Emerging Asset Class
Digital assets have emerged as an alternative asset class for investors seeking superior returns and portfolio diversification. According to CoinMarketCap, the investable digital asset, or cryptocurrency market, consists of approximately 22,000 assets, totaling approximately $1T in market capitalization.
A cryptocurrency is a digitalized medium of exchange that leverages cryptography to confirm, secure, and record transactions. More specifically, cryptocurrencies leverage blockchain technology to manage transactions on a decentralized ledger that is immutable and available for public review. Bitcoin, which first emerged in 2009, is the oldest active cryptocurrency and is currently the most liquid and widely used cryptocurrency.
Blockchain technology, which underpins cryptocurrencies, is an immutable database that allows for data transfers between computers within its network, often referred to as nodes. The nodes are often incentivized to participate in and secure the network via monetary rewards, which are generally paid via a network’s native currency. For example, the ether (“ETH”) token is the Ethereum blockchain’s native token and is used in managing the blockchain’s operations.
It should be noted that cryptocurrency is a use case of blockchain technology. Proponents of blockchain technology present it as a revolutionary framework that can drastically improve current methods of data storage, handling, and transfers. Moreover, they note the vast applicability of the technology in other facets of the economy, such as but not limited to: medical services, legal services, infrastructure, and entertainment.
Digital Asset Market Participants
There exists multiple types of participants in the digital asset space. They include, but are not limited to: cryptocurrency traders and investors, cryptocurrency miners, and companies creating products and services related to the infrastructure of blockchains and their applications.
Traders and investors typically engage in cryptocurrency transactions for economic gain. Trading decisions can be made on a discretionary or a formula-based basis. These transactions provide liquidity in the secondary cryptocurrency market, easing the cost of trading for market participants.
Miners participate in the formation and management of a blockchain’s consensus mechanism, which is integral in the transaction confirmation process. For example, blockchains employing a proof-of-work consensus mechanism require miners to process computationally intensive algorithms to confirm transactions and extend blockchains. Blockchains employing a proof-of-stake consensus mechanism confirms transactions by staking native tokens, which provides the network with computing resources.
Firms and trade groups operating in the blockchain space provide products and services such as but not limited to: research and development of blockchain technologies for cryptocurrency and non-cryptocurrency-related use cases, trading and custody of cryptocurrencies, digital asset lending, insurance services, and creating hardware for cryptocurrency mining and storage.
As an alternative to owning cryptocurrencies directly on a spot basis, investment vehicles provide investors and companies the opportunity to invest in digital assets. These vehicles alleviate the burden of self-custody, which may be a deterrent for some investors from logistical and legal perspectives.
Common investment vehicles include: derivatives such as futures and options on cryptocurrencies, private investment firms such as hedge funds and venture capital, and exchange traded products. Currently, there is much speculation about the possible approval of a spot Bitcoin exchange traded fund (“ETF”) in the U.S. An approved U.S. spot Bitcoin ETF would provide regulatory certainty, credibility, and capital flows into the broader cryptocurrency market. That said, related products such as Bitcoin futures and futures-based ETFs exist in the U.S.
In addition, spot Bitcoin ETFs are available in the Canadian market.
Glossary of Relevant Terms
Altcoin: a cryptocurrency other than Bitcoin.
Bitcoin: generally regarded as the oldest and largest active cryptocurrency by market capitalization. It was introduced in 2009 by a pseudonymous creator known as “Satoshi Nakamoto.”
Blockchain: A decentralized framework and technology for data storage. Data can be duplicated and distributed across the network of computers operating within a blockchain. Blockchains do not require a centralized intermediary.
Block reward: When blocks are created by miners or validators, a block reward is issued. This takes the form of newly minted cryptocurrency, which is used as an incentive for participants to help keep the blockchain running.
Consensus: the method by which blockchain participants agree on regarding the next block to be added to the blockchain. The two most prominent consensus mechanisms are proof-of-work and proof-of-stake.
Cryptography: the science of securing information. Methods include the SHA-256 hashing algorithm and private-key/public-key cryptography.
Decentralized applications or dApps: programs that run on top of blockchain networks. They deploy smart contracts to provide tools and services for users.
Decentralized finance: a financial framework that leverages blockchain technology to facilitate transactions without intervention from a centralized party.
ERC-20: the technical standard for fungible tokens created using the Ethereum blockchain and is the most commonly used crypto-token standard.
Ethereum: the blockchain that supports the second-largest cryptocurrency by market capitalization. The network is called Ethereum and its native currency is called ether, commonly referred to as “ETH”. The Ethereum network incorporates smart contracts and is the foundation for other digital currencies and projects.
Exchanges: a platform that allows digital assets to be traded, generally for a fee. Decentralized exchanges allow users to trade directly with other participants via wallets. Centralized exchanges require users to sign up with the exchange, with the exchange acting as a market maker and matching customer trades.
Gas: the fee required to execute a transaction or contract on the Ethereum network. The fee is paid in Ethereum’s native token, ETH.
Halving: a 50% reduction of mining block rewards for a particular cryptocurrency.
Initial coin offering: akin to an initial public offering, an initial coin offering is a mechanism that companies use to raise capital to finance its expenditures, usually a new cryptocurrency.
Ledger: a distributed digital record of transactions that can be viewed by the public.
Mining: the process of 1) verifying and adding new data to a blockchain ledger and 2) adding new coins into circulation.
Non-fungible Token: a digital certificate of ownership that represents a digital or physical asset. It has a unique code that serves as a digital identifier.
Private key: an alphanumeric code that confirms one’s ownership of a wallet and provides access to the assets held therein.
Public key: an alphanumeric code used to create an address for transactions.
Smart contract: a computer program that automatically executes a transaction given a predetermined input.
Stablecoin: a cryptocurrency that pegs its value to an external reference, such as the U.S. dollar.
Token: units of value issued by platforms built on top of existing blockchains.
Wallet: a device or service that stores cryptocurrencies. There are generally two types of wallets: hot and cold. A hot crypto wallet is connected to the internet, while a cold wallet is offline, usually linked and accessible through hardware devices. Since a cold wallet is offline, it is less vulnerable to online hacks or theft than a hot wallet. Cold wallets are only online when it’s physically plugged in or using a unique QR code. Once connected, the user can engage in transactions. Hot wallets deploy security measures such as recovery seed phrases and are used because of its convenience with respect to trading.