Navigating the frontier: Understanding digital asset

The current landscape

In January 2024, the U.S. Securities and Exchange Commission (SEC) approved the first Bitcoin Exchange-Traded Funds (ETFs), a significant step towards integrating digital assets into mainstream financial systems. On the first day of trading, the spot Bitcoin ETFs achieved a remarkable daily trading volume of $4.6 billion. Within three days, investors invested almost $2 billion into Bitcoin ETFs. Furthermore, the BlackRock iShares Bitcoin Trust (IBIT) was among the top five ETFs in 2024 based on inflows, raising $3.2 billion just 17 days after launch. These figures demonstrate the demand for Bitcoin as an investment asset and reflect investors’ confidence in the growth potential and legitimacy of cryptocurrencies and digital assets in the broader financial ecosystem.

The digital asset market has grown exponentially in the last decade, going from a niche to a significant segment. The market capitalization of digital assets was around $14 billion in 2016, and it surged to approximately $3 trillion by 2021. However, it shrunk to around $1 trillion by the end of 2023. Despite this rapid expansion, digital assets still represent a small fraction of the overall investment market, including equities, bonds, and other traditional assets totaling hundreds of trillion dollars globally. The digital assets space is in its early stages of adoption compared to the total market cap of the U.S. stock market of around $50 trillion (Source: S & P). This disparity underscores that while digital assets are growing at an unprecedented pace, they are still in their infancy.

Nevertheless, the interest of investors and the emergence of digital assets are expected to continue rising. For example, Cathie Wood, CEO of ARK Invest, expects the digital asset market to grow to $25 Trillion by 2030 (Source: The Street). Though the predictions vary a lot from the different players, it seems common sense that the digital asset space will continue its growth rapidly. Coming with that is bringing with it both opportunities and challenges.

Understanding digital assets

The unique characteristics of digital assets

The history of digital assets dates back to 2009 when Bitcoin was created. Bitcoin was the first decentralized digital currency that enabled peer-to-peer transactions across a secure and immutable ledger called the blockchain. This innovative technology eliminated the need for traditional financial intermediaries, paving the way for the cryptocurrency movement. Following Bitcoin’s success, the digital asset space experienced significant growth. In 2015, Ethereum was launched, which extended blockchain capabilities beyond simple monetary transactions. With its introduction of smart contracts, Ethereum provided a programmable blockchain platform for developers to create decentralized applications (DApps) and issue their digital assets.

Digital assets built on this blockchain technology have unique characteristics that set them apart from traditional financial assets:

• Decentralization: Unlike traditional assets controlled by central authorities, digital assets operate on decentralized networks. This decentralization reduces the risk of censorship and interference from central entities.

• Immutability: Blockchain technology ensures that once a transaction is recorded on the ledger, it cannot be altered or deleted. This characteristic guarantees the integrity and permanence of transaction histories.

• Transparency: While providing privacy for users’ identities, blockchain technology offers transparency in transactions. Anyone can view the transactions on the blockchain, promoting a transparent financial environment.

• Programmability: The advent of smart contracts on platforms like Ethereum introduced programmability into digital assets. This allows for creating complex financial instruments and automated systems directly on the blockchain.

• Global Accessibility: Digital assets can be accessed and transacted by anyone with an internet connection, offering global reach and inclusivity beyond the constraints of traditional financial systems.

Different types of digital assets

Since the inception of Bitcoin and Ethereum, digital assets have come a long way. Nowadays, there are several types of digital assets, each with its purpose. By exploring the table below, we can better understand their functionality, how they generate value, and what sets them apart.

Traditional assets vs. digital assets

As we are now aware of the unique characteristics and different types of digital assets, let’s compare them to traditional investment options. In the table below, we analyze various aspects of the investment classes.

