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ALTERNATIVE_INVESTMENTS_CFA1 > CHAPTER 7: INTRO TO DIGITAL ASSETS > Flashcards

CHAPTER 7: INTRO TO DIGITAL ASSETS Flashcards

1
Q

Digital Assets

A
  • New investment class; created, stored, and transmitted electronically with ownership/use rights.
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2
Q

Distributed Ledger:

A
  • Shared database across network nodes.
  • Infinite nodes possible; each has a copy.
  • Consensus mechanism ensures synchronization.
  • Immutable records; once created, cannot be changed.
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3
Q

Distributed Ledger Technology (DLT) and Cryptography:

A
  • Uses cryptography for data security through encryption.
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4
Q

Smart Contracts:

A
  • Self-executing programs based on pre-set conditions.
  • Example: Auto transfer of collateral on default.
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5
Q

DLT Networks:

A
  • Peer-to-peer financial asset creation, exchange, and tracking.
  • No central authority for transaction validation.
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6
Q

DLT Benefits:

A
  • Accurate, transparent, and secure record-keeping.
  • Faster ownership transfer.
  • Facilitates peer-to-peer interaction
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7
Q

DLT Drawback:

A
  • High energy consumption for transaction verification.
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8
Q

Blockchain Characteristics:

A
  • Information recorded in sequential blocks.
  • Blocks are chained and secured with cryptography.
  • Each block groups transactions and links to the previous block.
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9
Q

Adding Transactions to Blockchain:

A
  1. Transaction occurs between buyer and seller.
  2. Transaction is broadcast to network nodes.
  3. Nodes validate transaction details and parties.
  4. Verified transaction forms a new block with others.
  5. New block is cryptographically linked to previous blocks.
  6. Transaction completes, updating the ledger.
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10
Q

BITCOIN: Permissionless or Permissioned?

A

Permissionless

ETH also permissionless

RIPLE: XRP: Permissioned

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11
Q

Consensus Protocols:

A
  • Set of rules for verifying and chaining blockchain transactions.
  • Two main types: Proof of Work (PoW) and Proof of Stake (PoS).
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12
Q

Proof of Stake (PoS):

A
  • Validators pledge capital to vouch for block validity.
  • Validators propose blocks and must be attested by majority.
  • Security based on stakeholders controlling computational power.

DLT Networks:
- Can be permissionless or permissioned.

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12
Q

Proof of Work (PoW):

A
  • Uses computational lottery to add blocks.
  • Miners solve cryptographic problems to verify transactions.
  • Requires powerful computers and large energy consumption.
  • High computational power makes manipulation difficult.
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13
Q

BTC: PROOF OF WORK
ETH: PROOF OF STAKE

A

BTC: You bring computing power

ETH: You bring money (stakes)

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14
Q

Permissionless Networks:

A
  • Open to any user.
  • Transactions are immutable.
  • All users see all transactions.
  • No central authority.
  • Example: Bitcoin.
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15
Q

Permissioned Networks:

A
  • Restricted participation.
  • Controlled access levels.
  • Different permissions for users.
  • Example: Users enter transactions, regulators view history
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16
Q

PERMISSIONED VS PERMISSIONLESS

A

Speed:
- Permissioned: Faster, limited validators.
- Permissionless: Slower, many validators.

Cost:
- Permissioned: Cost-effective, few validators.
- Permissionless: Costly, many validators.

Decentralization:
- Permissioned: Partially decentralized.
- Permissionless: Fully decentralized.

Access:
- Permissioned: Limited membership.
- Permissionless: Unlimited membership.

Governance:
- Permissioned: Centralized organization.
- Permissionless: Decentralized, member-maintained.

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17
Q

Digital Assets & Types

A
  • Electronic records with rights to use, buy, or sell.

