Introduction to Digital Assets

This reading explains distributed ledger technology, blockchains and their consensus protocols, permissionless and permissioned networks, and the main types of digital asset. It then compares digital assets with traditional assets, describes the ways to invest in them directly and indirectly, and covers their return drivers, risk and diversification potential.

LOS 86.a — Distributed ledger technology and the digital assets built on it

What a digital asset is

Digital assets are assets that are created, stored and transferred electronically. The class is young and includes cryptocurrencies, tokens and digital collectibles. Every digital asset is secured and validated with distributed ledger technology (DLT), often called blockchain technology. A cryptocurrency runs on its own blockchain; a crypto token is built on top of a blockchain that already exists.

The distributed ledger

A distributed ledger is a database that is shared among market participants. Each participant keeps an identical copy, and the ledger holds a record of every transaction.

A DLT network has three parts:

1. a digital ledger (the shared record itself);
2. a consensus mechanism, which is how the network agrees on the state of the ledger by validating transactions and then updating the ledger; and
3. a network of participants (who may perform the network's functions).

Validation plus updating makes records immutable, meaning they cannot be changed afterwards, while keeping them visible to all participants. Cryptography encrypts the data so that unauthorized parties cannot read it.

Smart contracts are computer programs on a DLT network that execute by themselves when pre-agreed terms and conditions are met. Examples: automatically settling contingent claims, or moving collateral to a lender when a borrower defaults.

Blockchains and consensus protocols

A blockchain is a digital ledger that stores information in blocks recorded in sequence. Each block holds a group of transactions plus a cryptographic link (a hash) to the block before it, so the blocks form a chain. A new transaction joins the chain only after authorized participants validate it.

Consensus protocols decide how blocks are chained together and are designed to resist manipulation.

Because a PoW attack needs a majority of the network, a blockchain with many participants is harder to attack and more likely to succeed.

Permissionless versus permissioned networks

Types of digital assets

Digital assets fall into two families, cryptocurrencies and tokens.

Family	Type	Example or note
Cryptocurrencies	Bitcoin	The most widely traded cryptocurrency
Cryptocurrencies	Altcoins: other cryptocurrencies	Ether, on the Ethereum network
Cryptocurrencies	Altcoins: stablecoins	Tether, pegged to the US dollar
Cryptocurrencies	Altcoins: meme coins	Dogecoin
Cryptocurrencies	Central bank digital currencies (CBDCs)	A central bank's equivalent of a cryptocurrency
Tokens	Nonfungible tokens (NFTs)	Each token is unique, e.g., a piece of digital artwork
Tokens	Security tokens	Initial coin offerings (ICOs)
Tokens	Utility tokens	Paying for network services and network fees
Tokens	Governance tokens	Voting on how a permissionless network operates

• Cryptocurrency: a digital currency issued privately, with no central bank backing. It allows near-real-time transactions without an intermediary. Many cryptocurrencies limit the number of units that can be issued to support their role as a store of value, yet prices are still very volatile. Bitcoin is the most widely traded. Altcoins are alternatives built on Bitcoin's technology. The best known is Ether on the Ethereum network, a programmable blockchain on which users build smart contracts, so its value is not limited to being a store of value. As of mid-2022, Bitcoin and Ether together made up more than 80% of the cryptocurrency market.
• Stablecoin: designed to hold a stable value by being linked to the value of another asset (such as the US dollar); Tether, pegged to the US dollar, is a widely used example. Reserve-backed stablecoins are secured by a reserve basket of assets. Algorithmic (smart) stablecoins instead use algorithms to mint additional units when demand increases; they may hold no actual reserves, and a peg that depends only on the algorithm can fail, as TerraUSD's did in 2022. Exam convention: a stablecoin cannot be converted into fiat currency and has no legal or regulatory backing. Current practice: some issuers do redeem their stablecoins for fiat currency, and some jurisdictions have begun to regulate stablecoin issuers. An asset-backed token is a special case: its value is pegged to a target asset such as gold.
• Meme coin: launched for entertainment. Prices can soar on social media attention and then collapse. The best known is Dogecoin.
• Central bank digital currency (CBDC): a central bank's equivalent of a cryptocurrency, in effect a digital version of its banknotes and coins. Unlike cryptocurrencies, it is government issued.
• Tokenization: using DLT to record and track the ownership history of physical assets (e.g., real estate), which reduces the work needed to verify ownership when assets change hands. The token is the unit that represents the ownership right.
• Nonfungible token (NFT): a form of tokenization that ties a digital asset to a certificate of authenticity. Each NFT represents a distinct item (e.g., a piece of digital art), unlike fungible tokens, which are interchangeable.
• Security token: tracks ownership rights in publicly traded securities digitally. A blockchain can handle custody, settlement, recordkeeping and post-trade processing on one ledger.
• Initial coin offering (ICO): a way for a company to raise money by selling crypto tokens in exchange for money or other cryptocurrency. An ICO is classified as an example of a security token. The tokens are often usable later for the issuer's products or services.
• Utility token: used to pay for services on the network, such as service payments and network fees. It compensates holders only for network activity, while a security token may pay dividends.
• Governance token: issued on permissionless networks. It gives holders voting rights over how the network operates, e.g., voting on how to fix a technical problem.

