8.7 Introduction to Digital Assets

Question 1

The three basic elements of distributed ledger technology (DLT)

Answer 1

digital ledger

a participant network

a consensus mechanism to confirm new entries

Question 2

digital ledger

Answer 2

a database that can be shared over a network among a potentially unlimited number network participants (nodes).

–> Each network participant has an identical copy of the database, which includes a verified record of all transactions.

—-> In order to add a new transaction entry to the ledger, a consensus must be reached among participants

Question 3

the two parts of the consensus mechanism to confirm new entries

Answer 3

1. the new transaction is validated
2. this decision is confirmed when network participants agree to accept a common version of the updated ledger.

Question 4

To verify the identities of network participants, what does DLT use?

Answer 4

cryptography

Once encrypted, data is unusable by anyone outside the network

The various features of DLT ensure a high level of network security and database integrity.

A distributed ledger’s records are immutable (i.e., unchangable), transparent, and accessible by all network participants with nearly real-time updates.

Cryptography is used to secure all data within the blockchain

Question 5

Blockchain

Answer 5

a popular type of digital ledger where information (e.g., ownership changes) is recorded sequentially in blocks that are linked (chained) together

Cryptography is used to secure all data within the blockchain

Question 6

The steps involved in adding a transaction to the blockchain are:

Answer 6

1. Buyer and seller agree to the transaction
2. A block is created to record the transaction information and sent to all of the network’s nodes
3. Authorized member verify the new transaction’s details and identify any related previous transactions
4. The verified data is combined with data from previous transactions in a new block
5. The new block is added to the ledger and, using a secure link (known as a hash), it is chained to other blocks containing transaction data
6. The transaction is considered complete and the new block becomes part of the updated ledger

Question 7

DLT has many potential applications in the financial such as?

Answer 7

it allows for the creation and exchange of financial assets over peer-to-peer (P2P) networks with permanent ownership records that can be instantly updated to reflect the latest transactions.

With DLT, it is possible to use smart contracts that execute automatically when specified terms are met.

–> This is particularly relevant for contingent claims and debt covenants.

offers the potential benefits of greater transparency, more accurate record keeping, and a faster ownership transfer process

Question 8

The main drawbacks of DLT

Answer 8

it is not fully secure, which raises data privacy concerns

it consumes massive amounts of energy.

Question 9

Consensus protocols

Answer 9

needed to prevent network participants from acting maliciously to create false records

Question 10

The two main consensus protocols

Answer 10

Proof of Work (PoW)

Proof of Stake (PoS).

Question 11

Proof of Work (PoW)

Answer 11

the most popular consensus protocol for digital assets

Computers on the network, known as miners, compete to solve complex algorithmic puzzles that are created whenever a transaction occurs.

A transaction is only added to the blockchain when a puzzle is solved and the successful miner can prove their solution to other network participants.

solving these puzzles requires immense amounts of computational power, so miners are motivated by the prospect of earning cryptocurrency if they are successful.

Question 12

Proof of Stake (PoS).

Answer 12

network participants become eligible to validate transactions by pledging a certain amount of their capital. After pledging a stake, a participant may be chosen to verify the veracity of a transaction and choose the block that it will be included in. A proposed block is accepted if a majority of other validators attest to its validity.

As with the PoW protocol, participants are motivated to perform this service because they are compensated with digital assets (e.g., cryptocurrency, tokens)

Validators control access to the network and serve as a check against the potential for malicious actors acquiring control of a majority of the network’s computational power.

Question 13

A permissionless network

Answer 13

open to any user who wishes to make transactions.

Any transactions that have been added to the blockchain can be seen by all network members because all nodes have a copy of the permanent ledger.

Once participants become members of a permissionless network, they are eligible to perform all network functions.

Question 14

advantage of a permissionless network

Answer 14

One advantage of permissionless networks is that transacting parties do not need to know, or even trust, each other.

Transactions are verified when a consensus is reached among a majority of members.

This lack of a centralized authority responsible for validating transactions ensures that permissionless networks cannot be brought down by a single point of failure

Bitcoin is one of many cryptocurrencies that uses a permissionless DLT network.

Question 15

Permissioned networks

Answer 15

allow varying levels of access.

Membership in permissioned networks is limited and restrictions can be placed on a member’s ability to participate in the validation process and they may only be able to view the selective details of transactions.

