolving, with new systems allowing near-instant person-to-person retail payments increasingly available around the world. The BIS notes that fast retail payment systems operate in 45 jurisdictions, and this number is projected to rise to 60 in the near future. Indeed, BIS Red Book statistics show that the number of cashless payments has risen sharply in recent years, especially in Emerging Markets (Table 1). In China and India, for example, the volume of cashless payments increased more than five-fold over 2014 to 2018, while the volume of cashless payments in Russia has tripled. At the other end of the spectrum, Singapore has seen the slowest growth in cashless payments, but that could be because noncash payments are already ubiquitous. As Figure 1 shows, the average inhabitant in Singapore made 831 cashless payments in 2018, substantially above the number of payments made per person in any other country. The next highest country, Korea, had only 547 payments per inhabitant in 2018, followed by Sweden with 529. Table 1: The volume of cashless payments has risen sharply in recent years, especially in Emerging Markets Total number (volume) of cashless payments by country, and CAGR; millions 2014 2015 2016 2017 2018 2014-18 CAGR China 36,620 66,709 96,639 133,920 198,362 52.6% India 4,644 6,995 10,926 15,811 24,430 51.4% Russia 11,367 14,338 19,174 25,797 34,836 32.3% Saudi Arabia 498 587 736 947 1,286 26.8% Indonesia 4,773 6,029 7,416 8,985 11,044 23.3% Argentina 1,385 1,548 1,845 2,049 2,375 14.4% Turkey 3,748 4,165 4,620 5,325 6,274 13.7% Korea 18,896 21,131 23,215 25,717 28,230 10.6% Mexico 3,495 3,798 4,030 4,546 5,068 9.7% South Africa 3,432 3,798 4,386 4,484 4,940 9.5% Australia 9,060 9,936 11,003 12,257 12,941 9.3% Italy 4,709 5,177 5,698 6,035 6,700 9.2% Switzerland 1,799 2,022 2,146 2,327 2,547 9.1% United Kingdom 21,270 23,080 25,152 27,139 29,778 8.8% Sweden 3,900 4,202 4,777 4,995 5,380 8.4% Netherlands 6,452 6,796 7,174 7,800 8,707 7.8% Spain 6,490 6,475 7,069 8,176 8,607 7.3% United States* 128,237 135,139 142,962 154,448 N/A 6.4% Germany 17,620 19,370 19,931 21,009 22,260 6.0% Brazil 27,582 28,251 28,954 31,065 34,600 5.8% Canada 11,531 12,000 12,610 13,315 14,452 5.8% France 18,958 20,208 20,908 21,964 23,498 5.5% Belgium 3,436 3,239 3,436 3,852 4,254 5.5% Singapore 3,886 4,029 4,256 4,391 4,687 4.8% * For the US, 2018 data were not available, so the Compound Annual Growth Rate (CAGR) shown is for 2014-17. Source: BIS Red Book, J.P. Morgan Figure 1: Cashless payments are most widely used in Singapore, Korea, and Sweden Average number of cashless payments per inhabitant in 2014 and 2018 * For the US, 2018 data were not available, so 2017 numbers are shown instead.Source: BIS Red Book, J.P. Morgan In contrast, although India, Saudi Arabia, and Indonesia have seen double-digit growth in cashless payments over 2014-18, noncash payments are still relatively uncommon in these countries: the number of cashless payments per inhabitant was only 18, 38, and 42 in 2018 for India, Saudi Arabia, and Indonesia, respectively. The value of cashless payments has been more mixed Although the total number of cashless payments increased for all countries in the sample above, the total value of these payments has been more mixed. In aggregate, the value of global cashless payments has increased significantly: for the 24 countries in the previous figures and including Japan, the value of such payments increased from $900trn in 2014 to approximately $1370trn in 2018 (assuming US values remained the same as in 2017). Figure 2: The value of cashless payments adjusted for GDP has declined in several countries over 2014-18 Value of cashless payments as a ratio to GDP in 2014 and 2018; number * For the US, 2018 data were not available, so 2017 numbers are shown instead.Source: BIS Red Book, J.P. Morgan However, China alone contributed $280trn of this increase, and on a country-by-country basis, growth rates were more mixed. Of these 25 countries, only 11 saw an increase in the total value of cashless payments over 2014-18. If we adjust for population, then even fewer countries saw growth. Only China, Korea, Singapore, Turkey, Indonesia, India, and the US (assuming 2017 numbers)—seven countries in total—saw an increase in the value of cashless payments per inhabitant. Another way we can look at these numbers is by adjusting for GDP. Figure 2, which displays the value of cashless payments as a multiple of GDP, shows that the UK and China had the highest value of cashless payments after adjusting for