It’s essential to note that a token can have features of various types, so the categorization is not rigid. For instance, Ether (ETH), Ethereum’s native token, was initially created as a utility token for facilitating transactions and smart contracts executing on the Ethereum network. However, it has evolved to serve many purposes. As a cryptocurrency, it is used to buy and sell Non-Fungible Tokens (NFTs). Moreover, with Ethereum’s transition to a proof-of-stake consensus mechanism, ETH has become a productive asset, allowing its holders to stake their ETH and earn yield. This demonstrates the complex nature of digital assets and shows that they can go beyond simple categorizations. It emphasizes the importance of understanding digital assets in detail and recognizing that their roles and value propositions can expand and evolve in response to technological advancements and market demands.

Rating digital assets

Challenges in rating digital assets

Now that we understand the differences that digital assets bring let’s explore the challenges faced by investors and analysts when rating and investing in digital assets compared to traditional financial instruments:

• Token Models: Digital assets utilize innovative tokenomics models that define the supply, distribution, utility, and governance mechanisms of tokens. These models are foundational in creating intrinsic value and driving economic activities.

• Market Dynamics: Digital assets are highly volatile, making it challenging to predict their future performance using traditional financial models.

• Regulatory Uncertainty: The regulatory environment for digital assets is evolving, with significant differences across jurisdictions. New regulatory laws can affect use cases and affect asset prices.

• Technological Complexity: Specialized knowledge is necessary to understand and evaluate digital assets, including assessing security vulnerabilities and new developments that can drastically affect asset prices.

• Community Engagement: Community sentiment influences the value of digital assets, which can be challenging to quantify. Social media trends, leader opinions, and community support can drive substantial fluctuations in asset prices.

• Liquidity Concerns: It can be challenging to value and assess risk for digital assets with liquidity issues, as buying or selling them can significantly affect market prices.

Given the challenges digital assets pose, developing new evaluation and rating methods is necessary. Here are three new methods to get a deeper understanding of digital assets.

Tokenomics analysis

The first method, tokenomics analysis, is a deep dive into the economic models that support digital assets. It looks at how supply and demand work, how tokens are spread out, and what benefits are built into a token’s system. However, it’s important to note that tokenomics analysis should be tailored to the specific asset, as the dynamics can vary significantly from one asset to another.

Key components of tokenomics analysis include:

• Supply Mechanics: This involves understanding the total number of tokens available, whether this amount will increase or decrease over time, and how tokens are created. This aspect is crucial for determining a token’s rarity and potential value over time.

• Demand Drivers: Identifying the factors that increase people’s desire for the token is key. This could be because the token is useful, people are buying it hoping its value will increase, or it can be used for transactions. What people want from a token can change a lot between different tokens, making this a vital area for determining if a token will likely succeed in the long run.

• Distribution and Allocation: Looking at who gets the tokens, including the project’s creators, the team working on it, investors, and regular users, helps understand if the token might end up being controlled by just a few people and how well the interests of everyone involved line up.

• Governance and Decision-making: Knowing how decisions are made in a token’s ecosystem and how people who own the token can have a say is important. This can influence how easily a token can adapt to new challenges and how much people trust where it’s going.

• Economic Incentives: Exploring what benefits encourage people to hold, use, or participate in the token’s ecosystem. This could be rewards for staking tokens, transaction fees, or other benefits.

In summary, tokenomics analysis examines the economic and reward structures driving an asset’s value. Moreover, this analysis should be adapted to each asset’s unique characteristics, acknowledging that the factors influencing one may not apply to another.

On-chain analysis

The second method we will explore is called on-chain analysis. This approach shifts the focus from the theoretical frameworks of tokenomics to the real-world evidence of blockchain activities. On-chain analysis concentrates on transactions, wallet activities, and interactions within and across blockchain networks and decentralized applications (DApps). Doing so provides a detailed view of the blockchain ecosystem, revealing insights into its participants’ operational dynamics and behaviors.

On-chain analysis involves a diverse set of metrics that must be carefully selected and interpreted based on the type of asset or application being analyzed. The metrics can vary widely in their applicability and significance across different token types.

