Investment Features of Digital Assets and Contrast them with Other Assets Classes

Digital assets have gained considerable importance in the financial services sector, establishing themselves as a novel asset category for investors, with cryptocurrencies primarily driving this surge.

Investments in cryptocurrencies are commonly recognized as an alternative asset. As digital assets gain traction, specific institutional investors are strategically exploring these assets for their potential to yield greater returns and potential diversification advantages.

An illustrative instance is Tesla’s $1.5 billion investment in Bitcoin in early 2021, signifying an increasing acknowledgment of cryptocurrencies as a credible asset category. When institutional investors become more comfortable with investing in digital assets, it could be an early sign that the market is nearing a tipping point.

Financial Service Providers and Digital Assets

Amid the increasing fascination with digital assets, diverse financial service entities, like digital exchanges, are broadening their infrastructure in preparation for potential investments in these assets. These providers extend a variety of services, such as secure storage, transaction handling, and asset management, all of which play a critical role in fostering the acceptance and expansion of digital assets.

Differences Between Digital and Traditional Financial Assets

• Differences in inherent value:  Compared to the majority of digital assets lack intrinsic value derived from underlying assets or potential cash flow. For instance, Bitcoin, the most widespread digital asset, does not possess physical collateral or cash flows. Its value is instead predicated on its restricted supply.
• Differences in validating transactions: Conventional assets are commonly logged in private ledgers managed by central entities like banks or governments. However, the ownership and transfer of digital assets are typically documented on a decentralized digital ledger, referred to as a blockchain, utilizing cryptography and advanced algorithms.
• Differences in the uses as a medium of exchange: Conventional financial assets are valued and traded in established currencies that are easily transacted and converted into fiat currencies. Digital assets like cryptocurrencies are sometimes used directly as replacements for real-world fiat currencies, especially in online transactions.
• Differences in legal and regulatory protection: The regulations concerning financial instruments and their trading are well-established and consistent across most jurisdictions, unlike digital assets. Specific and comprehensive regulations tailored to digital assets are still in the process of development.

Summary of Differences Between Digital and Traditional Assets

\begin{array}{l|l|l}
& \textbf{Digital Assets} & \textbf{Traditional Financial Assets} \\
\hline
\textbf{Inherent Value} & \text{Lacks fundamental or} & \text{Determined by future} \\
& \text{future cash flow} & \text{cash flow from assets} \\
& \text{Price driven by} & \\
& \text{blockchain features} & \\
\hline
\textbf{Transaction Validation} & \text{Recorded on decentralized} & \text{Recorded in private} \\
& \text{ledgers with cryptography} & \text{ledgers by central} \\
& \text{and algorithms for} & \text{intermediaries} \\
& \text{permissionless networks} & \\
\hline
\textbf{Uses as a Medium} & \text{Rarely used directly for} & \text{Not directly used as} \\
\textbf{of Exchange} & \text{exchange; targets large-scale} & \text{exchange; tradable into} \\
& \text{commercial acceptance} & \text{fiat for wide use} \\
\hline
\textbf{Legal and Regulatory} & \text{Ambiguous, often} & \text{Well-established,} \\
\textbf{Protection} & \text{contradictory, evolving} & \text{tested, and proven legal,} \\
& \text{Generally unregulated,} & \text{regulatory, commercial} \\
& \text{with minimal protections} & \text{standards, clear and} \\
& \text{Use may be illegal} & \text{well defined across} \\
& \text{or criminal in places} & \text{all jurisdictions} \\
\end{array}

Investible Digital Assets

The digital assets industry has experienced substantial expansion, resulting in the development of numerous cryptocurrencies and digital assets built upon specialized and optimized blockchains for various uses. The market is primarily dominated by Bitcoin and Ether, collectively representing more than 80% of the total cryptocurrency market value as of July 2022. Bitcoin alone held a market capitalization of around $1 trillion in July 2022, showcasing the substantial influence and expansion of these digital assets.

Bitcoin

Bitcoin, recognized as BTC or XBT, was introduced to ensure secure transactions within a peer-to-peer (P2P) network. It was formulated as a substitute for conventional currencies, functioning both as a means of exchange and a method to retain value. The foundational structure of Bitcoin remains influential in shaping the evolution of other forms of digital assets.

Altcoins

There are numerous cryptocurrencies using technology akin to Bitcoin, collectively termed as altcoins. Altcoins, short for alternative coins, encompass all cryptocurrencies apart from Bitcoin. Notable altcoins such as Ethereum, Ripple, and Litecoin seek to enhance Bitcoin’s limitations or introduce added features. For instance, Ethereum introduced smart contracts–self-executing agreements with contract terms written directly into code.

Smart Coins or Smart Contracts

A smart contract is a self-executing agreement in which the essential terms are coded directly into the contract lines. These contracts are executed via the blockchain network, ensuring a traceable and irreversible record, subject to immutable verification by the network’s nodes.

In addition to Ether, there are other types of altcoins, such as stablecoins and meme coins.

Stablecoins

Stablecoins are a unique type of cryptocurrency designed to maintain a stable value. This stability is achieved by pegging their value to another asset, such as the US dollar, precious metals, or other cryptocurrencies. For instance, the value of Tether (USDT), a well-known stablecoin, is linked to the US dollar.

There are different types of stablecoins, including smart stablecoins or algorithmic stablecoins. These are designed to use algorithms to control the available supply of the asset. For instance, they may mint additional assets when there is increased demand for the coin.

Limitations of Stablecoins

While stablecoins offer stability, they lack the ability to be exchanged for fiat currency and are not supported by legal or regulatory backing. This implies that governments and financial institutions do not recognize them as a valid form of currency.

Benefits of Stablecoins

Stablecoins have the potential to ease settlement processes and simplify cross-border trading, investments, and payments. They enable transactions among different physical and tokenized financial assets and instruments.

An example of a stablecoin is the asset-backed token, which maintains a fixed value relative to a specified asset, such as the US dollar or gold, through tokenization.

Meme Coins

Meme coins are cryptocurrencies often initiated by a joke and are generally launched for entertainment reasons. They can gain popularity in a short period of time, allowing early purchasers to sell their holdings at an often significant profit.

Question

Which of the following statements least likely reflects the status of stablecoins?

1. They cannot be directly exchanged for fiat money.
2. They have legal and regulatory backing similar to fiat currencies.
3. They can be used to purchase goods and services from vendors.

The correct answer is B.

Stablecoins do not have legal and regulatory backing similar to fiat currencies. While they aim to mimic the stability of fiat currencies by pegging their value to a reserve of assets, they are not issued or regulated by governments or financial institutions. This means they lack the same level of legal protections and guarantees as fiat currencies.

A is incorrect. Stablecoins lack the ability to be exchanged for fiat currency and are not supported by legal or regulatory backing.

C is incorrect. While not all vendors accept stablecoins, their use in purchasing goods and services is increasingly common, especially in digital and online marketplaces. However, it’s important to note that the acceptance of stablecoins as a form of payment varies depending on the specific vendor and jurisdiction.