the size of the economy in 2018. And although these values increased over 2014-18, that was not the case for the next countries in the list: the Netherlands, Saudi Arabia, Germany, Belgium, and Korea all saw declines in the value of cashless payments relative to the economy. Card and e-money payments have grown more rapidly than other types of noncash payments Among the types of noncash payments, we find that the growth of card and e-money payments has outpaced the rest (i.e., credit/debit transfers and checks; see Figure 3). This makes sense as innovation and consumer preferences have driven payments towards more convenient electronic payment methods. Figure 3: Card and e-money payments have grown more rapidly than other noncash payments CAGR over 2014-18 for card and e-money payments and CAGR for all other noncash payments** by country; % * For the US, 2018 data were not available, so the CAGR shown is for 2014-17.** To calculate all other noncash payments, we subtracted the number of card/e-money payments per inhabitant from the total number of noncash payments per inhabitant.Source: BIS Red Book, J.P. Morgan Cash use is still increasing in most countries This explosive growth of noncash payments begs the question of whether we are moving towards a cashless world. To answer this question, we looked at the change in currency in circulation as a percentage of GDP. As Figure 4 shows, cash has become a less important part of the economy for some countries. (We do note, however, that a negative number does not indicate that currency in circulation is actually declining; it could also indicate that currency in circulation is growing at a slower rate than GDP.) However, the majority of countries in our list actually saw currency as a percentage of GDP increase over 2014-18. Figure 4: Although the importance of cash is declining in some countries, most countries saw an increase in cash use in 2014-18 Change over 2014-18 (%-pt; left axis) and 2018 level (%; right axis) for banknotes and coins in circulation as a percentage of GDP Source: BIS Red Book, J.P. Morgan The 2019 Federal Reserve Payments Study shows similar trends for the US In December 2019, the Fed released its seventh triennial study on noncash payment trends in the US, and its findings were similar to what we have discussed above. In 2018, the number of core noncash payments—defined as payments using credit or debit cards, the automated clearinghouse (ACH) system, or checks—rose to 174.2bn in 2018, up from 143.6bn in 2015 and 123.9bn in 2012. Figure 5 shows these transactions broken down by broad payment type. Similar to the global trend, card transactions in the US increased most dramatically (up 57% over 2012-18), followed by ACH transfers (up 38%), while check use declined 27%. Figure 5: The number of card payments in the US have increased most dramatically over 2012-18, while check use has declined… Number of payments in the US made using cards, ACH, and checks by year; billions Source: The 2019 Federal Reserve Payments Study, J.P. Morgan The value of noncash payments in the US also increased over 2012-18, rising from $78.0trn in 2012 to $86.8trn in 2015 and to $97.0trn in 2018. Although the number of card transactions dwarfs the other two payment methods, the value of card transactions is quite small—only $7.1trn in 2018 versus $64.2trn for ACH payments, which accounted for two thirds of noncash payments by value (Figure 6). Figure 6: …but the value of card payments remains quite small compared to the other payment methods Value of payments in the US made using cards, ACH, and checks by year; $trn Source: The 2019 Federal Reserve Payments Study, J.P. Morgan Not only have noncash transactions increased, but their growth is also accelerating. The number of noncash payments increased by 6.7% per year over 2015-18 versus 5.1% over 2012-15, while the value of noncash payments rose by 3.8% over 2015-18, versus 3.6% over 2012-15. Card transactions have been growing fastest: over 2015-18, the number and value of card payments increased by 8.9% and 8.6%, respectively, versus growth of 6.8% and 5.9% over 2012-15. One last trend to note is the distribution between in-person and remote card payments. Although the majority of card transactions occur in person (72% versus 28% for remote transactions in 2018), the value of in-person and remote transactions were virtually identical in 2018: $3.30trn for in-person payments versus $3.29trn for remote payments. Kimberly Harano AC kimberly.l.harano@jpmorgan.com J.P. Morgan Securities LLC