Types of Digital Assets:

  • Bitcoin
  • Cryptocurrencies: Altcoins, Stablecoins, Central Bank Digital Currencies, Memecoins
  • Non-Fungible Tokens
  • Tokens: Security Tokens, Utility Tokens, Governance Tokens
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18
Q

Cryptocurrencies:

A
  • Digital or electronic currency without physical form.
  • Enable transactions between buyers and sellers.
  • Issued by private entities.
  • Usually lack central authority, except CBDCs.
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19
Q

Cryptocurrency Supply Limits:

A
  • Many have self-imposed issuance limits.
  • Example: Bitcoin’s limit of 21 million.
  • Limited supply may maintain value, but lack fundamentals causes volatility.
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20
Q

Initial Coin Offering (ICO):

A
  • Unregulated process for selling crypto-tokens to investors.
  • Investors fund the company, tokens used later for products/services.
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20
Q

Central Bank Digital Currencies (CBDCs):

A
  • Digital versions of central bank currencies.
  • Tokenized fiat currency, like digital bank notes or coins.
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21
Q

Which of the following is not a benefit of DLT?

A Streamlining of current post-trade processes.
B Energy efficient verification of transaction activity.
C Faster transfer of ownership.

A

B is correct. A drawback of DLT is that the computational processes underlying DLT require massive amounts of energy to verify transaction activity.

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22
Q

A cryptocurrency miner can receive new digital assets by:

A solving complex algorithm puzzles to validate blocks of transactions onto a blockchain network based on a PoW protocol.
B staking his own cryptocurrencies to validate and attest to the new blocks of transactions onto a blockchain network based on a PoS protocol.
C Both A) and B)

A

C is correct. The validation of the transactions, or “mining,” always comes with rewards under both PoW and PoS consensus protocols. A successful miner that validates the transactions obtains new digital assets, either a cryptocurrency or a token.

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23
Q

Compared to permissioned blockchain, permissionless network is characterized by:

A cost effectiveness.
B slower speed.
C limited membership.

A

B is correct. Permissionless network is slower as several members have to reach consensus, which decreases network speed and scalability.

A is not correct because permissionless is not cost-effective as many members are required to validate each transaction.

C is not correct because membership is unlimited, based on the decentralized nature of permissionless blockchain.

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24
Q

Tokenization:

A
  • Represents ownership of physical assets on blockchain.
  • Simplifies transactions by creating digital ownership records.
24
Q

Non-Fungible Tokens (NFTs):

A
  • Connect digital assets to certificates of authenticity.
  • Each token and asset are unique.
  • Commonly used for trading digital artwork.
25
Q

Digital Assets as an Asset Class:

A
  • Viewed as an alternative investment.
  • Sought by institutional investors for higher returns and diversification.
25
Q

Security Tokens:

A
  • Digitize ownership rights of publicly traded securities.
  • Stored on blockchain for efficient post-trade processing.
  • Enable near-real-time trade verification and settlement.
25
Q

Governance Tokens:

A
  • Used in permissionless networks for voting on network operations.
26
Q

Utility Tokens:

A
  • Used for services within a network (e.g., pay for services, network fees).
  • Compensate only for network activities.
27
Q

Characteristics of Digital Assets:

A
  • Differ from traditional assets in value, transaction validation, legal medium of exchange, and regulatory protection.
28
Q

Digital Assets vs Traditional Financial Assets

A

Inherent Value:
Digital: No fundamental value or cash flow.
Traditional: Value from future cash flow.

Transaction Validation:
Digital: Recorded on decentralized ledgers using cryptography.
Traditional: Recorded in private ledgers by central intermediaries.

Medium of Exchange:
Digital: Few used directly; target large-scale acceptance.
Traditional: Transacted and exchanged into widely used fiat currencies.

Legal and Regulatory Protection:
Digital: Ambiguous, evolving; minimal legal protections.
Traditional: Clear, predictable standards; legally protected.

29
Q

Bitcoin and Altcoins

A

Bitcoin: Widely traded, designed as currency alternative.
Altcoins: Other cryptocurrencies, e.g., Ether, with programmable blockchains for applications.

30
Q

Stablecoins:

A

Linked to other assets, reducing volatility.
Protection: Collateralized by fiat, metals, or cryptocurrencies.

31
Q

Meme Coins:

A

Inspired by jokes, launched for entertainment.
Example: Dogecoin.

32
Q

Investment Methods:

A

Direct: Using cryptocurrency wallets for direct ownership.
Indirect: Exchange-traded products and hedge funds.

33
Q

Cryptocurrency Exchanges:

A

Types: Centralized and decentralized exchanges.

34
Q

Centralized Exchanges:

A

Popularity: Most popular, despite conflicting with Bitcoin’s decentralized ideology.

Functionality: Privately held, offering trading platforms with volume, liquidity, and price transparency.

