Our glossary of digital assets
Our glossary of digital assets
Altcoins are cryptocurrencies. There are thousands of different altcoins in existence, embracing a huge diversity of features, utility and potential value. The prefix “alt” comes from “alternative to bitcoin”; hence the term can be used to describe all cryptocurrencies other than bitcoin.
The transaction in an atomic settlement is bound by smart “hashed timelock” contracts. This ensures that settlement elements of the deal (the transfer of ownership and payment) all take place at exactly the same time – or do not take place at all.
The transactions are executed only when certain data is disclosed as “proof”.
Atomic settlement’s main benefit is that the participants don’t need to place trust in an intermediary to hold their funds or assets for any period during the transaction; they trade directly with each other. Another benefit is the speed of the transaction, and the ability to undertake large numbers of transactions simultaneously. Today, many financial transactions settle two days after transaction (T+2), atomic settlement is instant (T0)
Bitcoin (BTC) is the best-known and inaugural cryptocurrency. It is also the one most closely associated with the ambition to create payment mechanisms free of the control of any government, central bank, private bank, individual or indeed any single entity whatsoever.
This striking ambition has gained bitcoin a mythic status. Some adherents believe its creation has posed a profound challenge to traditional trading systems, or indeed that it undermines fundamental structures of modern society.
Bitcoin is designed to have a fixed supply of 21 million coins, these can be traded in units as small as 0.00000001 BTC, also know as a “Satoshi”. This fixed supply was intended to mimic the finite nature of gold – hence the terms “digital gold” and the use of the word “mining” to describe the creation of new coins (see below).
In setting out the case for bitcoin, its founder – or founders – going by the name Satoshi Nakamoto, stated in a published paper: “Commerce has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model… The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services.”
However, after more than a decade in existence, it still fails as a payment provider due to its high level of volatility. Its function as a reserve asset still hasn’t materialised and its environmental impact remains a concern.
Blockchain describes a database where information is shared across a digital ledger in parcels or “blocks”. The ledger may be publicly accessible, or limited to a private, permissioned network. Transactions are recorded by this database and then distributed across the network and network participants, hence the term “distributed ledger technology” or DLT (see separate entry). Every “node” in the network will contain a replica of the records.
The security offered by blockchain arises because no changes can be made to individual records. They all need to be in agreement, and so any attempts to alter or delete single entries will be denied. This is sometimes called “network consensus”.
Blockchain’s use is still largely associated with cryptocurrency transactions, but many other uses are being developed and tested, and it is playing an enabling role in areas such as Web3 and the Metaverse.
Central bank digital currencies (CBDCs)
Central banks such as the Federal Reserve, Bank of Japan or Bank of England issue “fiat” currencies in the form of US dollars, British pounds or Japanese yen. These are called “fiat” (Latin for “decree”) because their value is as stated by a government, rather than underpinned by gold, silver or other reserve asset.
Many central banks are currently developing digital equivalents of existing fiat currencies. If they were to be rolled out, they would have the backing of their government just as today’s fiat currencies do. Potential advantages could be cheaper and faster transactions, reduced risk of commercial bank failures and ease of payments across borders.
Many large central banks, including the Bank of England and Federal Reserve, are investigating the use of CBDCs but have not yet committed to creating one. Countries which do have an active CBDC include The Bahamas, Nigeria and Jamaica.
This catch-all term describes digital currencies which aren’t tied to a central issuer. Transactions in these currencies rely on data stored and shared via distributed ledger technology (see separate entry). Cryptocurrencies are just one form of digital assets (see below).
DeFi is the commonly-used abbreviation for decentralized finance. As the name suggests, this is a system that aims to enable financial transactions without the need for a central financial institution (such as a bank or brokerage) acting as an intermediary.
This term pre-dates cryptocurrencies. It describes the switch from paper records to electronic record-keeping – a process which has been underway with traditional securities, such as company shares, for several decades.
This generic term applies to all assets which can exist and be maintained digitally, and which can be moved from one owner to another, or used as payment for goods and services, via digital transactions. They are likely to make use of distributed ledger technology (see separate entry).
Distributed ledger technology (DLT)
This describes the operation of blockchain, where blocks of data are shared across a network or “digital ledgers”.