The Chinese case study: Managing a cashless economy at scale Modernization of payments is a global theme, and a key driver of stablecoin projects like Libra.

To complement prior work in this area, we appeal to the Chinese experience with digital payments as a case study in financial disruption and consumer preferences.

We review the major third-party payments platforms in China, including business models, market structure, regulatory developments and importantly their interconnections to financial markets.

Money market funds and bank wealth management products form key components of the Chinese financial system.

The integration of these funds into online ecosystems (e.g., YU’E Bao and Alipay/Alibaba) helped drive explosive growth in AUM…

…but this has since slowed, even as the money supply in China has continued expanding, likely reflecting much less attractive yield pick-up versus traditional bank deposits.

This interaction led to rapid technological and structural change, which in this case drove a similarly fast build-up of new risks to financial stability; timely regulatory intervention was key to managing this transition.

Though the convenience and features offered by integration into e-commerce networks was certainly a significant factor, the degree of sensitivity of Chinese MMF AUM to yield pick-up suggests economics was a comparable if not more important consideration compared to the network externalities of participating.

The example of China suggests that the transition to a mostly cashless economy can be managed at scale. Lessons from the Chinese experience In a recent publication, we considered the practical implications, and risk posed, by the potential rise of stablecoin-based ecosystems (see The market implications of Libra and other stablecoins, J. Younger et al., 5 Sept. 2019), as well as the hurdles to them achieving global scale (see Can stablecoins achieve global scale?, J. Younger et al., 3 Dec. 2019). For that work, we took a more first-principles approach, applying the lessons of more traditional fiat currency payment systems to alternative venues like Libra and its cousins. In doing so we highlighted two key risks posed by current design choices: the potential for gridlock in the absence of intraday liquidity via either overdraft or netting on the one hand, and the inherent instability of negative yielding collateral on the other. At this point, Facebook appears to be considering some modest design changes in the wake of several high profile presumptive Libra Association members bowing out. However, news reports suggest no moves to address the concerns raised above. A complementary approach to evaluating the market and financial stability implications of stablecoins is to appeal to case studies. Given that these projects, including Libra, remain at a very early stage of development, good examples are unsurprisingly difficult to come by. That said, the recent Chinese experience is, in our view, one worth considering for several reasons. First, this region in particular is likely to be critical to the success of any new global or cross-border payments system. Asia has already been the engine of growth in global payments over the past few years. In fact, China now makes up nearly a quarter of retail payments activity globally, up from only 11% as recently as 2012 (Figure 1). This growth has mostly come at the expense of larger developed economies, especially the US and Euro Zone for which market share has fallen. Along similar lines, projections from the McKinsey Global Payments Report for 2019 suggest this should remain the case going forward . Figure 1: Asia has driven most of the growth in retail payments globally over the past few years … Gross annual retail payment volume; $trn * Includes the remaining six of the top 10 payments systems by value transferred: the U.K., Brazil, Mexico, Korea, India, and Canada.Note: Payments data from the most recent BIS Red Book.Source: J.P. Morgan, BIS Figure 2: … which likely reflects increasing levels of financial inclusion via third party payments venues, especially the explosive growth in mobile wallets Annual volume in mobile and internet-based third party payments in China, annual growth rates for mobile, internet, and total are indicated; RMBbn Source: J.P. Morgan, PBoC This has been driven in large part by the expansion of e-commerce, which in China we estimate exceeded RMB10trn in 2019. That would represent a more than 400% increase over the past four years—more than twice the pace of increase in overall retail sales over the same period. In large part this likely reflects broader financial inclusion via online and mobile payments—for example, a survey conducted by the World Bank found that roughly 67% of adults in China made or received digital payments in 2017, up from 45% three years earlier—account ownership at a financial institution, on the other hand, barely budged over the same period. Consistent with this, third-party payments have experienced explosive growth over the past few years, the vast majority of which comes from mobile wallets (Figure 2). In this sense, the Chinese payments system has already moved significantly towards digital payments, and thus in principle the leap to a token-based stablecoin system would be much less disruptive. Second, China appears to have more growth potential, particularly