This article unpacks the terms used for entities such as digital assets, sweeping away misunderstandings and problems to get at the picture.
This news service writes regularly about what goes under the moniker of “digital assets” (as in this feature here), and whatever the gyrations of markets, there’s little sign of them fading away. In some respects, interest is rising. To try and make sense of the terrain is UK-based writer and figure in the buy-side of financial services, Dr Ian Hunt (more detail on the author below). The editors are pleased to share these insights and invite responses. The usual editorial disclaimers apply. Email firstname.lastname@example.org
We hear lots about digital assets. There are loud claims of impending world domination. There are well-publicised instances of financial impropriety and fraud. There are demands from established investors for secure ways to access new digital asset classes. There are demands from Millennials and Gen Zs for a better way to invest. There are wild fluctuations in the value of cryptos.
In the background, there are agonised noises from regulators struggling to control new assets that are designed not to be controlled. They flip and flop trying, and often failing, to pigeonhole the badly behaved assets and entities that are crashing the conventional party.
To add to the noise, governments and central banks announce that they are pro- or anti-digital assets, without being specific on what digital assets they are talking about. In the UK, government ministers have claimed that the UK will be a world fulcrum for trading and managing digital assets, while the UK regulators are constraining any meaningful initiatives in the same space. It's a mess.
So what are digital assets and what do they really contribute to the landscape of finance? Under the blanket term “digital,” what kinds of digital assets are out there? How do they behave? What should we be promoting, and what should we fight shy of? This article tries to provide some answers to these questions.
The general public (1) (and general media) perception is that digital assets ARE crypto, and that they amount to the same thing: they are all dodgy. Better-informed commentators are aware that conventional assets of various kinds are being tokenized, and they call these “digital assets” too. However, there is an obvious flaw in each of these positions: the true cryptos, like Litecoin and bitcoin, are currencies, not assets as such, and tokenized conventional assets are conventional, not digital.
The only thing digital about tokenizsed conventional assets is the representation of their ownership in the form of a token on a digital ledger, rather than as a conventional share, unit or title deed. True cryptocurrencies, on the other hand, are purely digital, and don’t depend on any conventional assets or cash for their value: they are not marks of ownership of something else – they are the thing that is owned. There is no pool of conventional cash behind a holding in bitcoin. However, and despite their differences, cryptos and tokenized assets are both examples of tokens on a digital ledger.
So there are two basic kinds of token that we find on a digital ledger: those that reference conventional assets (or cash) outside the ledger, and those that don’t. We call the former “backed” or “collateralised” tokens, as they depend on something external for their security and their value. The latter we call “native digital” tokens, as they exist only on the ledger, and have no dependence on anything external for their value or security.
This may appear very worrying – there are digital tokens that have nothing behind them to underwrite their value and security? Yes, this is true, but it is a less unfamiliar idea than it sounds: pounds sterling, US dollars and euros are tokens (albeit of a different kind) and have virtually no reference to anything external to give them value or security: the gold standard disappeared years ago, and now less than 2 per cent of sterling is gold-backed: the rest is just a promise.
Within the apparently new world of digital ledgers, we can recognise some very familiar faces: In the conventional world of finance, there is cash, and there are assets. In the digital world there is cash and there are assets too. Cash may be an investable (in both cases), but its role is as a means of exchange, denominating the value of assets, and intermediating transactions, rather than being strictly an asset itself. Reflecting this distinction between cash and assets, we can extend our basic categorisation of tokens on a digital ledger into four:
1. Collateralised cash tokens;
2. Collateralised asset tokens;
3. Native digital cash; and
4. Native digital assets.
Collateralised cash tokens
A collateralised cash token is a token on a digital ledger that gives its holder title to all or part of a pool of value outside the ledger. Prominent examples are Tether, USD Coin and Dai.
That pool of value may be in the form of cash, near-cash assets (like Treasuries or gilts), or a combination of both. Such tokens are known as “stablecoins” because they aim to achieve stability against some reference currency or cash-like asset. The tokens can be used in on-ledger transactions, to enable digital versus digital settlement, which can be quicker, more efficient, and lower risk than conventional settlements.
As collateralised stablecoins depend on a relationship to external assets and/or cash, then there is the need for two service providers to manage that relationship: They are:
• An issuer and redeemer of tokens, who
maintains the strict one-to-one relationship between the tokens
in issue and the external pool of value; and
• A safe-keeper of the assets and/or cash which collateralise the stablecoin: it doesn’t help the stability of a stablecoin if the underlying collateral disappears!