Special Situations Report: Digital Assets – So Much More Than Currency

Abstracting Crypto’s Complexities

Crypto has become a divisive term, where it seems investors are either passionately supportive or dismissive of this emerging asset class. Yet we’ve also noticed that very few actually understand this technology. While Bitcoin captures the most attention, its limited use cases make it an outlier vs other digital assets. We attempt to simplify the complexities of digital assets for traditional investors while outlining blockchain’s use cases and advantages over traditional technology and finance.

Objectives of Web3

Web3.0 refers to a decentralized internet that performs the same functions as today’s internet but operates without centralized intermediaries. While Web2 giants like Google, Meta, and Amazon disproportionately influence tech ecosystems today, Web3 disintermediates the internet by incentivizing thousands of independent parties to collectively validate and process transactions. Web3 creates a trustless, permissionless, and theoretically more secure internet and financial system with the same breadth of use cases as Web2.

Tokenomics of Owning Crypto

Digital Assets (crypto) incentivize and represent economic ownership of blockchain technologies. Thousands of digital assets exist with a cumulative market cap exceeding $1 trillion, where 42 tokens have market caps of over $1bn. Digital assets accrue a share of the earnings generated by their underlying blockchain applications. Value is distributed to token holders as a dividend and/or by reducing the number of tokens in circulation (almost like a stock buyback).

Ways to Invest in Digital Assets

Many digital assets are trading at comparable valuations to traditional equities, and we do not believe this reflects the potential for Web3 revenues to scale by multiples. We outline ways investors can gain direct exposure to digital assets, including via crypto exchanges and OTC/Prime Brokers for institutional trading. Investors can also gain indirect exposure via equities involved in blockchain and ETPs for digital assets.

Investment Thesis

We view Digital Assets as an emerging asset class that is deeply misunderstood by institutional investors. As investors better understand Web3’s advantages over traditional tech and financial applications, we see greater demand for Digital Assets that earn a share of the economics generated by their underlying Web3 protocols. Web3 and blockchain technology remain nascent relative to their disruptive potential, and revenues can scale by multiples if decentralized applications become mainstream.

Blockchain technology enables a wide array of use cases comparable to many internet and financial applications used today. These blockchain applications, collectively known as Web3, facilitate transactions and applications without centralized intermediaries. These decentralized applications offer greater levels of security while reducing risks related to single points of failure and lack of transparency.

There are thousands of decentralized applications, and many of these maintain a unique digital asset tied to each protocol. In aggregate, the market value of all digital assets is $1.1 trillion, where many of these assets earn a share of the fees generated by their respective applications. The market values for many digital assets trade at comparable earnings yields as traditional equities; however, we do not believe this valuation reflects the potential for Web3 revenues to scale by multiples.

What is Web3?

Web3 is a decentralized internet. While today’s internet is dominated by the largest companies in the world (Google, Meta, Apple, and Amazon), Web3 facilitates peer-to-peer transactions without centralized intermediaries. To simplify Web3, we compare the evolution of sending a simple email.

• Web 1.0. In the earliest forms of the internet, sending an email from one user to another was more decentralized. A user would send a message directly to another user’s IP address. But as use cases for the internet grew (music, videos, money, etc.), it became increasingly complex for users to directly share various types of content.

• Web 2.0. Technology platforms such as Google and Facebook streamline complex transactions for users. When sending an email, users no longer send messages directly. Rather, a user’s email on Gmail is sent to Google’s centralized server and then distributed to the intended recipient’s Gmail account. When sending messages from Gmail accounts to Outlook, Google’s servers will communicate with Microsoft’s centralized servers.

• Web 3.0. Web3 facilitates transactions without relying on centralized intermediaries. For an email, rather than relying on a small group of intermediaries to transfer a message, a Web3 email is processed by a decentralized network of thousands of independent parties. Members of this independent network can range from a single person with a computer to a corporation with warehouses of servers.

Each member of this independent network maintains its own record of the same email being sent, creating a “distributed ledger” stored across each computer. The email is sent once a certain percent of these independent validators confirm their ledgers align. Because the message is encrypted, only the email’s sender and receiver can read the email.

Similar to Web2, where users can complete complex transactions, Web3 supports smart contracts that enable a wide array of use cases. As we explain in the next chapter, Web3 use cases range from decentralized finance (trading or borrowing of assets) to decentralized social media, decentralized physical infrastructure (such as maps and WiFi), and much more.

Why limiting centralization is important

In the case of sending an email, there are several risks related to relying on centralized intermediaries. These risks are typically related to single points of failure.

• The intermediary’s server could temporarily go down, causing delays in sending the message.
• The intermediary’s server could permanently go down in the event it stops providing service.
• The intermediary could choose to censor the email and never actually send it.
• The intermediary could abuse its trust and read the private email.

As such, when relying on centralized intermediaries, users must place a great deal of trust in them. For example, a business must trust that its bank will custody assets safely. A regional supermarket using AWS must trust that Amazon will not pass sensitive information to Whole Foods. If a politician or activist is using social media to share information, they must trust that the service does not censor them.

