Digital Assets 101

Sid Ulker and Simon Williams provide a need-to-know overview (3 minute read)

"Writing a description for this thing for general audiences is bloody hard. There's nothing to relate it to."
Satoshi Nakamoto (the pseudonymous founder of Bitcoin)

What are Digital Assets?

A digital asset is any asset that is represented digitally or electronically. In financial services, digital assets include stocks and shares, investment funds, bonds, sovereign debt, central bank digital currencies (CBDCs), stablecoins and cryptocurrency.

What is DLT?

In simple terms, a ledger is a digital store of structured data. This is enabled by technology. The ledger is replicated (hence distributed) across a network of computers (each called a node). This ledger technology may be used to store information or be used to create or represent digital assets, including financial instruments such as bonds and shares.

What is Blockchain?

Blockchain is a type of DLT. A blockchain ledger consists of blocks of information. Any change to the ledger is made by adding a new information block to the existing blocks (which together form a chain, hence blockchain).

For example, each block in a digital bond's blockchain ledger may represent a bond holders ownership. If the bond is transferred, a new block representing the new owner's entitlement is added. The chain of blocks – the blockchain - therefore shows the bond's current owner and also ownership history.

A key feature of a blockchain is its consensus mechanism. Consensus, as the name suggests, is the process for determining the status of the blockchain and any changes. For example, who owns a particular bond, and the bond's new owner after a transfer. With a permissionless public blockchain (such as Bitcoin), the blockchain does not have a central governing authority. Consensus happens when a majority of the blockchain's nodes agree the blockchain's status – i.e. whether the new record should be added to the blockchain ledger. In contrast, a permissioned private blockchain might have a central governing blockchain authority which solely determines the blockchain's content and any changes.

Use case examples

• Securities, Funds and Bonds: digitally represented-securities, funds and bonds, with DLT as the record of ownership and means of transfer.
• Money and Payments: payment systems utilising digital rails and digital forms of money (for example central bank digital currencies (CBDCs), stablecoins, tokenised deposits and/ or cryptocurrencies).
• Tokenisation: the process of representing an interest in asset ownership (including, for example, fractional interests) on a blockchain. For example, blockchain tokens representing fractional ownership of physical gold bars.
• Clearing and Settlement: fast, efficient, 24/7 and automated clearing and settlement, with reduced intermediation.
• Record keeping: multifarious real-time records (eg asset ownership, coupon/ dividend data and tax information), instantly available, and without the need for reconciliation.
• Identity verification: expedited and part-automated identity checks, for example for AML, KYC and CTF.
• Loyalty and reward programs: redeemable blockchain issued tokens as rewards and incentives.

Benefits

• Speed: near instantaneous settlement (known as 'atomic settlement').
• Transparency: the potential for participants and others to view transactions and records (for example on a public blockchain, albeit that the record is likely to be pseudonymous).
• Automated: programmable and self-executing transactions (known as 'smart contracts').
• Disintermediation: less intermediation is required, saving time and costs.
• Decentralised: a public permissionless blockchain has no central governing authority. In some scenarios this could offer a more secure environment and with greater trust between participants. It is also possible to implement a blockchain with a central governing authority (for example using a public blockchain permissioned layer or a private permissioned blockchain).
• Immutable: as a permanent record, DLT offers financial crime protections.
• Real-time records, removing the need for further reconciliation.
• Reduced costs, through increased speed, automation and less intermediation.
• Product access: more asset classes, fractionalised assets with smaller denominations, and reduced investment minimums.
• Increased liquidity, which entails further overall capital market benefits.
• Regulation: the digital assets ecosystem is increasingly subject to regulation. Regulation acts as a virtuous circle; enabling wider mainstream adoption. At the same time, the current status of regulation is potentially limiting adoption and scaling. Legislators and regulators are implementing changes, however in many cases this is work-in-progress and there is fragmentation across international jurisdictions.

Downsides

• Energy use The particular blockchain used will dictate the consensus protocol. Some consensus protocols are resource intensive. For example, 'proof of work' requires substantial computational power. In contrast, for example, 'proof of stake' consensus is far less resource intensive. Proof of work consensus is less frequently used for new blockchains.
• Immutability could be a disadvantage of a public permissionless blockchain. For example, with financial crime, eg a hacked wallet, the misappropriated digital assets may not be recoverable. In contrast, the blockchain could be implemented with a central governing authority which determines ownership (for example using a public blockchain permissioned layer or a private permissioned blockchain).
• Cyber and technology risks are ever-present in our globally connected world. As for all forms of technology, it is imperative to identify and mitigate these risks.
• Scalability currently many laws and regulations are still catching up with digital transformation since they were not designed with DLT in mind. Accordingly, existing features of legal and regulatory frameworks may restrict scalability of digital transformation. Legislators and regulators are looking to update these frameworks but these are still being developed and there is a great deal of fragmentation across jurisdictions.

So, not just Bitcoin?

Bitcoin was the first cryptocurrency, and is the most famous. However, DLT is a technology with many financial (and non-financial) use cases. Cryptocurrency is only one of many DLT financial sector use cases, and in turn Bitcoin is only one of many cryptocurrencies.

What's next?

Distributed ledger technology is the future. It holds the capacity to transform the world to a greater extent than the internet. In the not too distant future, not using DLT will be as unimaginable as not today using the internet.

The Digital Assets train is fast leaving the station; financial institutions not on it will be left behind.

This article is a high level overview. For more information visit http://www.ashurst.com/digitalassets.