The rules governing a permissioned network are overseen by a centralized organization and relatively few members are required to validate transactions.

Compared to a permissionless network, this structure is faster and more cost-effective, as less processing power and bandwidth are required.

Question 16

Types of Digital Assets

Answer 16

Digital assets can be classified into two broad categories — cryptocurrencies and tokens.

Question 17

Cryptocurrencies

Answer 17

The most common digital assets are cryptocurrencies, which may be issued by private organizations, companies, and even individuals.

used to store and transfer value and can be exchanged almost instantaneously without requiring the services of an intermediary.

Because they are not backed by a monetary authority (i.e., central bank), many cryptocurrencies are subject to self-imposed limits in order to maintain their value. Despite these limits, cryptocurrencies tend to be highly volatile assets, due in part to their lack of clear fundamentals.

Question 18

Tokenization

Answer 18

the process of representing ownership rights to physical assets on a distributed ledger

Question 19

types of tokens

Answer 19

Non-fungible tokens (NFTs)

Security tokens

Utility tokens

Governance tokens

Question 20

Non-fungible tokens (NFTs)

Answer 20

use blockchain technology to link digital assets to certificates of authenticity.

Essentially, NFTs provide a stamp to represents the ownership of unique virtual assets.

The most common use of NFTs is for trading digital artwork.

Question 21

Security tokens

Answer 21

represent digitized ownership rights of publicly traded securities.

They have the potential to make securities trading easier and more transparent by eliminating the need for post-trade reconciliation and transaction verification.

Companies can raise capital by issuing digital tokens in an initial coin offering (ICO).

Owners can use these tokens to purchase the company’s products or services. Security tokens may pay dividends but, unlike common shares, they do not confer voting rights.

Question 22

initial coin offering (ICO).

Answer 22

ICOs are often an attractive alternative to initial public offerings of securities, because they can be executed more quickly and at lower cost.

Although ICO are largely unregulated, new rules are being considered in various jurisdictions in response to numerous fraudulent schemes.

Question 23

Utility tokens

Answer 23

are used to pay for services within a specific network.

Question 24

Governance tokens

Answer 24

confer voting rights to members of a permissionless networks.

When important decisions must be made about the network, owners of governance tokens are eligible to participate in the vote.

Question 25

Distinguishing Characteristics of Digital Assets

Answer 25

Inherent value

Validating transactions

Use as a medium of exchange

Acceptance as a medium of exchange

Legal and regulatory protection

Question 26

Inherent value of Digital Assets

Answer 26

Financial assets are valued based on the cash flows that they are expected to generate in the future. By contrast, very few digital assets provide cash flows, which makes them difficult to value. Digital assets derive their value from perceived scarcity and expected price appreciation.

The value of a digital asset will also be affected by features of the network on which it is traded (e.g., PoS vs. PoW protocol).

Question 27

Validating transactions with Digital Assets

Answer 27

The decentralized digital ledger technology used to record digital asset transactions is the opposite of the centralized, private ledger systems used by intermediaries to validate transactions for traditional financial assets.

Question 28

Digital Assets’ Use as a medium of exchange

Answer 28

Financial assets can be readily exchanged for units of fiat currency.

By contrast, many digital assets (e.g., cryptocurrencies) are substitutes for fiat currencies, particularly for transactions in the Web3 ecosystem that is built on blockchain technologies.

Question 29

Acceptance as a medium of exchange of Digital Assets

Answer 29

Currently, digital assets have gained very limited acceptance as a medium of exchange.

Digital asset transactions can be very costly and cryptocurrencies are not legal tender.

Additionally, many jurisdictions restrict (and even ban) the use of cryptocurrencies.

Question 30

Legal and regulatory protection with Digital Assets

Answer 30

In most jurisdictions, the rules that govern the trading of traditional financial assets are well-established, clear, and predictable. The opposite is true for digital assets. A comprehensive legal and regulatory framework for trading digital assets has yet to developed.

In the United States, certain digital assets are considered to be commodities and regulated accordingly. Authorities in other countries treat digital assets as non-financial assets. Actions that are illegal when trading traditional financial assets are not necessarily prohibited when trading digital assets, which makes them highly speculative investments.

Question 31

AltCoins

Answer 31

Cryptocurrencies other than Bitcoin are known as altcoins.

