7. Digital Assets

-Decentralized network of multiple nodes

-Nodes can update ledger and share changes across network

-No node has power over other nodes

-Consensus mechanism: network agress to changes

• Individual computers in ledger / blockchain

• Store full / partical copy of ledger

• Validate / transmit data

• Follow consensus rules

• Most common form of DLT

• Blocks added in chronological (time) order using cryptography

• Each block verifies previous —> immutability (cannot be altered)

• Open to anyone to set up nodes (validating transactions)

• Decentralized governance; no central authority

• Examples: BTC, ETH

• Require permission to access and participate

• More centralized governance —> used by enterprises

-Blockchain

-Remote Procedure Call (RPC) Node

-Digital Wallets

-End Use

• Server interface allowing external systems (wallets) to communicate with blockchain

• Access point for querying data / broadcasting transactions

• Enables to interact with blockchain without running own node

• Software / hardware tool that manages public & private keys

• Private key is stored locally —> never leaves wallet

• Signs transactions authorizing asset transfers

• Secret value authorizing transactions

• Kept secure; access to assets

• Bank-style: PIN

• Identifies your account; safe to share with anyone

• Used to verify signatures and receive assets

• Bank: account number

• Hot wallet: connected to internet

• Cold wallet: offlien for security

• Hardware wallet: physical device (USB)

• Software wallet: app/program

• Transactions signed via Elliptic Curve Digital Signature Algorithm (ECDSA)

• Private key → Public key → Address (public key is derived from the private key)

• One-way cryptographic function: only private key can generate public key

• Consensus required to address double-spending problem

• 2 mechanisms

  • Proof of Work (PoW)

  • Proof of Stake (PoS)

• Miners must expend significant computational resources to add block (BTC)

• Block with most accumulated work is accepted by network

• High costs make fraud unattractive and prevents double spending

• Validators must lock up stake (digital assets) to earn right to propose and validate blocks (ETH)

• If validator submits invalid transactions —> stakes get slashed

• Secure Hash Algorithm (SHA 256)

  • converts text/number —> 64-digit hexadecimal number

  • 16 different characters (a-f, 0-9)

• PoW by finding correct unlikely hash output with computing power

  
  

• No central authority —> changes if majority of network participants agree

• If change —> Fork occurs

  • Hard fork

  • Soft fork

• Two separate blockchains

• New blockchain incompatible with old blockchain

• One new blockchain that is backward compatible (old rules still apply)

• Decentralization & security require independent validators verifying —> slows scalability

• Increasing scalability reduces decentralization & security (fewer validators or off-chain mechanisms)

• Decentralization

• Scalability

• Security

• Self-executing code deployed on a decentralized blockchain network (ETH)

• Core building blocks of decentralized applications (dApps)

• Deploying / modifying contracts requires paying transaction fees

• Layer 1

  • Main blockchain where transactions occur using native coin

  • Limited speed and interoperability

• Layer 2 (Optional; e.g., BTC)

  • Built on top of Layer 1

  • Move transactions off-chain to improve speed & scalability

• Form of smart contract representing ownership of digital assets

• Fungible Tokens: all tokens are interchangeable and identical; each unit has the same value and properties —> stablecoins

• Nonfungible Tokens (NFT): tokens are unique —> unique digital artwork

• Financial services built on blockchains using smart contracts

• Operate without traditional intermediaries —> decentralized autonomous organizations (DAOs)

• Decentralized Exchanges (DEXs)

• Borrowing / lending platforms

• Stablecoins

• Services providing external, real-world data to blockchains and smart contracts

• Enable smart contracts to execute based on off-chain information (e.g., prices, interest rates, or events)

• Public cryptocurrency blockchain

• Peer-to-peer digital currency by Satoshi Nakamoto in 2008

• Enables secure value transfer without central authority or intermediary

1 BTC = 100 mm Satoshis

• UTXO: unspent transaction output model

  • transaction output that has not yet been spent

  • Represents amount of BTC available for future transactions

• Transaction creation (send/sign with private key)

• Broadcast and validation (broadcast to network / validate by nodes)

• Mempool (transactions waiting verification)

• Block formation (miners select transactions from mempool)

• Proof of Work (miners verify; solution every 10min)

• Consensus and reward (network validates / Block added)

• Mining power = hash rate

• Hashing problem

  • Higher hash rate —> hashing problem more complex to keep new block creation at one block every 10 minutes

