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Digital assets: bits and bytes in the financial arena

Digital assets are assets that are traded, used and stored digitally. Learn more about the different types of digital assets.

22 Sep 2022 8 min read

The main points in a nutshell

The term digital assets basically includes any and all assets (e.g., documents, images) that can be stored, traded and used digitally.
It is often used to describe assets based on distributed ledger technology (DLT) or more specifically blockchain technology.
There are different types of digital assets, spanning from tokenized assets – linked to securities, commodities, real estate or essentially any other asset – to central bank digital currencies (CBDCs) and crypto assets
Digital assets are reflected as tokens on the blockchain and can represent all sorts of assets, utilities or rights.

How digital assets work

Digital assets are a form of digital investment, often built on blockchain technology. Digital assets can represent different rights (e.g., property or usage rights) and can therefore have different characteristics. The Swiss Financial Market Supervisory Authority (FINMA) distinguishes between utility tokens, payment tokens and asset tokens.

The key terms explained:

Distributed Ledger Technology: A decentralized database that uses different computers as nodes to make copies of itself. Decentralization ensures that the database is resilient and trustworthy without having to rely on a single counterparty.
Blockchain: A form of Distributed Ledger Technology that stores data in an irreversible sequence of coupled blocks. This means that historical data (e.g., transactions) cannot be modified, therefore becoming immutable.
Cryptography: Cryptography ensures that the data is encrypted and can only be accessed by authorized entities. Most blockchains use established cryptographic standards used in traditional applications today (e.g., online banking).
Consensus algorithm: Algorithms are fixed IT processes used to solve one or more problems. Consensus algorithms ensure that distributed networks agree on a common set of data values (e.g., transactions).
Fungible assets: Assets that are interchangeable, such as most equities, a currency or gold.
Non-fungible assets: Assets that are not interchangeable because they are unique. On the blockchain, these assets are called non-fungible tokens (NFT) and are often provided with unique characteristics (e.g., a photo, a certificate or a diploma).

How do digital assets work?

Digital assets are based on blockchains, a specific application of distributed ledgers enabling the storage and transfer of value.

Illustration of the relationship between Distributed Ledger Technology, blockchain, digital assets, crypto currencies and tokens.

Distributed Ledger Technology (DLT)

A ledger is a database used to document various transactions. Unlike centralized databases, distributed ledgers leverage a decentralized computer network with copies of the database, which maintain the distributed ledger. In the case of a new data entry, the change is diffused across the ledgers on the distributed network, so that all databases have the same set of data.

The distributed network reaches an agreement on the status of the ledger through what is known as a consensus algorithm. Since distributed ledgers have no central authority to check and audit them, the entire database network must agree on the status of the ledger via an algorithm. All instances of the decentralized network, i.e., all copies of the database, agree on what transaction data is stored in the databases. Two methods of consensus have prevailed: proof of work and proof of stake. In short, proof of work ensures consensus through the consumption of energy and proof of stake by depositing assets as a security.

Blockchain

Blockchains are a specific type of DLT which enter information in a sequence. This sequence consists of a combination of transaction and reference data – known as blocks – which are cryptographically linked to each other.

This link is achieved by means of a hash function which generates a standardized and encrypted output of all data in the block, including the previous hash function. So if a new block is to be recorded on the chain, it must contain the hash function of the previous block. If something is changed on a block, the output of the corresponding hash function also changes and the reference to the next block is no longer correct. The hash function thus leads to the immutability of data within validated blocks as any historical change will break the chain.

Access to tokens on the blockchain are managed by public and private key pairs. The public key can be thought of as a type of account number. As the name suggests, it is public and can be shared to receive tokens. The private key, on the other hand, regulates authentication and access to the tokens, and must never be shared publicly. Only with this key can the owner trigger a transaction with the token, which is registered on the blockchain.

How does a blockchain work?

What kinds of digital assets are there?