in the B2C and P2P e-commerce transactions that would likely be first adopters of stablecoins. Based on official figures, current activity totaled nearly $2trn in 2018, making it the fourth largest market by this measure. Though impressive, this represents a somewhat smaller fraction of GDP and overall retail payments than other large economies, which implies ample room for further expansion (Table 1). Additionally with a higher overall fraction of these payments tied to B2C transactions, this growth is likely more representative of what the Libra Association has highlighted as the intended uses of Libra, and by extension other stablecoins. Table 1: Though China is not the largest e-commerce market yet, but it has substantial room to grow relative to GDP and overall retail payments, with more B2C activity than most developed countries 2018 e-commerce statistics by country; $bn unless otherwise specified Economy Total % of GDP % of retail payments B2C Share B2C Value United States $9,430 46% 14% 8% $800 Euro zone $5,922 35% 36% 29% $1,727 Germany $1,640 41% 44% 6% $96 Italy $352 17% 19% 7% $24 France $778 28% 12% 13% $98 Japan $2,975 61% 11% 5% $147 China $1,989 18% 4% 31% $617 Korea $1,360 84% 7% 5% $73 United Kingdom $820 29% 9% 27% $224 Canada $539 31% 12% 12% $63 India $404 15% 23% 8% $31 Source: J.P. Morgan, various official data sources, UNCTAD Finally, the connection between non-bank payments in China and domestic money markets offers a valuable laboratory for tracking flows in and out of those ecosystems. In particular, the two largest providers of these services—Alipay and WeChat Pay—recently began offering financial products as a way to earn income on funds kept within their network. These primarily consist of sweeps into money market funds (MMFs) that then invest in short-term onshore securities and bank deposits. They are not, however, required to participate in either system. In this sense, users of Alipay and WeChat Pay can use their servicers in one of two ways: pure payment rails that simply connect more traditional bank accounts, or as an expansive ecosystem in which their transactional cash and even savings are kept within those proprietary networks. Both were likely at play to some extent in the dramatic growth of MMF assets in China, which outpaced broad money supply by nearly 60%, and their subsequent decline—in sharp contrast to other major economies (Figure 3). Figure 3: The linkage between money markets and payment ecosystems like Alipay initially drove a surge of investment into MMFs, but more recently these flows have reversed MMF assets versus M2 for the US, Eurozone, and China; unitless and set to 100 as of 1Q 2016 Source: J.P. Morgan, IIF, Haver Analytics, various official sources Are they doing this for economic reasons, for example higher rates of return than traditional short-term investments? Or for the network externalities associated with participation in those systems? And are there any negative financial stability implications of such a rapid and large-scale reallocation of savings? Granted third-party payments in China are quite different from stablecoins, especially on the technology front. But they share the arguably more important feature of being a payments and e-commerce network that is both integrated into social media platforms and largely separated from the traditional banking system. In this sense, the size of Chinese money markets relative to the money supply offers a rather unique, even if imperfect, test of how consumers react to economic versus network-related incentives. With this backdrop in mind, this chapter presents a deep dive into the Chinese alternative payments system. We consider the mechanics and evolution of these systems, as well as the economic incentives of their providers. We also consider the implications for the structure of Chinese financial markets, including wealth management products (WMPs) and money market funds (MMFs). Finally, payments-related MMFs have had a rather dramatic impact on Chinese funding markets, with potential financial stability implications, but also value as a diagnostic of the relative importance of different consumer incentives. This is interesting in of itself, as we move towards a cashless global economy. However, for all the reasons mentioned above, it should be seen as a case study with lessons for the designers of Libra and other stablecoins. China’s third-party payment market Market overview The hyper-growth stage is over; industry focus shifts from customer penetration to usage frequency. According to iResearch, China’s third-party payment volume grew from RMB7trn in 2013 to RMB223trn in 2018. Such rapid industry development is mainly driven by exponential growth of mobile payments. Mobile payment volume expanded from RMB1trn in 2013 to RMB192trn in 2018, representing 86% of total third-party payment volume (Table 2). Table 2: Mobile payment penetration has largely saturated Alipay Global annual active users ~1.2bn Domestic annual active users ~900m Tenpay WeChat Pay MAU >800m Mobile payment penetration % 94.7% Source: Company data, IPSOS Broadly speaking, there are three key use cases for digital payment in China: Consumption payments : daily consumption payments both online and offline. This component is by far the largest, comprising roughly 70% of industry revenue.