• Risk to consensus mechanismn: 51% attack

• Occurs when single party controls more than 50% of network’s mining power

• Could manipulate transaction confirming fraudulent transactions for new blocks

• Hashing process is probabilistic and random

• Randomness prevents any single node from consistently influencing block creation (exception: xx% mining power)

• Preprogrammed / controlled by blockchain code

• Total supply: 21 mm; gradually released

• Mining process: currently 3.125 BTC rewarded / halving every 210.000 blocks

• BTC block has 1 MB size limit —> user pay fee to have transaction in next block

• Bank account: no

• Hours: 24/7

• Reversibility: no

• Cost: low

• Speed: high

• Coverage: global

• AML compliance

• Transactions are pseudonymous -> not linked to real-world identities

• Public blockchain with smart contract functionality

• Uses Solidarity on Ethereum Virtual Machine (EVM)

• Launched in 2015

• 2016: major DAO was hacked —> $60mm of ETH stolen

• Hard fork reversed hack

• Native Currency

• Nonnative Tokens

• Native Currency: ETH

  • ETH used to pay gas for transactions and smart contracts

  • Gas: Priced in gwei (1 ETH = 1 billion gwei); ETH paid is burned

• Fungible tokens (ERC-20)

  • Interchangeable tokens (stablecoins)

• Nonfungible tokens (ERC-721)

  • Unique tokens representing distinct assets (artwork)

• Pre-Sep 15, 2022: PoW

• Pst-Sep 15, 2022: PoS

  
  

• Validators stake ETH to propose blocks; random selection weighted by stake, —> misbehavior punished via slashing

• 99%+ lower energy use and faster transactions, better incentive alignment —> greater centralization risk

• Stablecoins

• Central Bank Digital Currencies

• Stablecoins are cryptocurrencies designed to maintain price stability —> pegging their value to reference asset

• Stability though algorithms —> fiat, crypto, commodity backing (TerraUSD collapse)

• CBDCs are digital versions of fiat money issued and backed by central bank

• Aim to lower payment costs while preserving government control over money —> enabling more targeted monetary or fiscal policy

• Utility (smart contracts)

• Security (collateral)

• DeFi (tokens within DeFi ecosystem)

• Governance (holders vote)

• Financial services delivered through blockchain-based dApps (e.g., trading, lending, insurance)

  • ETH built on Layer 2 networks

• dApps operated by DAOs —> rely on oracles for off-chain data

• Incentivize participation though yield farming

• Deposit digital assets into liquidity pools, lending protocols, or staking systems

• In return, earn rewards (interest, fees, or tokens) for helping network run —> providing liquidity or validating transactions

• Web 1.0 -> read-only internet

• Web 2.0 -> read/write SoMe-driven internet

• Web 3.0 -> decentralized blockchain-based internet

• Decentralized blockchain-based internet

• Reduces reliance on large tech intermediaries -> shifting data ownership to users

• Enables new applications -> gaming, SoMe, metaverse, finance

• Diversification

• Return potential

• Research suggests not effective inflation or crisis hedge

• Diversification across strategies

• Complementary to VC

• Hedge against technological disruption

• Returns n/a in other ACs

• Alpha opportunities due to market inefficiencies

• Currently available investments

• Future innovations

• Direct holdings (self custody or qualified custodian)

• ETFs

• Funds (HF or PE Fund)

• Tokenizing private assets -> provide liquidity

• Smart contracts -> new code behaviors

• Decentralized DD processes

• Zero-knowledge proof -> truth without verification

• End of bond bull market

• Narrow equity gains

• Increasing correlation to trad. assets

• Shrinking public markets

• Elevated macro risks

• Expand risk/return opportunity set

• Improve Sharpe Ratio (Iman Conover: asset have own return pattern but have correlation)

• Positive skewness

• Not for risk-averse investors

• Returns (new AC; little data)

• Volatility (4 drawdowns > 70%)

• Liquidity

• Counterparty risk

• Systemic risk

• Programming / coding errors (wormhole: $300mm ETH from Layer 2)

• Cybersecurity

• Obsolescence

• Fraud

• Custody / Wallets

• Regulation

• Fraudulent apps/websites/digital asset service providers

• Pumping and dumping (inflate price; dump shares)

• Cryptocurrency scams and fraud estimated to be over $10 billion per year

• Hot wallets: can be hacked

• Cold wallets: can be lost/damaged

  • Estimated bitcoin loss due to loss of private keys: 4 million

• Regulation of decentralized system