A distinction is made between native and non-native digital assets, both of which can be either fungible or non-fungible. Non-native digital assets are assets that already exist outside of the blockchain, such as money, securities, real estate or tangible assets. Native digital assets are exclusive to the blockchain itself.

The graphic illustrates the categories of digital assets:

Illustration that provides an overview of all digital assets, from non-native digital to native digital that can be subdivided into non-fungible and fungible assets.

Digital assets can be categorized according to their purpose:

Payment tokens: Bitcoin is perhaps the most well-known example. Digital assets aiming to fulfil the traditional role of fiat money are called crypto currencies. The price and value is primarily a function of supply and demand.
Asset tokens: Assets and their value are linked to physical assets, e.g., securities.
Utility tokens: A token that is often native to a blockchain, decentral application or a company (e.g., loyalty points). It provides access to services of a blockchain protocol or decentralized applications.

However, it is possible that one token combines several of the above characteristics, making them difficult to categorize.

Further subgroups can be defined. The following two types of digital asset illustrate innovative solutions that impinge upon the real world:

Payment token – stablecoins: Stablecoins aim to maintain a stable value by being pegged to another asset, e.g., US dollar or gold. To achieve this, these coins are often backed by the respective collateral but also through other mechanisms (e.g., managing supply and demand). Contrary to what the name suggests, the coin can loose its “peg” to the value of the underlying asset.
Asset token – security tokens: Tokenization makes it possible to link rights to real-world assets like securities, bonds and even art with tokens entered on a blockchain. In some jurisdictions (e.g., Switzerland) the law recognizes the blockchain as the main registry of a security, meaning the token incorporates all rights of the security. This is commonly referred to as a tokenized security. However, most jurisdictions do not recognize the token as security and still require a central registry. Therefore the token is merely a unit of account to track ownership.

The opportunities presented by digital assets

Digital assets also have certain characteristics that differentiate them from conventional assets.

Transaction costs: Digital assets have lower transaction costs than assets like traditional stocks or other securities because no intermediaries are needed to facilitate the transfer.
Fast transactions: Unlike with a traditional stock exchange, digital assets can be traded at any time of the day or night, seven days a week. Transactions are executed instantly on the blockchain protocol, regardless of when a transaction takes place.
Independence: Digital assets on public networks can be stored, traded and transferred independently of intermediaries with very low barriers. This provides for greater freedom on how to manage your assets as well as new risks, for example losing access to your assets. Moreover, many intermediaries trading and holding digital assets are not regulated, increasing counterparty risk.
Programmability: Digital assets can be endowed with inherent logic, i.e., complex conditions can be programmed into the asset directly and executed automatically. One example would be an automated dividend payout of a tokenized security.

What are the risks of digital assets?

The risks presented by digital assets are based on trends in society:

Volatility: Digital assets, especially crypto currencies, tend to have a higher volatility compared to traditional asset classes, meaning their price can fluctuate wildly.
Cybercrime: The pseudonymity of decentralized networks can make cybercrime easier. There have been a number of prominent ransomware attacks in which hackers have demanded Bitcoin as a ransom, such as the Colonial Pipeline attack in summer 2021.
As many digital assets can be traded and transferred independently of regulated intermediaries, they are also used for money laundering. However, authorities are getting better at tracking such transactions which is also enabled by the transparence of blockchains.
Environment: Bitcoin is responsible for the production of 69 million tons of carbon dioxide¹ every year. Blockchains using a proof-of-work consensus algorithm, such as Bitcoin, depend on an enormous amount of energy due to the colossal computing power required by the consensus algorithm. Newer consensus algorithms are more efficient (e.g., Ethereum reduced its energy consumption by 99% by switching to proof of stake).

Digital assets are becoming more relevant and open up new opportunities across all industries, as well as significant risks. Because many market participants are struggling to follow this technological development and the rapidly advancing technology behind it, dealing with these digital assets and understanding how they work is crucial to be able to make informed decisions.

¹ Krypto gegen Klima: Der Bitcoin ist eine Umweltsau

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