Investment Forms and Vehicles Used in Digital Asset Investments

Investments in digital assets can be undertaken either directly on the blockchain or indirectly through exchange-traded products and hedge funds.

Direct Investment on the Blockchain

Direct investment on the blockchain requires a cryptocurrency wallet. The wallet holds the essential public and private digital codes needed to access the assets. These codes can be stored and used through a computer website or a mobile device application.

Investments directly made in digital assets occur through digital exchanges. These transactions are registered on the blockchain, a decentralized, distributed digital ledger that documents transactions across numerous computers.

In contrast to conventional stock exchanges, cryptocurrency exchanges usually operate around the clock, enabling uninterrupted trading, which may contribute to increased market volatility.

There are two types of cryptocurrency exchanges: centralized and decentralized.

Centralized Exchanges

Centralized exchanges, privately owned platforms for trading cryptocurrencies, share similarities with traditional stock exchanges such as the New York Stock Exchange or the NASDAQ. They offer volume, liquidity, and price transparency, much like conventional stock exchanges, providing real-time trading data.

Trading on these platforms is electronic and direct, similar to online stock trading platforms, without an intermediary broker or dealer. However, these exchanges, which operate on private servers, face security vulnerabilities. If these servers are compromised, the entire system may be affected, potentially disrupting trade and risking the exposure of crucial user information.

Some centralized exchanges fall under regulation, subject to varying regulations depending on the jurisdiction. They might be regulated as financial exchanges or other types of financial intermediaries.

Decentralized Exchanges

Decentralized exchanges operate in a manner similar to the operation of Bitcoin, mirroring the decentralized protocol of blockchain technology. They function as peer-to-peer trading platforms, lacking a central control mechanism, and run on a distributed platform without centralized coordination or authority.

In decentralized exchanges, if one of the computers on the network is compromised, the exchange remains functional because numerous other computers continue to operate on the network. This resilience is comparable to how a distributed network, such as the Internet, remains operational even if one server experiences issues.

Decentralized exchanges present challenges in terms of regulation since there is no single entity, organization, or group that controls the system. Traders on decentralized exchanges generally have the freedom to transact without being subject to regulatory scrutiny, potentially creating opportunities for illegal activities.

Issues with Cryptocurrency Exchanges

Centralized and decentralized exchanges both encounter issues related to fraud, manipulation, and potential concerns regarding investor protection due to the limited oversight they face. In contrast to exchanges for traditional assets like equity securities and futures contracts, cryptocurrency and their trading platforms operate with minimal regulation. This lack of regulation permits the possibility for individuals or groups to conduct fraudulent activities or manipulate markets.

Risks of Direct Investment in Cryptocurrencies

Investing directly in cryptocurrencies carries several risks. These include:

• Fraud Risk: The rise of cryptocurrencies has resulted in a surge in fraudulent activities, encompassing pump-and-dump schemes, market manipulation, theft, and endeavors aiming to acquire access credentials for cryptocurrency wallet information. Prior to investing in any cryptocurrency, conducting comprehensive due diligence is crucial.
• Access Risk: Cryptocurrencies are typically stored in a digital wallet accessible solely through a unique passkey, called a private key. If this key is misplaced, the assets within the wallet become unrecoverable. It’s estimated that approximately 20% of all Bitcoins are in wallets that have been lost or abandoned, rendering the owners unable to access their holdings.
• Concentration Risk: A substantial portion of smaller cryptocurrencies, known as altcoins, may be predominantly owned by a limited number of holders commonly known as “whales.” These are entities possessing a considerable amount of a cryptocurrency, potentially affecting its price.

Indirect Digital Asset Investment Forms

There are several alternatives available for gaining indirect exposure to digital assets. These include:

Cryptocurrency Coin Trusts

These trusts enable investors to trade shares representing significant holdings of a cryptocurrency. These shares are tradable over the counter (OTC) and function similarly to closed-end funds.

Investing in a coin trust eliminates the need for investors to create a digital wallet or manage encryption keys to enter the cryptocurrency market, simplifying the investment process.

These trusts often offer increased transparency in trading as they regularly disclose their holdings, providing investors with a clear view of the specific assets held within the trust.

However, they come with notable drawbacks, including substantial fees and expenses, occasionally surpassing 2%.

Cryptocurrency Futures Contracts

Cryptocurrency futures contracts involve purchasing or selling a specified amount of cryptocurrency at an agreed-upon price on a particular future date. For instance, when you buy a Bitcoin futures contract at $10,000, you’re committing to purchasing Bitcoin at $10,000 on a future date, regardless of the current market price.

Unlike physical commodities, these contracts are generally settled in cash, meaning no actual cryptocurrency changes hands. This eliminates concerns about storing or securing the cryptocurrency.

Futures trading involves leverage, allowing control over a considerable amount of cryptocurrency with a relatively small investment. However, this also escalates the investment’s risk.

The market for cryptocurrency futures might be less mature, potentially less liquid, and more volatile compared to more established futures markets leading to significant price volatility.

