Digital Assets – an economic resource, with positive value, represented in binary form.
The digitization of assets (also known as tokenization) can be achieved by representing physical assets by unique identification characters allowing the ownership rights to be transmitted and traded on a digital medium. Whereas securitization is the process of converting an illiquid asset or group of assets into a financial security, tokenization is the next step which allows for digital trading of that security. Digital assets are also nothing new… the Depository Trust & Clearing Corporation (DTCC) was created in 1973 to alleviate the amount of paperwork needed to process securities transactions by holding all paper stock certificates and keeping electronic records of all transactions. Digital Dollars and Euros are stored on centralized ledgers controlled by their respective central banks. In the modern financial world, a majority of portfolios hold things (stocks, bonds, currencies, commodity futures) which can be considered digital assets, but the ownership rights of these assets are managed by some central governing authority.
For the rest of this conversation, we will focus on decentralized digitized assets and particularly cryptocurrencies and digital commodities. Distributed Ledger Technology (DLT) – a database that is synchronized and consensually shared – has made this decentralization possible by creating a new ecosystem with the capacity to manage digital assets on a network, authenticated and validated by collective collaboration. The blockchain protocol is a DLT, and its most popular applications have been Bitcoin and Ethereum. The decentralization feature is achieved by rewarding users with cryptocurrency for computing a hash value (a function that is easy to validate, hard to compute) for a set of new transactions (a block) and then appending it to the end of the chain of all historical blocks once a majority of users have validated it.
There are more than 600 other cryptocurrencies at this time, as anyone with a laptop and a dream (and perhaps accompanied by an understanding of DLT) can create one. For starters, Bitcoin happens to be the name of both the protocol (uppercase “B”) and the currency (lower case “b”). Ethereum is the protocol name, and ether is the cryptocurrency token which can be transferred and allows one party to compensate another for computations performed. Ethereum is a newer protocol, with the potential to replace Bitcoin as the standard due to faster transaction processing speeds and its more widespread usage in smart contracts – a self executing protocol stored on the blockchain to promote and validate conditions of a contract (will be discussed in a later blog post). Bitcoin has a market capitalization of $40 billion USD and ether has $26 billion. Regulatory bodies are scrambling to classify these assets: The Commodity Futures Trading Commission (CFTC) asserts that it’s a commodity, the Internal Revenue Service (IRS) deems it property, and the U.S. Securities and Exchange Commission (SEC) has decided to approach it on a case-by-case basis.
As a digital asset, bitcoin and ether have been on a tear recently, rising 150% and 3,400% respectively year-to-date as of June 30. This appreciation is part of a longer term trend stretching back to the two previous years: bitcoin was up 39% and 128% in 2015 and 2016. Ether has had a much shorter lifespan, with its Initial Coin Offering (ICO) priced at around 40 cents in July 2014 with trading commencing at the end of July 2015.
While returns to date have been astronomical, the volatility cannot be overlooked. Bitcoin prices dropped 84% peak to trough when the initial bitcoin bubble popped from late 2013 to early 2015; ether experienced a 78% peak-to-trough decline in 2015 over three months and a two-day 45% drop in 2016 due to the Decentralized Autonomous Organization (DAO) Hack. Monthly correlations over the past five year period against other traditional asset classes showed that bitcoin had low historical correlations with most other asset classes. Surprisingly, the correlation between bitcoin and gold was slightly negative. Gold is generally considered a safe asset that appreciates during periods of “risk-off” and can be used as an inflation hedge for the US dollar. In the five year historical period, we actually found that bitcoin appreciated in periods of “risk-on” and had a positive correlation to US equities.
As bitcoin’s proof of concept matures, the industry is rapidly moving into digital commodities. Commodities have been, and currently are used to store wealth and retain some sort of economic value. Digital commodities have the possibility of eradicating complexities around physical ownership, with the benefit of receiving spot pricing. The newly launched Royal Mint Gold (RMG), a collaboration between Britain’s Royal Mint and the CME is one of the latest applications. RMG gives the purchaser the ownership of physical gold in the British Royal Mint vault. Smart contracts are addressing issues around paperwork, post execution settlement and fulfilment of preconditions required for title transfer. In March, Natixis, IBM and Trafigura “pioneered the first blockchain solution in commodity trade finance for US crude oil transactions… major steps in a crude oil transaction [were] digitized on the blockchain… [with] the buyer, seller and respective banks all on the same ledger, all parties simultaneously [viewed] and [shared] data on the status, from the time a new trade is confirmed and validated, to when the crude oil is inspected, to its final delivery and cancellation of the letter of credit.” AgriDigital, ZrCoin, Bilur are just a few more emerging digital commodities to watch.
Bitcoin may have caught our collective attention as an asset because of its exponential growth in a low asset return environment, but the technology behind it has potential to disrupt the asset management landscape. As Digital Assets continue to evolve, asset managers will need to address their incorporation in the investable universe and also into business infrastructures.
 For a list of all cryptocurrencies and market caps: http://coinmarketcap.com/currencies/views/all/
”Bitcoin: Ringing the bell for a new asset class,” Chris Burniske & Adam White, January 2017, http://research.ark-invest.com/hubfs/1_Download_Files_ARK-Invest/White_Papers/Bitcoin-Ringing-The-Bell-For-A-New-Asset-Class.pdf
 Historical prices from GDAX: https://www.investing.com/currencies/btc-usd-historical-data
 $50 Million of virtual currency was “stolen” from Ethereum owners by exploiting a loophole in the smart contract code. Controversy over whether or not the hack should be rolled back has created an alternate universe of crypto-currency known as Ethereum Classic, in which the exploit was not rewound.
 Data provided by GDAX and Bloomberg. Other indices used: S&P 500 Index, US Bonds (Bloomberg Barclays US Aggregate Bond Index), Gold (Bloomberg Gold Commodity Index), WTI Oil (Bloomberg WTI Crude Oil Commodity Index), REIT (Dow Jones Equity REIT Total Return Index), and EM Currency (MSCI Emerging Markets Currency Index).
 “Natixis, IBM and Trafigura introduce first-ever Blockchain solution for U.S. crude oil market”, News Room, http://www-03.ibm.com/press/us/en/pressrelease/51951.wss