Digital Assets

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What are digital assets?

Digital assets are assets based directly or indirectly on a blockchain or another digital, distributed, and encryption-based ledger or similar technology.

Blockchain is a decentralised ledger of all transactions across a peer-to-peer network enabling multiple users to maintain their copy of the shared ledger. They are cryptographically secured using mathematical algorithms to regulate the creation of new units (tokens) and to verify the legally binding transfer of values/funds.

Despite the commonly used designation 'cryptocurrency', it is questionable whether the commonly accepted requirements of a currency (e.g. medium of payment, unit of account, and store of value) are met because of the high volatility, transaction costs, and current level of adoption.

Digital assets are neither supervised nor controlled by a central authority and operate independently of banks; ownership and transaction-related information are stored in digital public ledgers. Digital assets of all kinds can be issued with relatively little effort; as of November 2021, more than 14,000 of them are known (source: coinmarketcap.com).

Advantages / Disadvantages

Advantages

• Direct participation in a new asset class
• Participation in companies or projects that are not available via traditional financial instruments
• Participation in market environments where traditional instruments offer few opportunities
• Transformation of non-bankable assets into bankable, transferable, and tradeable assets
• Diversification benefits (which have been observed to a certain extent over medium to long term)
• Opportunities for high returns via high-risk investment instruments

Disadvantages

• Pricing and forecasting of digital assets is very complex due to the still low adoption rate, network effects, the interaction of speculators and the evolving regulatory environment, the growing influence of central banks, governments, and national and supranational regulatory authorities, and the incentives of other market participants (e.g. miners).
• Possible liquidity constraints: only some marketplaces for digital assets operate in a regulated environment.
• High volatility: digital assets are subject to sudden price changes and their cause is not always clear to the investor.
• Predictability: past performance is no reliable indicator of future returns.
• Brokerage and custody costs: the brokerage and custody costs decrease the return from the investment.

Important risks to consider (I)

General risks associated with digital assets

• Access and use of the services and infrastructure provided at own risk
• The risk of loss in holding and/or trading digital assets can be substantial

Risks associated with the trading of digital assets

• Trading and execution risks
• Market risks including, but not limited to, liquidity and volatility risks
• Internet transmission risks
• Transaction delay risks
• Wallet transfer risk
• Settlement risks

Risks associated with the storage/custody of digital assets in general

• Risk of losing access to digital assets
• Risk of unauthorized access
• Risk of hacking or any sort of cybercrime
• Risks associated with potential lack of segregation of digital assets
• Risk of technical problems or operational mistakes

Important risks to consider (II)

Risks associated with regulation

• Legal and regulatory risks in general including, but not limited to, financial crime, market abuse, investment and product-related risks
• Default and insolvency risks of market participants
• Lack of supervision and lack of a central regulatory authority
• Risk of seizure of digital assets and sanctions
• Risk of digital assets being considered 'tainted' (e.g., because of interaction or exposure with addresses seen as linked to criminal activity)
• Risks associated with regulation-driven trading bans or investment restrictions
• Risk associated with specific types of digital assets

Risks associated with the underlying technology

• Risks of digital assets existing on a distributed ledger only
• Risks relating to the technologies employed
• Risk of weaknesses in the field of cryptography
• Fork risks and risks of similar events
• Risks associated with consensus mechanism
• Risks of immature technology, e.g. software bugs and exploits/hacks

Important risks to consider (III)

Risks associated with market conduct

• Insider dealings, e.g., pump and dump
• Induced transactions through disclosure of misleading information
• Other forms of market manipulation, e.g. front running, wash trading, or stop-loss hunting
• Risk of exploitation of weaknesses of on-chain governance mechanisms (e.g., in 'DAOs')

Risks associated with financial crime

• Investment fraud, e.g. fraudulent capital raising with ICOs or Ponzi schemes
• Fraud through 'rug pulls' (theft or misappropriation of digital assets by way of undocumented software features and/or collusion)
• Money laundering and Terrorist financing

What to expect from digital assets

Investment horizon

• Short term
• Medium term
• Longer term

Income expectation

• Capital gain

Market expectation

• Independent
• High volatility
• Increasing

Important to know before investing in digital assets

How does a blockchain work?

