ALT 7 Introduction to Digital Assets
Digital assets are items that can be created, stored, and moved purely as electronic records, with rights of ownership or use attached to them. The family is broad: cryptocurrencies, tokens, and digital collectables all sit inside it. What ties them together is the technology underneath, a distributed ledger secured by cryptography. Since Bitcoin appeared in 2009 as a niche idea in the technology world, this corner of finance has drifted toward the mainstream as an alternative asset class. This lesson works through the plumbing (distributed ledgers and consensus), the main kinds of digital asset, how investors gain exposure, and the risk and return that come with the class.
Distributed ledgers and consensus
A distributed ledger is a database copied across many participants in a network, so that every member holds a matching and complete record of current and past transactions. Three pieces make up a DLT network: the digital ledger itself, a participant network of computers (called nodes), and a consensus mechanism that confirms new entries. Consensus is the process by which the nodes agree on one common state of the ledger, and it runs in two steps, first validating a transaction and then agreeing to update the ledger. Written this way, records are treated as effectively immutable, yet they stay transparent and visible to participants close to real time.
Cryptography does the securing. It is an algorithmic method of scrambling data so that anyone without authorization who intercepts it cannot use it, which gives the network both security and database integrity. The same tools verify participant identity and encrypt the stored data. DLT can also host smart contracts, which are small programs that run themselves once pre-agreed terms are met, for example paying out a contingent claim on a derivative or transferring collateral automatically the moment a default occurs.
The appeal for finance is direct. DLT could let parties create financial assets, exchange them, and follow their ownership peer-to-peer (P2P), with greater accuracy, transparency, and security, faster transfers of ownership, and no central record keeper. The technology is not flawless, though: privacy and data breaches remain possible, and the computation behind it can consume very large amounts of energy.
Blockchain and how a transaction is added
A blockchain is one type of distributed ledger. Information such as a change in ownership is recorded in blocks, and each block is linked, or chained, to the one before it and locked with cryptographic methods. Every block carries a batch of transactions plus a secure reference to the prior block, known as a hash, so the whole history holds together in order. A new transaction only joins after a consensus mechanism validates it and the preceding history. The steps run roughly like this:
- A buyer and a seller transact.
- A block holding the transaction details is built and broadcast to the network of nodes.
- Nodes check the transaction details and the parties involved.
- Once verified, the transaction is grouped with others into a new block of a predetermined size.
- That block is linked, through a cryptographic process, to the existing chain of earlier blocks.
- The transaction is treated as complete and the ledger is updated.
Proof of work and proof of stake
How a new block is allowed to join the chain, and so become the accepted truth, is set by the consensus protocol. These protocols are built to withstand malicious tampering up to a defined level of security. Two of them dominate.
Under proof of work (PoW), the right to add a block is won through a costly computational lottery. Special computers called miners race to solve a hard cryptographic puzzle each time a transaction occurs, spending real electricity to do it, and the winner locks the block in and earns newly issued cryptocurrency. Because rewriting the past would mean redoing all that work, altering history is extraordinarily expensive: an attacker would need to command a majority of the network. Participants accept the longest chain as the one true record, so a fraudster trying to build a longer, falsified chain would have to outrun the combined computing power of everyone else. That boundary is the well-known 51 percent threshold, and on large networks such as Bitcoin or Ethereum reaching it is effectively beyond any single actor or coordinated group. Even a brief spell of majority control limits how much history can be changed. PoW has been the most widely used protocol for digital assets.
Proof of stake (PoS) swaps raw computation for pledged capital. Chosen participants, the validators, lock up (stake) a digital asset to vouch for a proposed block, and a majority of the other validators, who have staked as well, must attest that the block is valid. Validators earn rewards both for proposing blocks and for attesting to blocks proposed by others. Security here rests on a group of honest stakers, and their pledged stakes, keeping malicious parties from seizing a majority of the network.
Under either protocol, validating transactions is rewarded, a process loosely called mining: the successful validator receives a new digital asset, whether a coin or a token. The pace of mining, and how quickly transactions are confirmed, generally governs how much new digital asset a given ledger can create.
Two blockchain networks confirm blocks in different ways. Network A picks the participant who may add the next block by requiring each candidate to pledge a quantity of the network’s own coin as a bond, after which other bonded participants confirm the block. Network B has specialized machines compete to solve a difficult puzzle, and the winner adds the block.
