Blockchain Chronicle. Digital assets should continue their march forward like the web after the dot.com crash.
Blockchain technology is undoubtedly a potential revolution. Wherever a transparent, immutable, digital record of information might come in handy, blockchain has the potential to disrupt the status quo. Just as the Internet has changed the world over the past 25 years, the combination of open source software, public key cryptography, and distributed ledger (“blockchain”) technology is expected to become an increasingly important part of many aspects of our lives over the next two decades. . A key area of impact is investment, as digital assets are an entirely new asset class.
The adoption curve of digital resources
In just over a decade, digital assets have grown from the ground up to a dynamic, diverse, high-growth ecosystem. The number of cryptocurrency users has reached 300 million as of the end of 2021. The total market capitalization of the industry is close to $1 trillion after reaching $3 trillion as of the end of 2021. Like the railroad in the mid-19thand century or cars at the beginning of the XXand century, digital assets are on track to achieve full adoption in the 21stand century. This situation generates potential opportunities for investors. However, the adoption of new technologies is never linear. The early stages of technological evolution are prone to glitches, setbacks and setbacks, and culminate in periods of bubbles followed by crashes. 2022 is the perfect example of this with the notable implosion of the Earth/Moon earlier this year and FTX more recently. However, it is important to note that these recent events have been a failure of business models and risk management versus cyber security or technology issues. Digital assets could continue their march forward like the Internet after the dot.com stock market crash.
Investors can now invest in the sector using multiple strategies depending on their investment horizon and preferences.
Map of WisdomTree’s digital investing universe
The evolution of the technology behind digital assets has given rise to a diversified ecosystem that offers many investment opportunities. Identifying and ranking these value propositions is key to realizing the investment potential of the industry. WisdomTree’s Digital Asset Taxonomy divides the digital investment universe into eight categories based on use cases, i.e. what users can do with these digital assets. Investors can now invest in the sector using multiple strategies depending on their investment horizon and preferences:
- Diversified exposure to the entire ecosystem via baskets or indices
- Exposure to “sectors” or, in our terminology, taxonomic categories
- Exposure to individual values based on the use case and economic function (“tokenomics”) of a given digital asset.
Digital Asset Taxonomy WisdomTree
Source: tree of wisdom. 2022
Tier 1 Payments
Tier 1 is the initial category of the digital asset. It allows users to transact digitally rather than through traditional means of payment, such as credit cards, PayPal, etc., which result in intermediaries charging fees and taking days to settle. Level 1 allows for direct, irreversible and instant money transfers. Bitcoin is the leading digital asset.
Centralized Financial Tokens are issued by unlisted companies and are used or issued using the “tech stacks” of digital assets. They are direct competitors of traditional financial service providers. Think of them as traditional finance, but with a modernized back office infrastructure. Binance or the defunct FTT token would fall into this category.
Layer 1 smart contract networks
Smart contracts are based on pioneering Bitcoin technology and allow users to build sophisticated decentralized applications (dApps). Several competing and complementary smart contract platforms operate at scale. Each of them has its own ecosystem of decentralized applications, such as Ethereum, Solana and Avalanche.
Stable cryptocurrencies or “stablecoins”
Stablecoins are the link between the world of digital assets and the physical world. These are tokens designed to copy certain fiat currencies.
Level 2 scalability
Over time, as the use of a protocol increases, capacity constraints can arise. This situation calls for layer 2 scaling solutions which are protocols that increase the capacity of the underlying layer 1 networks without changing anything at the technical level of layer 1, such as for example Polygon.
Decentralized finance or Defi copies traditional financial services and encompasses later versions of the centralized finance category. Defi offers services such as trading, lending or loan, options, derivatives, etc.
NFT (“non-fungible token”)
Non-Fungible Tokens (NFTs) are digital collectibles. Each NFT is an entry in a registry corresponding to a unique digital or physical object belonging to various categories such as art, game, metaverse, sports, etc.
This category includes oracles and data storage.
Do you securely access digital assets?
Investors can invest in digital assets through many access points such as personal wallets, accounts with a centralized exchange, Exchange Traded Products (ETPs) backed by physical assets, exposure secured by derivative products such as futures contracts or Exchange Traded Funds (ETFs) based on futures contracts. However, we have seen the risk inherent in some of them and the choice offered to institutional investors is indeed very limited:
- Personal wallets can be quite risky due to the cyber security risk
- Accounts with centralized exchanges are exposed to many risks, from hacking to the collapse of the exchange itself (as in the case of FTX).
- Derivative-based exposure via futures-type contracts can be useful where leverage is needed, but negative roll yield will penalize medium to long-term investments.
Digital resources can revolutionize our economy in the same way that the Internet and social networks have done.
Overall, for an institutional investor who only takes long positions, choosing a physical asset-backed ETP appears to be the most robust and easiest to set up. These ETPs can offer a high degree of security thanks to cold storage, precise monitoring thanks to their physical medium (no loss of yield on renewal), smooth integration with existing systems, efficient trading and low costs. While ETPs backed by physical assets and backed by digital assets are recent, the offering is already reaching a scale that requires a clear selection process and due diligence, particularly on the financial strength of the issuer.
The place of digital assets in an asset allocation
Digital resources can revolutionize our economy in the same way that the Internet and social networks have done. Their expected growth is key, but digital assets also stand out in three other ways:
- Digital assets have a statistically positive slope unlike stocks (which have a negative slope)
- Digital assets show asymmetric reward. Their downside risk is limited to the amount invested, but their upside potential is many times that amount.
- Digital assets show low statistical correlation with traditional asset classes.
Despite the growth potential of digital assets, many investors are still torn between the pros and cons. They currently represent approximately 1% of the total market capitalization of liquid assets globally (the “market portfolio”). To minimize discrepancies with the market portfolio, a passive investor or misinformed investor can invest around 1% in digital assets. Indeed, a decision not to invest is equivalent to an active decision to underweight digital assets, which is equivalent to thinking that this sector will disappear over time. For more sophisticated investors with industry knowledge, increasing the allocation to these assets by a few percentage points can prove beneficial.