Web3 reduces these risks by using many independent entities to facilitate transactions. If some independent validators are unable to confirm the transaction or deliberately choose not to, the transaction will still be completed if a large percentage of validators fulfill their duties. As such, transactions face less risk of becoming compromised when the pool of validators is decentralized. This result is why Web3 is often viewed as “trustless” because it relies on a network of entities, rather than a single one, to facilitate and confirm transactions.

Blockchain vs. Crypto

It seems the broader public acknowledges the merits of blockchain technology, but there’s confusion why cryptocurrencies or digital assets are needed. As just described in our Web3 explanation, blockchain technology facilitates and confirms transactions via distributed networks of validators. However, blockchain technology can also exist without digital assets.

Permissioned vs. Permissionless

For example, a consortium of banks could create their own blockchain network for trading assets. A dozen banks could create a network where transactions between banks are observed by each bank participating in the blockchain. The group could mandate that transactions are only confirmed when over 70% of participants verify each transaction. This result would reduce the level of trust required between any two banks, thus simplifying transactions with almost instant confirmations rather than the T+2 required for most financial activities today.

However, even if 12 banks participate in a blockchain, centralization is not entirely eliminated. For example, nine of these banks could collude for competitive reasons and only process certain transactions. The consortium could also block new banks from participating in the blockchain or kick out certain incumbents. Alternatively, as more participants are involved in the blockchain, risks related to collusion are reduced.

If thousands of entities are involved in this blockchain, it becomes very difficult for participants to collude or censor transactions. As such, more open and permissionless blockchains have less risks related to centralization and collusion and is likely why a vast majority of blockchain transactions today take place on open and permissionless blockchains rather than closed/permissioned ones.

Transaction data on permissionless blockchains is also publically accessible. Because blockchain transactions are stored across multiple independent computers, network participants can access the records of all transactions. In fact, records for most permissionless blockchains are publicly available on internet websites.

This level of transparency would have restricted dishonest intermediaries like Bernie Madoff and FTX from misappropriating customer assets. Instead, Web3 users can independently verify their assets are safe. Additionally, because blockchain technology is open source, all users have access to the underlying computer programming and can verify each application’s legitimacy.

Incentivizing Permissionless

Cryptocurrencies (i.e., digital assets) are used to incentivize participation in open and permissionless blockchains. To incentivize independent validators to facilitate transactions, Web3 users must use a blockchain’s native currency/token to pay fees. For example, if a user wants to transact on the Ethereum blockchain, they must pay network fees in Ethereum’s native currency, Ether (ETH). These fees are used to compensate the network’s independent validators.

Staking vs. Mining

Blockchain validators facilitate transactions and earn rewards via two methods:

• Mining is used by Bitcoin to validate transactions; however, mining is increasingly uncommon across most blockchain protocols. When Bitcoin (BTC) holders send BTC to other users, they must pay network fees in BTC. Bitcoin’s independent validators use high-powered computers to solve a complex puzzle, where the winning validator facilitates the transaction and is awarded the network fee in BTC.
• Staking is the most common way transactions are validated on modern blockchains. Similar to Bitcoin, users in a Proof of Stake blockchain will pay network fees in the blockchain’s native currency. However, unlike Bitcoin, Proof of Stake validators put up collateral in the blockchain’s native currency. Instead of solving a complex puzzle, stakers are randomly selected to facilitate transactions to earn network fees. Validators in a Proof of Stake blockchain are more aligned with the value of the native asset. In many blockchains, validators can increase their probability of earning network fees by committing more collateral. As such, the value of fees earned is proportional to the value staked. Some blockchains also “burn” a portion of user transaction fees to reduce the supply of native tokens, thus offering a disinflationary benefit to all token holders. Additionally, blockchains disincentive malicious activity by slashing the staked collateral of dishonest validators.

Web3 Advantages over Traditional Tech & Finance

Here is a list of fundamental advantages that decentralized applications have over traditional technology and financial intermediaries.

• Security. Blockchain networks offer better security guarantees than centralized intermediaries. If a centralized intermediary’s security is compromised, then all platform activity is at risk. Alternatively, malicious actors need to compromise hundreds (or thousands) of independent validators to gain control of a blockchain.
• Settlement speed. The trustless nature of blockchain transactions offers significantly faster settlement times than traditional finance. While traditional financial transactions settle over one to two days, blockchain transactions settle in minutes to milliseconds, depending on the network.
• Immutability. Once transactions are finalized, they become immutable which eliminates double-spending and chargebacks faced by centralized intermediaries.
• Cost efficiency. Web3 applications replace complex technology/financial systems with self-running lines of code. This replacement enables significantly leaner cost structures versus centralized intermediaries, resulting in significantly lower transaction costs in Web3.
• Composability. Assets and applications on a common blockchain can more easily interact than activity between centralized intermediaries. For example, a Web3 user can seamlessly borrow assets from one application and immediately trade the borrowed assets on a different application.
• Transparency. All blockchain activity is publically verifiable, meaning Web3 users can verify all assets and transaction activity. Additionally, most Web3 protocols are open-sourced, meaning anyone has access to the programming.
• Self-custody. Web3 is non-custodial, meaning users have sole control over their assets. Web3 applications are also non-custodial, meaning users can interact with applications directly from their self-custodial wallet.