Permissioned and permissionless networks
DLT comes in two governance forms. A permissionless (open) network lets any user transact and lets every participant see every transaction and perform every network function. Its strength is that no central authority decides what is valid, the consensus mechanism does, so no single point of failure exists and, once written, a transaction cannot be changed barring manipulation. Parties do not need to trust one another. Bitcoin, launched in 2009 as the public ledger for its virtual currency, is the classic open network, and the many cryptocurrencies that followed use permissionless networks too. A permissioned network instead restricts what members may do: access is tiered, so one participant may add transactions, a regulator may be allowed only to view them, and another may see selected details but not the full record.
| Feature | Permissioned | Permissionless |
|---|---|---|
| Speed | Faster; few authorized members validate | Slower; many members must reach consensus |
| Cost | Cost-effective; few validators per transaction | Not cost-effective; many validators per transaction |
| Decentralization | Partial; limited members in the chain | Full; every member can reach the network |
| Access | Membership limited | Membership unlimited |
| Governance | Set by a centralized organization | Decentralized, maintained by the members |
Because a permissionless ledger is open to all, that heavy decentralization demands more processing power and bandwidth and costs more; a permissioned ledger reverses the trade-off, buying speed and lower cost by limiting who may validate.
Types of digital assets
A digital asset exists only as an electronic record carrying rights to use, buy, or sell, and it can stand for a security, a currency, a property, or a commodity. The broad split is between cryptocurrencies and tokens.
Cryptocurrencies (also called digital currencies) are units used to store or transfer value, allowing near-real-time transactions between parties with no intermediary. They take no physical form and are privately issued by people, companies, and other organizations, so they carry no backing from a central bank or monetary authority. Most run on open DLT systems. Many set a self-imposed ceiling on how many units can ever exist; that scarcity may support a store of value, but prices have still swung sharply, partly because there is no agreed way to value them. Central banks, watching all this, are studying their own versions: a central bank digital currency (CBDC) is a tokenized form of the state’s fiat currency, in effect a digital banknote or coin, and unlike a privately issued coin it is a liability of the central bank.
Tokens, by contrast, are built on an existing blockchain rather than running their own. Through tokenization, ownership of a physical asset (real estate, luxury goods, commodities) is represented as a single digital record on a ledger, which streamlines the verification a change of ownership normally demands. Several token types matter:
- Non-fungible tokens (NFTs) link a digital asset to a certificate of authenticity. Unlike a fungible cryptocurrency, each NFT and the object it represents is unique, so it stamps ownership; the most common use is the trading of digital art.
- Security tokens put the ownership rights in publicly traded securities into digital form, and holding custody on a blockchain sharpens settlement, post-trade processing, custody, and record keeping. An initial coin offering (ICO) is one example: an unregulated sale of crypto-tokens to investors for money or another cryptocurrency, usually giving a right to future products or services. ICOs can be cheaper and faster than an IPO, but they typically carry no voting rights and have drawn many fraud cases.
- Utility tokens pay for services and network fees within a network. Unlike security tokens, which may pay dividends, they only compensate for activity on the network.
- Governance tokens act as votes on how a permissionless network is run, for example choosing a fix when a technical problem arises.
Sort the following digital assets into cryptocurrencies and tokens: an initial coin offering (ICO), a non-fungible token, a central bank digital currency, Ether, a stablecoin, and a utility token.
Digital assets have moved from the fringe toward the financial mainstream. About 70 cryptocurrencies existed back in 2013; come early 2022 the count stood near 10,000, put out by corporations, by organizations, and often by individuals. Cryptocurrency is usually treated as an alternative asset, and as some institutional investors reach for its higher potential return and possible diversification, exchanges and custodians have built out their infrastructure to serve that demand. Growing institutional comfort may itself be an early sign that the market is nearing a tipping point.
How digital assets differ from traditional assets
The one real similarity is that indirect vehicles, exchange-traded funds and hedge funds, now invest in both worlds. The differences are larger, and they fall under four headings.
- Inherent value. Most digital assets have no fundamental value. There are no expected earnings, interest, or dividends to anchor a price, so value comes only from anticipated appreciation, a perceived scarcity (from limits on total supply), and the potential to transfer value later thanks to features written into the underlying algorithm. A financial asset, by contrast, is valued on the cash flows it is expected to generate.