: daily consumption payments both online and offline. This component is by far the largest, comprising roughly 70% of industry revenue. Financial payments : non-payment financial products such as loans, wealth management products, and insurance. This represents a significant fraction of value transferred on third-party payment networks, but because Alipay, Tenpay and others don’t directly charge on payment services, revenue is generated through distribution fees.

: non-payment financial products such as loans, wealth management products, and insurance. This represents a significant fraction of value transferred on third-party payment networks, but because Alipay, Tenpay and others don’t directly charge on payment services, revenue is generated through distribution fees. Other payments : money transfer including social payment (e.g., WeChat red pocket) among users. Payment companies only generate revenue when users withdraw money from their payment account to their bank account, but the associated fees are usually sized only to offset the 10bp charged by traditional banks. According to IPSOS, China’s mobile payment systems have reached the 1bn users milestone, with the penetration rate of total smartphone users close to 95% (Table 1). We believe the industry has therefore shifted from penetration-driven growth to frequency-driven growth, suggesting the hyper-growth stage is already over: total/mobile payment volume should grow at a more modest 2-year CAGR of 27%/30% during 2018-20E. Value chain and economics split NetsUnion is in full operation; the near-term economic impact is likely to be insignificant. As the primary regulatory authority for the third-party payments, PBoC mandated the establishment of NetsUnion to process online payment transactions in that market. Since the second half of 2018, all mobile payment transactions are required to be cleared by this centralized clearinghouse—in contrast to the direct connections among mobile payment providers and individual banks that existed in the past (Figure 4). So far, this transition has been smooth and we do not anticipate any major operational incident, even during peak time such as Double 11. Figure 4: Online payment model transits from direct connection model to centralized model Source: J.P. Morgan PBoC also indicated that the establishment of NetsUnion is for regulatory purposes and not for commercial gains, and consequently it does not charge a fee for its clearing and routing services. Further, given it will not be profit-seeking, we believe any fees imposed in the future will be small, and therefore will either not constitute a material cost increase to payment companies or can also be easily passed on to merchants/customers. Using UnionPay’s offline bank card transaction charge as an example, the rate should be no more than 6.25bps (approximately 10% of total payment service charges). Furthermore, this fee is borne equally by issuing parties and merchant acquirers. Economics split across the value chain. As NetsUnion currently does not charge a fee, payment service fees are mainly split between issuing parties—e.g., Alipay and Tenpay—and merchant acquirers (Figure 5)—e.g., China UMS and Huifu, though in some cases Alipay and Tenpay also play the role of merchant acquirers. For these two market participants, take rates are trending lower in the last few years, mainly due to 1) industry competition and 2) small merchant penetration. Figure 5: Key participants in the third-party payment value chain and their economics split Source: J.P. Morgan Alipay and Tenpay generally take 20-60bps of total payment value per transaction depending on the use case. For example, the take rate of offline consumption on QR code is lower than that of pure online in-app payment. Merchant acquirers can take 10-15bps per transaction, and they sometimes need to share the economics with their channel partners. We think further downside risk on take rate is limited because 1) the charge rate is already low, 2) the main phase of merchant coverage expansion is largely done, and 3) the major players have shifted their focus from pure volume growth towards more balance between growth and earnings. Figure 6: A schematic of funding sources for third-party payment providers in China Source: J.P. Morgan How do third-party payment providers source funding? There are four major funding sources of third-party payment transactions (Figure 6), including payment account balance, consumer lending products, money market fund products (e.g., YU’E Bao), and traditional bank accounts. When funds are sourced from a bank account, payment companies are required to pay a 10bps processing fee to the bank—otherwise there are no fees. Competitive landscape Mobile payment : Mobile payments remain a duopoly structure, with Alipay and Tenpay combined representing more than 90% market share. We believe Tenpay has an advantage in the offline payment market by leveraging WeChat’s large user base and high usage frequency, while Alipay still leads in online consumption payments supported by Alibaba’s online retail marketplaces (Figure 7).

