Digital assets
Our financial system furthers its evolution as technological innovations continue to develop. It’s impossible to deny the existence of digital assets in the modern world. Financial professionals must understand their mechanics and suitability as their presence becomes more ubiquitous.
In this chapter, we’ll discuss the following topics related to digital assets:
- Definition
- DeFi
- Types & characteristics
- Regulation
Definition
Let’s start by defining what a digital asset is. According to the Internal Revenue Service (IRS):
Digital assets are broadly defined as any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology
The IRS does not currently consider any digital asset a currency (even cryptocurrencies). Our government generally only considers fiat currency, which is backed by a government, to be actual currency. The US Dollar, Euro, and Japanese Yen are all examples of fiat currencies.
Digital assets lack government backing and are largely valued based on demand. The more they are in demand, the higher their value increases (like all other investments and securities). Their values are measured on a fiat currency basis; for example, one Bitcoin (BTC) is worth roughly $27,000 as of June 2023.
DeFi
Digital assets are central to the decentralized finance (DeFi) movement. DeFi involves the removal of centralized third parties (e.g., financial services companies, banks), allowing users to transact directly.
For example, most people traditionally acquire loans through banks, which act as an intermediary between depositors (those supplying the money) and debtors (those borrowing the money). Conversely, a DeFi loan could use an algorithm to match a borrower and lender directly based on the requirements of each (e.g., the lender is willing to lend $10,000 at 7% interest, and the borrower is willing to borrow $10,000 at 7%). Instead of a bank acting as a middleman and collecting fees for their services, a computer system connects the borrower and lender (often for much less than what a bank would charge).
Most DeFi transactions are governed by smart contracts, which embed the transaction terms (e.g., loan repayment or transaction terms) into lines of code written on the blockchain (discussed below). For example, let’s assume a business agrees to purchase TVs directly from a manufacturer via smart contracts with a digital asset (e.g., a cryptocurrency). The smart contract could automate much of the process, including requiring the business to post the digital assets as collateral before the TVs are shipped and releasing the digital assets to the manufacturer when the TVs are received.
Types and characteristics
The digital asset world is complex and diverse, but there are three primary types of digital assets to be aware of:
- Cryptocurrencies
- Stablecoins
- Non-fungible tokens (NFTs)
Cryptocurrencies
The IRS defines a cryptocurrency as:
A convertible virtual currency that can be used as payment for goods and services, digitally traded between users, and exchanged for or into real currencies or [other] digital assets.
The three most popular cryptocurrencies today are:
Cryptocurrencies are secured by cryptography, which is the act of concealing information through the use of codes and mathematical equations. ‘Crypto’ means ‘secret’ in Greek; therefore, ‘cryptocurrency’ could be roughly translated to ‘secret currency.’ Most major cryptocurrencies, including the three listed above, utilize public-private encryption. Cryptocurrency users maintain a ‘public key,’ a long alphanumeric string of characters (like a strong password). This key represents the public encryption that can be shared with anyone to receive cryptocurrency. Users also possess a ‘private key,’ also a long alphanumeric string of characters. This key represents the private encryption that should never be shared and is used to claim received cryptocurrencies.
To better understand this concept, let’s go through a quick example. Assume Ben wants to send some BTC to Amanda. Amanda must share her public key with Ben. Once he obtains her public key, he can send Amanda the BTC directly or through a third-party app or service (e.g., Coinbase). Amanda must possess her private key (which she should never share) to access the BTC she received.
Cryptocurrency users maintain their private keys in various wallets. Paper wallets involve physically writing down the private key (e.g., in a notebook). Hardware wallets store private keys on devices like USB drives. Online (digital) wallets store keys in apps or other online-based programs. Users must safeguard their private keys, regardless of the wallet used. If the key is lost, it is virtually impossible to regain access to the stored cryptocurrency. There have been many examples of users losing access, including a man who mistakenly threw away a hard drive holding his private key to 8,000 BTC, which was worth more than $200 million as of June 2023.
Like all other currencies, cryptocurrencies are used as a medium of exchange that allows the avoidance of a barter system. For example, paying for groceries with a currency is much easier than trading other goods (e.g., shoes for a steak). Their existence provides options beyond traditional currencies like the US Dollar. As more people adopt and embrace cryptocurrencies, there are more ways to transact business.
All cryptocurrency transactions are recorded on the blockchain, which is a shared database (ledger). The blockchain reports the public keys of the sender and receiver, the amount of the cryptocurrency transferred, and any associated fees paid to third parties (e.g., transaction fees imposed by crypto exchanges).