- Validating transactions. Traditional assets sit in private ledgers kept by central intermediaries; digital assets are usually recorded on a decentralized ledger using cryptography and enhanced algorithms. Whether validation happens on a permissioned or a permissionless network, and under PoW or PoS, feeds into how the asset is perceived.
- Uses as a medium of exchange. Traditional financial instruments are priced and change hands in widely accepted fiat currencies, and convert into them readily. Fiat currencies are the foundation of every country’s payment system. A few cryptocurrencies stand in for fiat in specific settings, especially online in the emerging Web3 world (a proposed third iteration of the internet built on blockchains, decentralization, and token-based economies), but mainstream acceptance is thin, partly because transaction costs can be too high to process large volumes. In most jurisdictions cryptocurrencies are not legal tender and cannot settle debt the way fiat can, and several countries restrict or ban their use, with ownership even carrying criminal risk in some places.
- Legal and regulatory protection. Rules for traditional instruments are clear, tested, and broadly consistent across borders. Rules specific to digital assets, covering how they are formed, traded, and treated in law, are still being drafted. US regulators call some digital currencies commodities while others treat them as non-financial assets, and without clear recognition or protection their value stays highly speculative. The venues where they trade are generally not regulated as financial exchanges, so manipulation and outright fraud that would be illegal in traditional markets are not necessarily barred.
| Aspect | Digital assets | Traditional financial assets |
|---|---|---|
| Inherent value | Carries no fundamental value and no future cash flow; price set by blockchain features | Value set by future cash flow the assets generate |
| Transaction validation | Usually on decentralized ledgers using cryptography and algorithms | Recorded in private ledgers kept by central intermediaries |
| Medium of exchange | Very few used directly; limited mainstream acceptance | Not used directly, but readily exchanged into widely used fiat currencies |
| Legal and regulatory protection | Ambiguous, evolving, largely unregulated; use can be illegal in some countries | Well-established, tested standards, clear across jurisdictions |
In February 2021 Tesla disclosed that it had put USD 1.5 billion into Bitcoin to diversify a cash balance of more than USD 19 billion at the end of 2020, and said it would begin accepting Bitcoin for its vehicles on a limited basis. It suspended that in May 2021, citing the fossil-fuel intensity of Bitcoin mining, later resumed, and in January 2022 started taking Dogecoin for selected merchandise. In July 2022 it sold 75 percent of its Bitcoin holding after the price fell, but kept its Dogecoin. The episode shows both the appeal and the volatility that come with a corporate digital-asset position.
Bitcoin and altcoins
Different blockchains are tuned for different jobs, which is why so many coins exist. As of July 2022, Bitcoin and Ether between them accounted for over 80 percent of all cryptocurrency market value. Bitcoin (BTC, sometimes XBT) was built to make payments secure over a P2P network and to serve as an alternative currency and store of value; it is the most recognized and most heavily traded coin, and its design still shapes newer assets. The thousands of coins built on Bitcoin-like technology are called altcoins.
The leading altcoin is Ether, launched in 2015 on the Ethereum network. Ether adds a programmable blockchain, letting users build applications that validate or secure transactions and payments, so programmable coins can do more than store value. Programmable altcoins of this kind also go by the name smart coins, and the self-executing agreements they run, with the salient terms written straight into the code and settled on the network, are smart contracts; execution leaves a trackable, irreversible record that the nodes verify. Stablecoins and meme coins are further altcoin varieties.
Stablecoins
A stablecoin aims to hold a steady value by linking to another asset, and it is collateralized by a basket that is usually legal tender, precious metals, or another cryptocurrency. That reserve shields holders from price swings and from losses if the coin runs into trouble. Some, called smart or algorithmic stablecoins, instead lean on an algorithm to manage supply, minting more units when demand rises. Stablecoins cannot be swapped for fiat money and carry no legal or regulatory backing. They may ease settlement and cross-border trading and payments, and one relative, the asset-backed token, keeps parity with a target such as the US dollar or gold through tokenization, giving a wallet holder exposure to assets both on the chain and off it.
Two stablecoins each aim to hold a value of one US dollar. Coin A is backed by a reserve of fiat currencies, gold, and Treasuries, and each unit can be redeemed from the issuer for its dollar value or traded on the open market. Coin B holds no reserve of financial or physical assets; instead an algorithm ties it to a companion governance token, minting or destroying that token to defend the peg. Under stress, the companion token count jumped from 350 million to 6.5 trillion units in a single week, and both collapsed.