: Mobile payments remain a duopoly structure, with Alipay and Tenpay combined representing more than 90% market share. We believe Tenpay has an advantage in the offline payment market by leveraging WeChat’s large user base and high usage frequency, while Alipay still leads in online consumption payments supported by Alibaba’s online retail marketplaces (Figure 7). Internet payment : The internet payment market structure is more fragmented than mobile, with the top three players taking 57% market share. The market scale is also much smaller than mobile payment, only accounting for 14% of total third-party payment volume in 2018 (Figure 8). Figure 7: Market share of third-party mobile payment in 2018 Source: Analysys, J.P. Morgan estimates Figure 8: Market share of third-party Internet payment in 2018 Source: Analysys, J.P. Morgan estimates Regulatory changes reshape industry landscape Two major regulation-driven changes have been implemented in recent years: 1) diminishing interest income from client reserve funds3 and 2) establishment of NetsUnion with a centralized clearance model (versus previously payment companies directly connected to banks; see discussion above). We believe both changes are mainly for risk management purposes, and that Chinese regulators generally remain supportive of market innovation. These new, tighter regulations have had some negative financial impacts on the industry. In particular, 1) above has effectively eliminated interest revenue from customer reserve funds. We estimate Tencent had RMB7bn client reserve fund related interest income in 2018, and this number declined to RMB200mn in 2019 (this interest revenue has reduced to 0% from mid-Jan 2019 onwards; Table 3). In addition, although NetsUnion has indicated that it has no intention to charge a fee for clearing and routing services, it may change in the future, causing incremental operating cost for payment service providers. Table 3: Internet income from client reserve fund diminished in Tencent's Fintech and business services segment (RMB mn) 1Q18 2Q18 3Q18 4Q18 2018 2019E Fintech & business services revenue 15,182 16,666 19,343 21,600 72,791 101,981 Interest income 2,500 2,050 1,520 859 6,929 200 as % of segment revenue 16% 12% 8% 4% 10% 0% Source: J.P. Morgan estimates, Company data Figure 9: YU’E Bao adopts a hybrid 1P and 3P model Source: J.P. Morgan, Company data Connections between digital payments and money markets The rise of YU’E Bao YU’E Bao was launched by Tianhong Asset Management (51% owned by Ant Financial) in June 2013. Since then, it has quickly gained strong traction and become one of the largest money market funds (MMFs) in the world. As of mid-2019, YU’E Bao AUM reached RMB1,034bn, or 14% of China’s total MMF AUM. YU’E Bao has expanded from one single MMF operated by Tianhong Asset Management to a marketplace that is made of Tianhong and more than 30 third-party MMF managers. The decline in AUM since 1H18 is mostly attributable to Ant Financial’s decision to shift the YU’E Bao business model (in May 2018) from a pure principal model (1P) to a hybrid 1P and marketplace (3P) model by introducing third-party MMFs. Its overall (1P+3P) AUM remains largely stable (Figure 9). According to The Paper (澎湃新闻), YU’E Bao introduced 13 third-party funds by the end of that year, with a combined incremental AUM of over RMB600bn. Adding this amount to YU’E Bao’s 1P AUM at the end of 2018, this platform actually expanded by approximately 10% YoY in 2018. This past Investor Day, Ant Financial management indicated total AUM (1P+3P) had reached RMB2 trillion. Given that the Chinese MMF complex experienced some outflows in aggregate (contracting by 4% in 1H19 versus 2H18; Figure 10), this product appears to be gaining some traction despite the industry-wide slowdown. Though a noticeably slower pace of growth compared to prior years, this is nonetheless a much different story than simply tracking the assets of the main fund. Figure 10: YU’E Bao assets grew explosively in 2016-17 and have continued growing when one includes MMF investments with third parties facilitated by the Ant Financial marketplace YU’E Bao AUM and that held by third parties on the Ant Financial marketplace (LHS; RMB bn) and as a fraction of the overall Chinese MMF industry (RHS; %) Sour