Trading: Electronic and direct, without intermediary brokers or dealers; occurs on private servers.

Risks: Vulnerable to security risks. Server compromise can halt trading and leak sensitive information.

Regulation: May be regulated based on jurisdiction.

35
Q

Decentralized Exchanges:

A

Operation: Mimics blockchain’s decentralized protocol, operating like Bitcoin.

Resilience: Remains operational even if one computer is attacked, due to multiple operational computers.

Difficulty in Regulation: Challenging to regulate as no single entity controls the system.

Security: Harder to attack than centralized exchanges.

Vulnerabilities:

Fraud and Manipulation: Both centralized and decentralized exchanges are susceptible due to lack of rigorous oversight and regulation.

36
Q

Direct Investment Risks:

A

Fraud: Risks include scam IPOs, pump and dump schemes, market manipulation, theft, and hacking schemes.

Access: Cryptocurrency wallets need a unique passkey; lost passkeys mean lost wallet contents forever.

Concentration: Smaller cryptocurrencies may be controlled by “whales” who can manipulate prices.

37
Q

Indirect Exposure Alternatives:

A
  1. Cryptocurrency Coin Trusts:

Function: Hold large pools of cryptocurrency, allowing trading in trust shares.
- Pros: No need for separate digital wallets; may offer trading transparency.
- Cons: High fees (sometimes >2%); trust shares may trade at a premium or discount to NAV.

  1. Cryptocurrency Futures:
    • Details: Allows trading on the future price of cryptocurrencies, providing leverage and risk management tools.
  2. Cryptocurrency Exchange-Traded Funds (ETFs):
    • Function: Trade like stocks, offering diversified exposure to various cryptocurrencies.
    • Pros: Easier for traditional investors to access; regulated like other ETFs.
    • Cons: Subject to management fees and potential tracking errors.
  3. Cryptocurrency Stocks:
    • Details: Investing in companies involved in cryptocurrency, such as mining companies or those holding large crypto assets.
  4. Hedge Funds Investing in Cryptocurrencies:
    • Details: Professional management of cryptocurrency investments, aiming for higher returns and strategic exposure
38
Q

Digital Forms of Investment for Non-Digital Assets

  1. Asset-Backed Tokens
A

Digital claims on physical or financial assets, collateralized by the underlying assets.

Examples: Gold, crude oil, real estate, and equities.

Benefits:

Increased Liquidity: Allow fractional ownership of high-priced assets (e.g., houses, art, precious metals, precious stones).

Transparency: Immutable digital records of ownership and transfers.

Cost Reduction: Lowers transaction, intermediation, and record-keeping costs.

39
Q

Issuance and Platforms

A

Network: Often issued on Ethereum or other smart contract platforms.

Smart Contracts: Enable peer-to-peer transactions via interoperable, transparent smart contracts.

dApps: Decentralized applications that facilitate transactions and recording on the blockchain without a central coordinating mechanism.

40
Q

Decentralized Finance (DeFi)

A

Movement: Push for financial decentralized applications based on open-source codes and smart contracts.

Goal: Design, combine, and develop decentralized financial applications as building blocks for sophisticated financial products and services.

41
Q

Pricing and Market Dynamics

A

Bitcoin and Digital Assets: Priced based on future asset appreciation rather than underlying cash flow.

Market Demand: Limited supply of cryptocurrencies drives prices.
Bitcoin Example: Supply capped at 21 million Bitcoins, viewed by some as a digital version of gold.

42
Q

Performance and Volatility

A

Bitcoin: High return, high volatility, and low correlations with traditional asset classes.

Historical Performance:

Price rose from $0.05 at inception to $68,789 on November 10, 2021.

Crashed to around $17,709 on June 18, 2022.

Risks: Highly volatile and risky investments.

Regulatory Restrictions: Some countries, like China, have imposed severe restrictions or bans.

Bitcoin as Digital Gold
Comparison: Viewed by some investors as the digital version of gold due to its limited supply and value proposition.

43
Q

Diversification Benefits

A

Low Correlation: Historically, digital assets have low correlations with traditional asset classes, aiding portfolio diversification.

Increased Correlations: Observed to increase, especially during periods of high market uncertainty.

44
Q

Centralized Exchanges

A

Popularity: Most popular, despite conflicting with Bitcoin’s decentralized ideology.