Meme coins
Meme coins are cryptocurrencies born from a joke and launched mostly for entertainment, riding a burst of popularity that lets early buyers sell at a considerable profit. Dogecoin, the original and best known, began in 2013 as a parody of the crypto craze, complete with a Shiba Inu logo and the deliberately misspelled doge. Unlike coins that are scarce by design, it was built with no supply limit, yet a devoted following and celebrity endorsements pushed its market value above USD 80 billion at its May 2021 peak, before it slid to about USD 11 billion by May 2022 as investors and speculators dumped it.
Exposure to digital assets can be direct, on the blockchain itself, or indirect, through familiar wrappers such as funds and futures. Direct ownership of Bitcoin or another coin means using a cryptocurrency wallet, which holds the public and private keys that unlock the asset on a website or a mobile application. Trading happens on two kinds of exchange.
Centralized and decentralized exchanges
Centralized exchanges are the most popular type. These privately held platforms offer volume, liquidity, and price transparency, with electronic direct trading and no intermediating broker or dealer. Because they run on private servers, they are exposed to security breaches: if the servers are compromised, the whole system can seize up, stopping trade and exposing vital user information, including the cryptographic keys to custodial wallets. Depending on jurisdiction, some are regulated as financial exchanges or other intermediaries.
Decentralized exchanges mirror the decentralized protocol of a blockchain, with no central control and operation across a distributed platform. If one computer on the network is attacked, the exchange keeps running because many others remain, which makes such attacks far harder and almost certain to fail. They are difficult to regulate because no single party controls the system, so traders face little regulatory scrutiny, which leaves room for illegal activity. Both kinds of exchange are exposed to fraud and manipulation and raise investor-protection worries, since oversight stays light. Unlike venues for equities or futures, crypto trading is largely unregulated, so tactics such as using social media to inflate a coin’s price are common.
Direct investment and its risks
Direct trades are recorded on the blockchain and, once validated, become permanent; most crypto exchanges run 24/7, allowing continuous trading. The risks are real. Fraud is widespread, from scam ICOs and pump-and-dump schemes to market manipulation, theft, and attempts to steal the credentials that unlock a wallet. Because holdings sit behind a unique passkey, losing that key makes them unrecoverable; roughly 20 percent of all Bitcoin is reportedly stranded in lost or abandoned wallets. And thin coins are often concentrated in a few large holders, nicknamed whales, who can hold enough to move the price on their own.
In a pump-and-dump scheme, early holders talk an asset up so others buy, then sell at the top and leave latecomers with steep losses; EthereumMax, heavily promoted by celebrities in 2021, lost almost all its value within a month. FTX, a large centralized Bahamas-based exchange founded in 2019 and valued at USD 31.6 billion in January 2022, collapsed in November 2022 after reports that affiliate Alameda Research held much of its USD 14.6 billion balance sheet in FTX’s own FTT token; the FTT price fell from over USD 25 to about USD 1 in just over a week, and FTX filed for bankruptcy on 11 November 2022 with USD 9 billion in liabilities and more than 100,000 creditors. Forsage, a decentralized platform, was charged by the US SEC in August 2022 as a crypto pyramid and Ponzi scheme that had raised more than USD 300 million. And by August 2022 about 41 percent of Shiba Inu had been burned, while the next ten holders sat on roughly 21 to 23 percent of the tokens, enough to sway a thinly traded market.
Indirect investment forms
Several routes give indirect exposure without direct ownership on the chain:
- Cryptocurrency coin trusts let investors trade shares in trusts that hold a large pool of a coin. They change hands over the counter (OTC) and act much like closed-end funds, so no wallet or encryption key is needed, and they may add transparency. Fees can be steep, in some cases above 2 percent, and shares may trade at a premium or a discount to net asset value.
- Cryptocurrency futures are exchange-traded agreements to buy or sell a set quantity of a coin at a set price on a future date. Bitcoin futures on the Chicago Mercantile Exchange, for instance, are based on the CME CF Bitcoin Reference Rate. They are usually cash settled, with no coin changing hands, and they are inherently leveraged. The market is less developed, potentially thinner, and more volatile than established futures markets.