The best known altcoin is Ether, which trades on the Ethereum network

Question 32

Stablecoins

Answer 32

have been designed to mitigate the common criticism that cryptocurrencies are extremely volatile

They are backed (collateralized) by baskets of assets, including legal tender, precious minerals, and other cryptocurrencies. In theory, these assets should protect stablecoin holders against some of the risks of other cryptocurrencies.

Smart stablecoins, also known as algorithmic stablecoins, seek to reduce their volatility by placing strict limits on their supply. Importantly, stablecoins do not enjoy any legal backing and cannot be exchanged for fiat money.

Recently, the stablecoin concept has been used to facilitate cross-border transactions of various physical and tokenized financial assets

Question 33

An asset-backed token

Answer 33

designed to maintain price parity with a target asset, which may be the US dollar or gold.

This gives owners exposure to asset both on and off the blockchain.

Question 34

Centralized exchanges

Answer 34

electronic platforms hosted on private servers that allow cryptocurrencies to be traded directly without the need for brokers or dealers

Depending on the jurisdiction, these may be regulated like other financial exchanges or they may be unregulated.

The main concern with centralized exchanges is that their servers are may be vulnerable to security threats, which puts user data at risk.

Nevertheless, centralized exchanges are very popular, offering liquidity and price transparency.

Question 35

decentralized exchanges

Answer 35

operate without a central control mechanism, which makes them less vulnerable to external attacks.

This type of exchange is difficult to regulate because there is no centralized controlling entity. This lack of regulatory oversight increases the risk of illegal activity.

Question 36

Indirect Digital Asset Investment Forms
Several alternatives exist to gain indirect exposure to digital assets, including the following:

Answer 36

Cryptocurrency coin trusts

Cryptocurrency futures contracts

Cryptocurrency exchange-traded funds

Cryptocurrency stocks

Hedge funds investing in cryptocurrencies

Question 37

Cryptocurrency coin trusts

Answer 37

are like closed-end funds with shares that trade over the counter (OTC).

Investors can access a share of a large underlying pool of cryptocurrency holdings without needing a digital wallet or worrying about losing their encryption keys.

These trusts may provide additional transparency relative to direct investing, although they can trade at a premium or discount to their net asset value.

The main disadvantage of cryptocurrency coin trust is that they charge high fees.

Question 38

Cryptocurrency futures contracts

Answer 38

are like other futures contracts in that they commit the long party to purchasing a specified amount of the underlying asset at a specific future date.

However, unlike contracts on physical commodities, cryptocurrency futures contracts are usually cash settled. Additionally, compared to more established commodities, cryptocurrency futures are less liquid and more volatile. Investors also need to be aware that futures contracts are inherently leveraged.

Question 39

Cryptocurrency exchange-traded funds

Answer 39

seek to replicate returns on digital assets in the same way as ETFs based on stocks, bonds, or commodities.

These ETFs usually invest in cryptocurrency derivatives rather than holding cryptocurrencies directly.

Question 40

Cryptocurrency stocks

Answer 40

are shares issued by companies with direct exposure to the cryptocurrency trade, such as exchanges, payment providers, and manufacturers of the specialized computers needed for cryptocurrency mining.

Question 41

Hedge funds investing in cryptocurrencies

Answer 41

offer indirect access to digital assets.

In addition to holding cryptocurrencies, many hedge funds actively participate in Bitcoin mining.

Question 42

Asset-backed tokens

Answer 42

create digital claims on physical assets (e.g., gold, oil) or financial assets (e.g., equities)

have the potential to increase the liquidity of assets with high unit costs (e.g., real estate, fine art) by allowing more fractional ownership.

Creating an immutable ownership record increases transparency and reduces transaction costs and reliance on intermediaries.

Regulators typically treat asset-backed tokens as securities because they confer an ownership interest in (and derive their value from) the underlying asset.

Question 43

decentralized finance

Answer 43

The objective of this movement is to use open-source financial applications as building blocks for sophisticated financial products and services.

Decentralized apps can be used to perform core financial functions, such as providing a medium of exchange, immutable record keeping, and tokenization of underlying assets.

Decentralized finance advocates argue that blockchain networks offer technical advantages over the traditional financial system in areas such as lending, trading, settlement, and payments.

However, the idea of overhauling the existing financial system has yet to be fully developed and most decentralized applications are limited to facilitating speculation in digital assets.