Functionality: Privately held, offering trading platforms with volume, liquidity, and price transparency.

Trading: Electronic and direct, without intermediary brokers or dealers; occurs on private servers.

Risks: Vulnerable to security risks. Server compromise can halt trading and leak sensitive information.

Regulation: May be regulated based on jurisdiction.

45
Q

Direct Investment Risks

A

Fraud: Risks include scam IPOs, pump and dump schemes, market manipulation, theft, and hacking schemes.

Access: Cryptocurrency wallets need a unique passkey; lost passkeys mean lost wallet contents forever.

Concentration: Smaller cryptocurrencies may be controlled by “whales” who can manipulate prices.

46
Q

Decentralized Exchanges

A

Operation: Mimics blockchain’s decentralized protocol, operating like Bitcoin.

Resilience: Remains operational even if one computer is attacked, due to multiple operational computers.

Difficulty in Regulation: Challenging to regulate as no single entity controls the system.

Security: Harder to attack than centralized exchanges.

47
Q

Asset-Backed Tokens

A

Definition: Digital claims on physical assets, financial assets, or financial instruments, collateralized by these underlying assets.
Examples: Gold, crude oil, real estate, and equities

48
Q

Benefits of Asset-Backed Tokens

A

Increased Liquidity: Enable fractional ownership of high-priced assets (e.g., houses, art, precious metals, precious stones), allowing multiple investors to own a fractional interest.

Transparency: Digital representation allows for an immutable record of ownership information and ownership transfer.

Cost Reduction: Lowers transaction, intermediation, and record-keeping costs.

49
Q

LO. Explain investment features of digital assets and contrast them with other asset classes.

A

The different types of digital assets are shown in the exhibit from the curriculum below:

Digital Assets Overview

  1. Cryptocurrencies:

Bitcoin: The most well-known cryptocurrency, designed as an alternative to traditional currencies.

Other Cryptocurrencies: Includes altcoins, stablecoins, central bank digital currencies (CBDCs), and memecoins.

Altcoins: Examples include Ether (Ethereum network) with programmable features.

Stablecoins: Pegged to other assets (e.g., fiat, precious metals) to reduce volatility. Backed by fiat currencies.

Central Bank Digital Currencies (CBDCs): Digital versions of fiat currencies issued by central banks.

Memecoins: Cryptocurrencies inspired by internet memes, often created for entertainment.

  1. Tokens:

Utility Tokens: Provide access to services within a network. eg: FB TRON, ETH, Polygon

Governance Tokens: Allow users to vote on network operations.

Security Tokens: Represent ownership rights to physical or financial assets, often digitized for efficiency.

  1. Non-Fungible Tokens (NFTs):

Unique digital assets representing ownership of specific items, commonly used in digital art.

Characteristics:
1. Asset-Backed Tokens: Represent digital claims on physical assets, improving liquidity and transparency.
2. Investment Forms: Direct (cryptocurrency wallets) and indirect (trusts, ETFs, futures, stocks, hedge funds).
3. Exchanges: Centralized (popular, private, security risks) and decentralized (resilient, hard to regulate).

49
Q

LO. Describe financial applications of distributed ledger technology.

A

Distributed Ledger Technology (DLT)

A distributed ledger is a database that can be shared across multiple computer entities (or nodes) in a network.

Key Features:
1. Peer-to-Peer Transactions: DLT networks enable the creation, exchange, and tracking of ownership of digital assets directly between peers, without a central authority validating the transactions.
2. Post-Trade and Compliance Efficiencies: DLT can improve post-trade processes and compliance through automation, smart contracts, and identity verification.
3. Network Types: DLT can be implemented as either permissionless or permissioned networks.

Consensus Protocols
A consensus protocol is a set of rules that govern how blocks in a blockchain network are cryptographically linked to ensure the complete and immutable history of transaction records.

Types of Consensus Protocols

  1. Proof of Work (PoW):

Mechanism: Miners compete to solve complex mathematical problems to validate transactions and create new blocks.
Energy Consumption: High energy consumption due to the computational power required.
Security: Highly secure but resource-intensive.

  1. Proof of Stake (PoS):

Mechanism: Validators are chosen based on the amount of cryptocurrency they hold and are willing to “stake” as collateral.
Energy Consumption: Lower energy consumption compared to PoW as it relies on staking rather than extensive computation.
Security: Security is dependent on the economic incentives to act honestly.