Cryptocurrency Exchange-traded Funds (ETFs)

A growing array of exchange-traded products, like ETFs, aim to mirror the returns from digital asset investments. Instead of directly investing in cryptocurrencies, these ETFs usually gain exposure to cryptocurrency values through cash and cryptocurrency derivatives. This strategy helps avoid the risks and complexities tied to holding cryptocurrencies directly.

Cryptocurrency Stocks

Investors gain indirect exposure to cryptocurrencies through entities related to digital assets. This involves purchasing shares in companies within the cryptocurrency realm, including those in cryptocurrency mining, payment providers accepting cryptocurrencies, corporations investing or transacting in cryptocurrencies, and companies developing products or services used in blockchain networks.

Hedge Funds Investing in Cryptocurrencies

Hedge funds have become a significant indirect investor in digital assets. Some hedge funds engage in Bitcoin mining as an avenue to boost their returns. This process involves employing high-powered computers to solve intricate mathematical problems and verify transactions within the Bitcoin network. Miners receive new Bitcoin as a reward, which can be subsequently sold for a profit.

Digital Forms of Investment for Non-digital Assets

Digital forms of investment for non-digital assets refer to various digital formats of investment where the value is derived from an underlying non-digital asset. A good example is asset-backed tokens.

Asset-backed tokens are digital representations of ownership in real or financial assets, deriving their value from the asset they’re linked to. These tokens provide digital ownership over assets like real estate, equities, gold, or crude oil. They introduce the concept of fractional ownership, enabling multiple investors to hold a fractional interest in the asset.

For example, consider a $1 million artwork. In traditional scenarios, it’s often unaffordable for most investors. However, asset-backed tokens could tokenize this artwork into a million tokens, each representing a 0.0001% stake in the artwork. This way, investors can own a fraction of the artwork for as little as $1, expanding access to high-value assets.

Advantages of Asset-backed Tokens

Asset-backed tokens heighten the liquidity through fractional ownership of high-priced assets such as art and precious metals.

The digital representation of the claims contributes to unchangeable information on ownership and ownership transfer. Consequently, this increases the transparency of transactions which in turn decreases costs of transaction, intermediation, and record keeping.

Usually, financial regulators categorize asset-backed tokens as securities because owning the token grants the holder an interest in the associated asset.

Issuance of Asset-backed Tokens

Asset-backed tokens are commonly released on platforms enabling peer-to-peer interaction through transparent smart contracts that endure throughout the chain’s duration. These platforms are called decentralized applications (dApps) that record transactions on the blockchain without relying on a central coordinating entity.

Decentralized Finance (DeFi)

The increased promotion of financial decentralized applications (dApps) evolved into a movement recognized as decentralized finance, commonly referred to as DeFi. DeFi endeavors to establish an array of open-source financial applications that function as the building blocks for advanced financial products and services.

DeFi acts as a marketplace for decentralized applications (dApps), aiming to fulfill essential financial functions such as being a medium of exchange, storing value, tokenizing underlying assets, and preserving an unchangeable record of asset ownership and transfers.

Consequently, smart contracts integrated into dApps can manage most elements of the conventional financial system, including lending, trading, investment, settlement, payment, and decentralized, authenticated, and instant transfers. They can offer time efficiency and risk mitigation in asset transfer and settlement. Nevertheless, the concept of DeFi is still in its early stages and requires further development.

Question

Which of the following is most likely the primary advantage of using smart contracts in DeFi lending and borrowing platforms?

1. Allow for the creation of new digital assets.
2. Increase the risk associated with lending and borrowing on DeFi platforms.
3. Automate the loan disbursement process, reducing the need for traditional financial intermediaries.

The correct answer is B.

Smart contracts automate the loan disbursement process, reducing the need for traditional financial intermediaries. This is the primary advantage of using smart contracts in Decentralized Finance (DeFi) lending and borrowing platforms. Smart contracts are self-executing contracts with the terms of the agreement directly written into code. They automatically execute transactions without the need for a third party, which in traditional finance would be a bank or other financial institution.<br>

This automation reduces the time and cost associated with loan disbursement, making the process more efficient. Furthermore, it also reduces the risk of human error and fraud, as the terms of the contract are immutable once they are written into the blockchain. This makes the lending and borrowing process on DeFi platforms more transparent, secure, and efficient, which is a significant advantage over traditional financial systems.

A is incorrect. While it is true that smart contracts can be used to create new digital assets, this is not their primary advantage in the context of DeFi lending and borrowing platforms. The creation of new digital assets is a feature of smart contracts, but it is not directly related to the lending and borrowing process on DeFi platforms.

B is incorrect. Smart contracts do not increase the risk associated with lending and borrowing on DeFi platforms. In fact, they reduce several types of risk, such as the risk of human error and fraud. However, it is important to note that while smart contracts can mitigate some risks, they also introduce new risks, such as the risk of bugs in the contract code. Nonetheless, these risks are not inherent to the use of smart contracts and can be mitigated through proper coding practices and security audits.