Distributed ledger vs centralised ledger

• Centralised ledger: transactions are verified, recorded, and executed by a central authority.
• Distributed ledger: transactions are recorded and validated directly by the network of peer users.

Distributed ledger technologies (DLT)

• Peer-to-peer network that enables multiple users to maintain their copy of a shared ledger.
• DLT allow their members to securely verify, execute, and record their transactions without intermediaries.
• Transactions are bundled in blocks linked using a cryptographic hash, which prevents retroactive modification.
• DLT employ consensus algorithms to synchronise data & ensure consistency across copies of ledger.
• A blockchain is an example of distributed ledger technology.

Each transaction block is marked with a hash (#) that refers to its previous block. The transaction history (chain of blocks) is identical on all computers in the network. When a new entry is made in the transaction history, an updated version is instantly distributed to every single node.

Classification of digital assets

Digital assets fall into two main groups.

Coin

A digital asset can be classified as a coin if it can operate independently using its own blockchain platform. Cryptocurrencies such as Bitcoin or Ethereum fall into this category. There is no issuer responsible for any claim.

Token

A digital asset that cannot run independently and depends on another blockchain platform to operate is classified as a token. Due to the many advantages of entering the Ethereum blockchain, many instruments on the Ethereum blockchain use the ERC-20 standard.

Digital assets can be further classified according to their economic function.

Native token

Native tokens, referring to payment tokens from FINMA definition, are intended to be used, now or in the future, as a means of payment for acquiring goods or services or as a means of money or value transfer. Payment tokens give rise to no claims on their issuer.

Utility, Service & Governance Token (USG)

Utility, Service & Governance Tokens (USG), referring to utility tokens from FINMA definition, are intended to provide digital access to an application or service by means of a blockchain-based infrastructure.

Security token

Security tokens, referring to asset tokens from FINMA definition, represent assets such as a debt or equity claim on the issuer. With respect to their economic function, they are analogous to equities, bonds, or derivatives. Tokens and coins enabling physical assets to be traded on the blockchain also qualify as security tokens.

Storage of digital assets

Digital Assets rely on cryptography to initiate transaction. Hence, cryptographic keys (or 'private keys') must be carefully safeguarded. These keys are typically managed through an application called a 'wallet'. Wallets can implement either 'hot' storage or 'cold' storage of the keys, as explained below. While an increased level of security comes with less flexibility or accessibility, clients will need to decide on their individual needs.

Hot storage

Online storage – permanently connected to the internet, which allows fast availability but less security.

• Secure hardware security module (HSM)
• Hosted at a secure data center
• All connections encrypted and secured
• Periodic penetration tests relying on science and research partners
• Assets available for trading in ca 1 hour

Cold storage

Offline storage – only connected to the internet for transfer of assets.

• Biometric and physical access controls
• Radio frequency (RF) shielded
• No connection to the internet
• Electronic equipment according to highest standards
• Protected against all known tempest attacks
• Assets available for trading in ca 2 hours

Transfer of digital assets

One of the key elements of digital assets is their decentralised validation and confirmation mechanism. Other participants of the blockchain network have to validate and confirm pending transactions. These participants are called 'miners' and are incentivised and paid for their work by the fees that are embedded in a transaction.

The fees involved have a direct influence on the speed with which a transaction is validated and confirmed by the participating miners. Miners will prioritise pending transactions with higher fees in order to maximise their profits. Transactions with fees that are too low to be commercially attractive for miners will lead to longer processing times.

The size of the fees paid varies. They largely depend on the overall transaction volume, but they also depend on the asset's price. Developments are currently under way (e.g. the Lightning Network) to substantially increase speed and scalability and to decrease transaction costs.

Direct and indirect exposure to digital assets

Direct exposure

• Direct purchasing of digital assets
• Cold/hot storage between bank and market access

• + Direct ownership of coins/tokens
• + Direct booking: client determination and custody of coin/token
• + Advised & execution only offering
• − Technology-and/or fraud-related risks with the protocol or foundation behind the token

Indirect exposure

• Exposure to digital assets through a financial instrument - e.g. funds and structured products (including exchange-traded products)

• + As a financial instrument, trading, portfolio integration, and reporting are straightforward (ISIN, factsheet, etc.)
• + Ability to gain diversified exposure through basket products
• − Sometimes there are counterparty risks
• − Potential for tracking error

Glossary