Digital Assets and Blockchain Technology: Frequently Asked Questions

Digital assets and blockchain technology have received considerable attention in recent years, and for good reason. These innovations have the potential to revolutionize the way the world thinks about our digital infrastructure. However, they raise a number of questions for financial advisers and their clients.

This blog post addresses some of the most common questions we encounter when discussing digital assets and blockchain technology. In the process, we highlight why we believe this space has such a large disruptive potential.

How do blockchains work and why are these networks considered disruptive?

A blockchain is a distributed database that can be viewed, accessed and updated by any participant in the network. On a blockchain, data is aggregated into individual blocks that are linked together with previous blocks to form a chain. This data may represent a transfer of value or settlement of any activity on an application. Together, the chain of individual blocks constitutes all of the network’s historical data. Thanks to the cryptographic architecture of advanced blockchains, retroactive modification of past data is almost impossible.

By requiring the database to be stored on all networked computers and all updates to the ledger to achieve consensus among users, blockchains offer a secure and decentralized method of data management. This underpins true digital ownership that cannot be revoked and creates a trustless and neutral settlement layer for data.

The spectrum of current use cases for this technology is broad. Because many of the most popular blockchains today support smart contract technology—the building blocks of decentralized applications (dapps)—blockchains have become viable data settlement layers for functions far beyond peer-to-peer value transfers. For more information on smart contracts, visit the blog post Exploring the Disruptive Potential of Smart Contracts.

What are digital assets?

Digital assets utilize blockchain and/or smart contract technology to represent a digital form of value, perform a function or stimulate certain activities. These assets are built based on code that governs all aspects of their economic value, utility and ownership.

Digital assets can be divided into two subclasses: cryptocurrencies and tokens. Cryptocurrencies are native blockchain assets that are used as digital goods to drive network activity. Ether (ETH), for example, is Ethereum’s original cryptocurrency used to pay for the settlement of data on the blockchain. Tokens are smart contract-based digital assets with a wide range of functions. Tokens can be fungible or non-fungible and can have many different use cases. These include running specific dapp activities or representing unique pieces of data as digital and real values ​​on the blockchain.

What are the main functions of cryptocurrencies?

Cryptocurrencies act as a decentralized, flexible and programmatic form of capital within blockchain networks. They are embedded with encryption technology that prevents double spending and allows individuals to verify that they own an asset. Cryptocurrencies can be used as digital currencies for peer-to-peer payments, as a medium to pay for data settlements in a block, as security in decentralized finance applications (DeFi) and much more.

Another primary function of cryptocurrencies is to incentivize blockchain security participants to act according to network rules. This is essential to coordinate and reach consensus on the state of the network. In exchange for proposing valid data certificates to the network, blockchains offer rewards in the form of cryptocurrencies. Dishonest data certificates that do not achieve consensus from the network receive no rewards and may be subject to penalties. In this way, cryptocurrencies provide an incentive mechanism that allows blockchains to operate securely without any central control points. For more information on how consensus mechanisms work, visit the Proof of Work vs. Proof of Stake: Why Their Differences Matter.

Why is there more than one cryptocurrency?

Cryptocurrencies serve different purposes and have different functions. Some cryptocurrencies, such as bitcoin (BTC), are primarily positioned as stores of value due to their scarce supply. Others, like ether (ETH), are positioned as valuable commodities needed for data settlement, and as a medium of exchange needed to interact with a growing ecosystem of dapps.

The open source nature of blockchain infrastructure allows developers to build a spectrum of cryptocurrencies positioned for different uses, each with unique value propositions.

What are the differences between the Bitcoin and Ethereum networks and why do their respective assets have value?

The Bitcoin network is a globally accessible database that enables the storage and peer-to-peer value transfer of its native asset, bitcoin (BTC). BTC is divisible, fungible and easily transferable with a programmatically defined monetary policy that ensures scarcity. Due to its great value characteristics, bitcoin is often referred to as a form of digital gold.

Ethereum extended Bitcoin’s innovative use of blockchain technology by creating a platform capable of hosting advanced applications on top of a blockchain, powered by Ethereum’s native asset, Ether (ETH). This innovation introduced the concept of smart contracts and laid the foundation for the invention of decentralized applications (dapps). Dapps have the potential to reconstitute the application layer of today’s internet. Because these applications are powered by ETH and settle their data to the Ethereum network, Ethereum is positioned as a settlement layer for a new internet of value.

Who controls digital assets?

No single party or network participant controls the digital asset space. The leading cryptocurrencies and tokens are maintained by a network of users who work together to validate and record transactions on the blockchain.

Importantly, participation in these distributed networks is open to anyone and requires only the right hardware and software knowledge. Software development and maintenance usually falls to a group of developers. Governance voting falls to a group of global participants and often determines software implementation. However, not all digital assets work in the same way and there are cases where cryptocurrencies and tokens can be centralized and manipulated by certain actors.

If digital assets are based on code that lives on a blockchain, can they be hacked? How safe are they?

Digital assets can be hacked and are exposed to cyber security risks. However, a blockchain’s design makes it incredibly difficult for attackers to tamper with historical data. Blockchains use advanced cryptography to ensure data integrity and security. They also have native defense mechanisms that require heavy resources and financial capital to carry out dishonest activity. When researching cryptocurrencies, ensuring proper decentralization and strong consensus mechanisms are critical to network security.

In addition, a flaw in smart contract code could be a vulnerability for dapps built on blockchains. Hackers often try to exploit holes in the code or infrastructure applications that these dapps rely on. When researching tokens, it is important to consider the smart contract behind the token, the development team, the token’s economic model, supply dynamics, infrastructure dependencies, and relevant activity on the chain.

How will regulation affect the digital asset space?

Regulation of digital assets is an important and complex topic. The rules applicable to these assets may vary depending on the location and the specific details of the asset, protocol or investment in question. Comprehensive regulatory frameworks can ease public skepticism and serve to attract users to this fascinating industry, but overly restrictive regulation can hinder growth and innovation. While the future regulatory landscape in the US and abroad remains unclear, we believe that regulation should ultimately be structured to provide investors and users with the protections necessary to allow this nascent industry to flourish.

How can investors start investing in digital assets?

Investors have regulated and unregulated methods of investing in digital assets. Regulated vehicles may offer greater protection for investors, but they may also impose stricter investor requirements and offer less direct exposure to their underlying assets. When considering regulated investment vehicles, it is important to consider management fees, custody infrastructure and client agreements.

Some of the leading regulated vehicles include private funds, separately managed accounts (SMAs), directly backed exchange-traded products (ETPs), derivatives-based exchange-traded funds (ETFs), and crypto-shares such as public miners and exchanges.

Unregulated vehicles are not subject to government oversight, which means they can be riskier for investors and offer no investor protection. The safest way to manage direct investments in digital assets is to use a self-custodial wallet. While this approach provides investors with direct exposure to the underlying, unique challenges and risks associated with managing a self-custodial wallet and investing directly in unregulated digital assets should be carefully considered.

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