- Cryptocurrency exchange-traded funds seek to replicate digital-asset returns without holding coins directly, gaining exposure through cash and cryptocurrency derivatives. A representative term sheet might charge annual expenses of 1.50 percent of NAV, describe the fund as non-diversified, and warn that the value could decline to zero.
- Cryptocurrency stocks are equities whose business ties them to digital assets: listed exchanges, payment providers that accept coins, corporations that accept, hold, or mine coins, and makers of the specialized hardware used to run blockchain networks.
- Hedge funds use approaches spanning discretionary long, long/short, quantitative, and multi-strategy styles to invest in coins and derivatives, and some mine Bitcoin themselves for extra return.
Classify each of the following as a direct or an indirect way to invest in digital assets: a cryptocurrency ETF, a cryptocurrency coin trust, an initial coin offering, a hedge fund that holds digital tokens, buying a digital-art NFT, trading cryptocurrency stocks, trading tokens on a cryptocurrency exchange, and buying Bitcoin futures on a futures exchange.
Digital forms for non-digital assets, and DeFi
Asset-backed tokens are digital claims against physical assets, financial assets, or instruments, collateralized by and drawing value from the underlying: tokenized gold, crude oil, real estate, or equities. By opening up fractional ownership of costly assets such as houses, art, and precious metals, they can improve liquidity, letting several investors each hold a slice, while the immutable record cuts transaction, intermediation, and record-keeping costs. Regulators generally classify them as securities, since the token conveys an ownership interest in the underlying asset.
These tokens are usually issued on Ethereum or a similar smart-contract platform, using interoperable smart contracts that run as decentralized applications, or dApps, recording transactions on the blockchain with no central coordinator. The wider push to build financial dApps grew into a movement called decentralized finance (DeFi): a marketplace of dApps meant to perform core financial functions, from serving as a medium of exchange and a store of value to tokenizing assets and keeping immutable ownership records. In principle, smart contracts embedded in dApps could carry out lending, trading, investing, settlement, payments, and transfers in a decentralized and authenticated manner, almost instantly, and supporters point to time savings and lower settlement risk. DeFi is still young, and so far most dApps have concentrated on extending leverage for speculation in digital assets.
Digital-asset values have climbed quickly since inception, lately helped by indirect vehicles that make access easier. Because the class is a relatively new innovation, its market is prone to rapid price swings and uncertainty, and most investors file it under alternatives.
Returns and volatility
Bitcoin and other cryptocurrencies derive value purely from appreciation, with no underlying cash flow, so demand pressing against a limited supply is a major price driver. Bitcoin’s supply is capped at 21 million coins by design, which is why some investors picture it as a digital version of gold. Since its 2009 launch its record has combined high return, high volatility, and low correlation with traditional asset classes. From publicly quoted prices that began around USD 0.05 in mid-2010, Bitcoin rose to a peak of USD 68,789 on 10 November 2021, then crashed to about USD 17,709 by 18 June 2022. The earliest holders earned phenomenal gains, while those who entered late could suffer heavy losses depending on their timing.
| Measure | Bitcoin (USD) | S&P 500 TR | MSCI World | Bloomberg Global Agg |
|---|---|---|---|---|
| Average | 8.84% | 1.13% | 0.66% | 0.16% |
| Standard deviation | 0.32 | 0.04 | 0.04 | 0.01 |
| Coefficient of variation | 3.66 | 3.43 | 6.09 | 8.16 |
The coefficient of variation scales the standard deviation by the mean, giving risk per unit of return:
Use the monthly log-return figures in the table above to compare Bitcoin with the S&P 500 Total Return series.
Diversification and correlations
Though purely speculative, cryptocurrencies have shown low correlation with traditional returns, a hint that their long-run price drivers differ. In practice those drivers include market adoption, network effects, technological advancement, regulatory developments, speculation, and general market risk appetite, several of them unique to the class.
| Bitcoin | S&P 500 TR | MSCI World | Bloomberg Global Agg | |
|---|---|---|---|---|
| Bitcoin (USD) | 1 | |||
| S&P 500 TR | 0.21 | 1 | ||
| MSCI World | 0.22 | 0.97 | 1 | |
| Bloomberg Global Agg | 0.14 | 0.25 | 0.33 | 1 |
Read the correlation matrix above to judge Bitcoin’s value as a portfolio diversifier, and note one caveat.