Emerging from the ashes of the financial wildfire that spread across the world in 2008, the seeds of a new digital financial ecosystem germinated from an email sent by Satoshi Nakamoto to a group of techies that November:“I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party. The paper is available at bitcoin.org/bitcoin.pdf.”
Two months later, Satoshi created 50 Bitcoins with the first transaction on a blockchain on January 3, 2009. Today, there are some 4,000 cryptocurrencies in the digital ecosystem, with a total market cap reaching $2.2 trillion last month. As of June 2020, at least 45 central banks were reported to be researching payments technology and applications, known as Central Bank Digital Currencies (CBDC), and in October 2020, the Bank for International Settlements as well as seven central banks (including the Federal Reserve, the European Central Bank and the Bank of England) published a report laying out critical requirements for CBDC.
Fast following on the heels of cryptocurrency innovation, other digital tokens were created, and the use of blockchain and “blockchain-like” technology was expanded in the public and private domains. This facilitated the transfer of a broader range of value units, digitized other types of tangible and intangible assets, and enabled the satisfaction of counterparty obligations under smart contracts wholly unrelated to assets.
In part one of our two-part series, we discuss what “digital assets” are, the blockchain infrastructure that supports them, and the emerging products, applications, processes, and organizations that use them, known as digital finance (DiFi).
Digital Financial Assets
In the broadest sense, “digital asset” refers to anything in a digital format, including photos, documents, audio, electronic records, websites, data related to individuals or accounts, and cryptocurrencies. Physical assets can be converted to digital assets when scanned and uploaded to a computer. Digital assets are stored (carried) on digital appliances/storage devices that function like filing cabinets (e.g., computers, telecommunication devices, and other modalities).
“Digital tokens” are financial digital assets that refer to a unit of value that can be owned, assigned (traded), or later redeemed. Because tokens serve different purposes, they can be treated differently under the law, and the law governing tokens and blockchains is not uniform across jurisdictions. For a more technical discussion, see this article published in Digital Asset Management (DAM) News.
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Cryptocurrencies (digital coins) are the most common form of the digital token and are used as a means of payment for goods or services and are “native” to a specific blockchain with a related name (e.g., Bitcoin/Bitcoin BC; Ether/Ethereum BC; NEO/NEO BC). Central Bank Digital Currency (CBDC) refers to a digital representation of fiat money issued by a Central Bank. Stablecoins are privately issued cryptocurrencies with a mechanism to minimize price fluctuation to “stabilize” their value, such as linkage to a reserve of stable, tangible assets such as currencies or commodities. For a discussion on CBDC and stablecoins, see this white paper by the law firm Clifford Chance.
They may be stored in “digital wallets,” earning interest and may increase in value for later use. Sometimes, they earn dividends (e.g., NEO pays “GAS”). In some cases, digital coin owners also have a say in the design and function of the associated blockchain (e.g., DASH). Also, the sponsor of a blockchain platform (e.g., Ether and NE) may allow other tokens to be transferred on its platform subject to payment of a user fee. For a “crypto” glossary and a list of cryptocurrencies, including their individual and aggregate market cap, see Coinmarketcap.com.
Other tokens serve different purposes, but typically they all function as part of a platform that sits on top of an existing blockchain. The benefit to the token issuer is the savings in time and money required to launch and operate their blockchain. Anyone can create a token, paying the blockchain sponsor to develop and validate (“mine”) transactions in his/her/their token. Tokens may be created to activate features in another application (“utility” tokens) called a decentralized application (dApp) or may represent underlying security (stock, bond, ETF), commodity, loan, or another asset (“asset-backed” tokens). In 2020, the commercial real estate firm, Red Swan, partnered with the blockchain sponsor, Polymath, to tokenize real estate. There also are “hybrid” tokens.
Non-fungible tokens (NFTs) represent ownership of something unique (identification code and metadata) for a particular user that can be bought and sold. Unlike cryptocurrencies, they are non-interchangeable and do not have any inherent value. They can be used to represent people’s identities, property rights, and artwork. Many are built on the Ethereum blockchain (e.g., crypto kitties).
Smart Contracts are misnomers as they are neither “smart” nor necessarily “contracts”! Instead, they are “business rules” translated into computer code (software algorithms) that “run the blockchain” (trigger actions) when predetermined conditions are met. They serve as the basis for the transference of a token, but they can also trigger actions that do not involve token transfers, including actions required under a legal contract.
Distributed Ledger Technologies (DLT). A Distributed Ledger is a database that exists across a network of computers at multiple locations or among multiple participants eliminating the need for a central authority or intermediary to process, validate or authenticate transactions or other types of data exchanges. The design eliminates the “single source of failure” present with a centralized or intermediated system and is quicker, more efficient, and cost-effective. The DLT transaction only rests on the ledger when a consensus is reached among the parties that it is accurate and valid. Transaction files are then timestamped and protected with a unique cryptographic signature providing a verifiable and auditable history. DLTs can be public or permission-ed (invitation-only) and operate solely by smart contracts or governed by an entity.
Blockchains are a type of DLT distinguished by the fact that data units are displayed in a sequence (blocks on a chain), with each unit dependent upon a logical relationship to all prior units. Public blockchains process peer-to-peer (non-intermediated) anonymous transactions in digital assets (e.g., cryptocurrency), which become immutable and cannot be changed when verified. Some blockchains, like Ethereum, will support token applications running on top of the blockchain and the cryptocurrency (payment token) embedded within it.
Digital asset management systems (DAMs) incorporate software, hardware, and services designed to manage, store, ingest, organize and retrieve digital assets.
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About the Author | Jilaine Bauer is Senior Compliance Consultant at Ascent. Previously, Jilaine worked as a Compliance Officer responsible for regulatory change management at one of the world’s most extensive financial market data and infrastructure providers, as an independent regulatory consultant within the financial services industry sector, and as a general counsel and compliance officer to multi-faceted financial services firms. She holds a law degree from Loyola University (Chicago) and a degree in psychology from the University of Illinois Urbana-Champaign. She also has corporate, advisory, and nonprofit board experience. Connect on LinkedIn.