Key metrics in on-chain analysis include:

• Transaction Volume and Value: Important for cryptocurrencies and utility tokens, indicating the activity level and economic significance.

• Active Addresses: A critical metric for all digital assets, showing user adoption and network health. For DApps, it can specifically highlight active user engagement.

• Token Movement: Particularly relevant for NFTs and specific governance or utility tokens, shedding light on investor sentiment and long-term holding patterns.

• Smart Contract Interactions: Essential for evaluating DApps and utility tokens, this metric reveals decentralized applications’ usage frequency and functionality on platforms like Ethereum.

Metrics crucial for understanding a cryptocurrency such as Bitcoin may differ significantly from those required to evaluate the value and engagement of a DApp or an NFT collection. On-chain analysis adapts its tools and methodologies to capture different digital assets’ unique aspects and activities. This enables investors and analysts to make informed decisions.

Security analysis

The third method we are going to discuss is security analysis. This approach aims to evaluate blockchain projects’ security practices, protocols, and audit outcomes. Smart contracts underpin the functionality and value of several digital assets, including stablecoins, utility tokens, NFTs, and governance tokens. Therefore, the reliability and robustness of the smart contracts are vital. Security vulnerabilities pose a risk of financial loss and can significantly affect asset prices.

Security impacts the rating of digital assets in several key ways:

• Trust and Confidence: Audits that confirm a strong security posture enhance investor confidence and lower the risk of security breaches for digital assets.

• Regulatory Compliance: With the regulatory landscape for digital assets becoming increasingly complex, adherence to security best practices and audit standards can play a crucial role in ensuring compliance.

• Reputation and Longevity: The long-term success of digital asset projects is closely tied to their security practices. Projects that consistently uphold high-security standards, promptly address vulnerabilities, and engage in ongoing security enhancements are more likely to survive.

Security analysis requires understanding blockchain and smart contract security and the broader implications of security practices on investor perception, market standing, and regulatory compliance. Security issues can significantly impact asset prices and projects’ regulatory compliance and longevity.

Conclusion

In January 2024, Bitcoin ETFs were approved by the U.S. Securities and Exchange Commission (SEC), leading to a surge in trading volumes. This surge highlights the increasing demand and acceptance of digital assets among investors. The digital asset market has grown significantly over the past decade; however, it is still in its infancy and is expected to expand rapidly in the next decade.

Digital assets have unique characteristics such as decentralization, immutability, transparency, programmability, and global accessibility. These features and the diversity of digital asset types, including cryptocurrencies, utility tokens, security tokens, governance tokens, stablecoins, and non-fungible tokens (NFTs), present new opportunities and challenges for investors.

Digital assets are different from traditional assets in several ways. One of the main challenges investors and analysts face is that digital assets have complex token models, market dynamics, regulatory uncertainty, and technological complexity. All these factors make it difficult to evaluate them. Therefore, new evaluation methods such as tokenomics analysis, on-chain analysis, and security analysis are essential in understanding digital assets’ intrinsic value, real-world blockchain activities, and security posture.

In summary, the digital asset sector is rapidly evolving, offering unprecedented opportunities for innovation and investment. However, navigating this frontier requires a deep understanding of the unique characteristics of digital assets, the challenges they pose, and the analytical approaches necessary for informed investment decisions.

In navigating the evolving world of digital assets, each needs to engage in thorough research and due diligence. The landscape of blockchain and cryptocurrencies is innovative and complex, featuring constant advancements and regulatory updates. Therefore, gaining knowledge from various sources is essential. By considering diverse perspectives and up-to-date information, individuals can develop a well-rounded understanding of digital assets’ potential risks and rewards.

*** Disclaimer: This article is for informational purposes only and should not be considered financial advice. Before making any investment decisions, we recommend consulting with a professional financial advisor. The author of this article is not liable for any monetary losses or damages arising from its use. ***