Stablecoins
A stablecoin is a type of cryptocurrency whose value is pegged to a fiat currency, asset, or commodity. The most popular stablecoin available today is Tether’s USDT, which pegs its value to the US Dollar and maintains a consistent $1.00 value per coin. Stablecoin issuers typically hold reserves of the pegged item and other assets to uphold the coin’s value. For example, Tether claims to maintain roughly $1.6 billion in reserves of fiat currencies and US Treasury securities to back and maintain the pegged value of its stablecoin.
Non-fungible tokens (NFTs)
Non-fungible tokens (NFTs) share many similar characteristics with cryptocurrencies. They are central to the DeFi movement, utilize smart contracts, and record their transactions on the blockchain. The primary difference between the two relates to their fungibility. Cryptocurrencies are fungible, which means they are replaceable. If a person holds two BTC, both are essentially identical and equally valuable. On the other hand, NFTs are non-fungible (as their name suggests), meaning each is unique. Similar to keys utilized by cryptocurrency users, each NFT is minted with a special identifier that distinguishes it from other NFTs.
NFTs have taken many different forms since their inception in 2014. Some examples include:
Like cryptocurrencies, NFT values are derived from demand. There have been wild price fluctuations in this space, including Jack Dorsey’s first tweet NFT that initially sold for $2.9 million, only to lose virtually all its value. Many NFT enthusiasts expect their value to be most realized in digital social platforms (e.g., wearing Nike NFT sneakers in the metaverse). At the same time, skeptics claim they are nothing more than lines of code.
Regulations
Digital assets and their markets have been described as the “digital wild west.” Price volatility, theft, and organizational disasters have plagued this sector since its inception. Until recently, financial regulators have avoided regulating digital assets and their marketplaces, largely due to legal constraints. For example, the Securities and Exchange Commission (SEC) can generally only regulate securities. Are cryptocurrencies and NFTs securities? This is the big question at the forefront of digital asset regulation.
The Supreme Court’s 1946 ruling on SEC vs. W.J. Howey Co. (covered in detail later in this material) determined a security is defined as meeting these requirements:
- Investment of money
- Common enterprise (pooling money with other investors)
- Expectation of profit
- Third-party management
The SEC has previously called cryptocurrencies like Bitcoin commodities, not securities. Commodities are regulated by the Commodity Futures Trade Commission (CFTC) and are generally outside of the jurisdiction of the SEC. However, this is not the case for most other cryptocurrencies. Gary Gensler, the current Chair of the SEC, firmly believes cryptocurrencies are securities. In September 2022, he made a lengthy speech outlining his argument. Here’s one of his opening lines:
“Of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities. Offers and sales of these thousands of crypto security tokens are covered under the securities laws.”
The differentiator between BTC and other digital assets now being considered securities is whether it constitutes an ‘investment contract.’ BTC was created by an anonymous person known by the pseudonym Satoshi Nakamoto. There is no issuer raising capital selling new BTC; instead, BTCs are mined by computers performing complicated calculations. On the other hand, most cryptocurrencies and other digital assets involve organizations raising funds in return for capital. We’ll quote SEC Chair Gary Gensler once again:
“If somebody is raising money selling a token and the buyer is anticipating profits based on the efforts of that group to sponsor the seller, that fits into something that’s a security”
The push for regulation of digital assets is fluid and changing, but regulators like the SEC are taking steps to enact regulatory authority. While the SEC has yet to comment on NFTs being considered securities, it is clearly considering most cryptocurrencies as securities. This can be confirmed by many of the SEC’s recent regulatory actions related to cryptocurrencies:
- SEC charges LOCIcoin issuer with fraud
- SEC charges multiple coin issuers with unlawful sale of unregistered securities
- SEC charges Bittrex with unlawful operation of an unregistered exchange
In particular, the SEC has recently focused on organizations performing initial coin offerings (ICOs) and considering them unregistered sales of securities. We’ll discuss this concept in a future chapter, but securities generally must be registered with the SEC and/or the state administrator (basically the SEC, but at the state level). A person or organization that offers unregistered securities without a valid exemption (exception) is breaking the law, subjecting them to fines, penalties, and possible jail time.
Most securities regulators are lobbying Congress to avoid writing specific regulations for digital assets. For example, the North American Securities Administrators Association (NASAA) (the organization responsible for this exam) wrote this letter to Congress in January 2022, which included this quote:
[NASAA has] used the elasticity of the securities regulatory framework to support and otherwise address all kinds of new approaches to capital formation and investment … We continue to work hard to ensure that the latest innovations in our capital markets occur within the well-established regulatory framework that supports investor protection and capital formation.
In other words, the regulators want to apply similar regulations imposed on securities to digital assets considered securities.
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