ICO versus regulated IPO

Example

A cooperative owns a $12 million grain terminal. It records ownership on a distributed ledger and issues 120,000 tokens, each representing $1/120,000$ of the terminal. Each token then represents a $100 claim ($12,000,000/120,000=100$). A buyer with $5,000 can hold 50 tokens, and each transfer of tokens is logged on the immutable ledger. This is tokenization: ownership of a physical asset is tracked on DLT. Because each token is a digital ownership claim on a physical asset, the tokens are also asset-backed tokens (LOS 86.c).

LOS 86.b — Investment features of digital assets versus other asset classes

The number of cryptocurrencies has grown from dozens to thousands, and institutional investors are paying attention because of high expected returns and possible diversification benefits. Exchanges and custodians have built infrastructure to serve them. Digital assets nonetheless differ from traditional financial assets in four main ways:

LOS 86.c — Investment forms and vehicles

Where cryptocurrencies trade

Direct owners hold a cryptocurrency wallet, which stores the digital encryption keys needed to access and trade the assets.

On both types, weak oversight raises investor protection concerns. Fraud and manipulation are more likely, e.g., pump-and-dump schemes that hype a coin on social media to push its price up.

Direct investment

A direct investment is a transaction recorded on the blockchain itself: buying tokens on a crypto exchange, trading an NFT, or taking part in an ICO. Most crypto exchanges trade continuously. Key risks:

• Fraud: theft, scam ICOs and attempts to obtain wallet credentials, on top of the manipulation risk that comes with weak exchange oversight.
• Loss of access: coins sit in wallets that require unique passkeys. If the passkey is lost, the coins cannot be retrieved and are effectively worthless. An estimated 20% of all Bitcoin sits in lost or abandoned wallets.
• Whales: a few large holders who own enough of a small cryptocurrency to manipulate its price. This is mainly a risk in thinly held coins; in the largest, widely held coins no single holder is likely to have that power.

Indirect investment

Digital investment in nondigital assets

Asset-backed tokens are digital claims on physical or financial (nondigital) assets such as oil, gold, real estate or equities, and they are collateralized by the underlying asset. They:

• can potentially make high-priced assets, such as real estate, more liquid through fractional ownership;
• create an immutable ownership record, which improves transparency and lowers transaction costs;
• are generally classified by regulators as securities.

They are often issued on Ethereum, where smart contracts allow P2P interaction. Decentralized applications (dApps) record transactions on the blockchain without a central system. Decentralized finance (DeFi) is the resulting marketplace of open-source dApps that can serve as a medium of exchange and a store of value, tokenize assets and keep immutable ownership records. Today most dApps focus on speculating in digital assets.

LOS 86.d — Risk, return and diversification

Return drivers. Returns on cryptocurrencies come mainly from asset appreciation. A major driver of prices is limited supply: Bitcoin is capped at 21 million units, and some call it "digital gold" for that reason. Prices are also affected by:

• market adoption and network impacts (network effects);
• technological innovation;
• regulation, including how new rules develop;
• speculation and investors' risk appetite.

Risk. Bitcoin and other cryptocurrencies have delivered high returns with high volatility compared with traditional asset classes, with very large rises followed by steep falls. Fraud, crime, uncertain regulation and outright bans in some countries (China banned cryptocurrencies in 2021) add to the uncertainty. Over January 2011 to January 2022, Bitcoin's average monthly log return was about 8.8%, against roughly 0.2% to 1.1% for US equities, global equities and global bonds, and its monthly standard deviation (about 0.32) was about eight times that of equities. Its coefficient of variation (standard deviation per unit of average return, about 3.7) was close to that of US equities and below those of global equities and global bonds.

Diversification. Historically, crypto returns have shown low correlations with traditional asset class returns (Bitcoin's monthly correlations with US equities, global equities and global bonds were only about 0.14 to 0.22 over the same period), so they may provide diversification benefits. The evidence is not settled, and correlations can rise during periods of extreme market stress, just when diversification is most needed.

Example

A coin's price goes from $8,000 to $20,000 over one year and then falls to $11,000 over the next. The first-year return is $20,000/8,000-1=150\%$, and the second-year return is $11,000/20,000-1=-45\%$. The two-year holding period return is $11,000/8,000-1=37.5\%$. No dividend or interest was received, so the whole return comes from price change. Such large swings are typical of the asset class's high volatility.