50
Q

LO. Explain investment features of digital assets and contrast them with other asset classes.

A

Digital Assets:

Traditional Financial Assets

A). Inherent value

  1. No fundamental value or future cash flow generation
  2. Value determined by future cash flow gener- ated from the assets

B). Transaction validation.
1. Price driven by certain features on the blockchain
2. Usually recorded on decentralized digital ledgers using cryptography and algorithms for permissionless blockchain networks
3. Recorded in private ledgers maintained by central intermediaries

C). Uses as a medium of exchange
1. Very few digital assets are used as a direct medium of exchange, mainly targeting large- scale commercially viable acceptance
2. Not used directly as a medium of exchange but can be readily transacted and exchanged into traditional fiat currencies that are widely used in the real world

D). Legal and regulatory protection
1. Ambiguous, often contradictory, evolving framework; generally unregulated, with mini- mal legal protections
2. Well-established, tested, and proven legal, regulatory, and commercial standards that are clear, predictable, and well defined across all jurisdictions
3. Use can be illegal or criminal in some countries

51
Q

LO. Describe investment forms and vehicles used in digital asset investments.

A

Investment in digital assets can be in the form of direct investment on the blockchain or indirect investments through exchange-traded products and hedge funds.

  1. Direct ownership of Bitcoin and other cryptocurrencies is accomplished through the use of a cryptocurrency wallet. Cryptocurrency exchanges can be classified into centralized exchanges and decentralized exchanges.

Alternatives to gain indirect exposure to digital assets include:
- Cryptocurrency coin trusts
- Cryptocurrency futures
- Cryptocurrency exchange traded funds
- Cryptocurrency stocks
- Hedge funds investing in cryptocurrency

52
Q

LO. Describe investment forms and vehicles used in digital asset investments.

A

Asset-backed tokens are digital claims on physical assets, financial assets, or financial instruments
and are collateralized by these underlying assets.

The push for financial decentralized applications based on opensource codes and smart contracts
has grown into a movement known as decentralized finance, or DeFi. DeFi seeks to design, combine, and develop decentralized financial applications as building blocks for sophisticated financial products and services.

53
Q

LO. Analyze sources of risk, return, and diversification among digital asset investments.

A

Bitcoin and other digital assets are priced based on future asset appreciation rather than any
underlying cash flow. The market demand for the limited supply of cryptocurrencies is a significant driver of prices.

Bitcoin’s performance has been characterized by high return, high volatility and low correlations
with traditional asset classes.

Because of their historically low correlations with other asset classes, digital assets can help
diversify a traditional asset portfolio. However, correlations have been observed to increase,
particularly during periods of high market uncertainty.

54
Q

Unlike traditional assets, transactions involving digital assets:

A derive their value from underlying future cash flows.
B can be illegal or criminal is some countries.
C are usually recorded on centralized digital ledgers.

A

B.

55
Q

Trading of digital artwork is most likely possible through:

A NFTs
B Security tokens
C Utility tokens

A

A is correct. The most common application for NFTs is the trading of digital artwork. NFTs differ from “fungible” tokens like cryptocurrencies in that each token and the authenticated object it represents are unique. As a result, they can “stamp” assets and represent digital assets in a virtual world.

B is not correct because security tokens digitize the ownership rights associated with publicly traded securities.

C is not correct because utility tokens provide services within a network, such as pay for services and network fees.

56
Q

Which of the following statements is not correct?

A Direct ownership of cryptocurrencies is possible through the use of a cryptocurrency wallet.
B Cryptocurrencies trade on decentralized exchanges only.
C ‘Whales’ are in a position to manipulate prices of cryptocurrencies.

A

B is correct. Cryptocurrency exchanges can be classified into centralized exchanges and decentralized exchanges.

A and C are true statements.

57
Q

Cryptocurrencies are potential diversifiers of an investment portfolio because of:

A lower correlation with other traditional investments.
B higher risk and return profile.
C self-imposed limit on supply.

A

A is correct. Because of their historically low correlations with other asset classes, digital assets can help diversify a traditional asset portfolio.

However, correlations have been observed to increase, particularly during periods of high market uncertainty.

58
Q
A

ALTERNATIVE_INVESTMENTS_CFA1 (7 decks)

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