Vitalik Buterin, who was recently described by Time Magazine as the “most influential person in crypto”, conceived Ethereum in 2013. He has called his creation a “decentralized operating system for blockchain”. It was intended to be a general-purpose blockchain which enabled people to write any kind of application onto it, as opposed to the previous blockchain which was solely used for creating, validating and transferring bitcoin. Its uses now include finance, web browsing, gaming, advertising, identity management, and supply chain management. Transactions on Ethereum are facilitated by “smart contracts” (explained below).
Ethereum’s associated digital currency is ether, which is the world’s second most-traded cryptocurrency.
Cryptocurrencies run on decentralised networks, which raises the question of who is in charge of ensuring the integrity of the network and processing transactions if no chosen entity is responsible. On public chains, miners are economically incentivised to keep the ‘database’ up to date and ensure everyone adheres to the rules.
Put simply, this describes the process by which new digital coins are minted (i.e. created) and put into circulation. The process behind it is anything but simple, however. It involves thousands of specialised computers that verify and validate transactions on a blockchain. They typically use either “proof of work” or “proof of stake” to validate transactions and create new blocks, they are then rewarded with the cryptocurrency native to that chain
- Proof of work
Proof of work is a “consensus mechanism”. These are needed to coordinate the operating of a blockchain and to mine coins. To generate a new coin via this method, vast networks of computers compete to solve what is essentially a mathematical puzzle. In the case of bitcoin, these computers must crack a 64-digit hexadecimal number known as a “hash”. The winner is rewarded for the computing power it has contributed with a coin. The intention of this seemingly convoluted process (and of “proof of stake”) is to ensure honest transactions and prevent fraud. However, critics point to the vast amount of energy this process uses as - while vast networks of computers compete to solve the hash - only one achieves the solution and the energy expunged by the wider network is effectively wasted. The annual energy consumption from the bitcoin network is often compared to the consumption of entire countries such as Pakistan or Norway. For a more domestic parallel, the energy it uses could power all the UK’s kettles for 22 years, according to the Cambridge Bitcoin Electricity Consumption Index.
- Proof of stake
Proof of stake is an alternative consensus mechanism to proof of work. In this method, users stake their coins as collateral to become a verifier of transactions on the network. A validator is chosen by the proof of stake protocol to review a block of transactions and check if they are accurate. Once validated, the block is added to the blockchain and the validator receives cryptocurrency as a reward. Should a validator attempt to add a block with inaccurate information, however, they are penalised by losing some of their stake.
Proof of stake uses far less energy than proof of work. Indeed, Ethereum’s much-heralded move to proof of work (known as the “merge”) has reduced Ethereum’s energy consumption by 99.95%. However, proof of stake can introduce other concerns such as concentration or centralisation, where validators with large numbers of assets to stake could have a higher chance of validating the chain than other participants.
A non-fungible token (NFT) is a unique digital item that lives on a blockchain. Fungible items are those that can be exchanged freely or interchanged with something similar. Dollars and bitcoin are fungible, whereas a piece of art isn’t. With NFTs, their uniqueness is their appeal as it enables ownership of physical or digital assets to be tagged and tracked.
There has been a tremendous amount of speculation around NFTs the past few years. Most notable perhaps was Twitter-founder Jack Dorsey’s first ever tweet, which he put up for auction as an NFT in 2021 which sold for $2.9 million. He in turn listed it for auction a year later with a list price of $46 million. The highest bid he received fell rather short of his target, however. He decided to keep hold of the NFT rather than accept the $277 offered.
Wide-ranging use-cases for NFTs are being developed related to areas such as gaming where ownership of in-game products can be bought and sold between players. Identity and access control can also apply this technology to ticket sales for popular events. Fashion houses could tag their products with verifiable ownership via an NFT to combat counterfeiting.
A node is a stakeholder (usually a computer) on a blockchain network. Depending on the type of blockchain, nodes keep track and serve as communication centres for tasks within the network.
Nodes form an essential part; all nodes on a blockchain are inter-connected and they constantly exchange the latest blockchain data to ensure they all stay up-to-date. Nodes check the validity of a block of transactions and accept or reject it. They also save and store transaction histories.
Smart contracts are computer programmes which sit inside a blockchain that automatically run when predetermined conditions are met. They reduce reliance on – if not completely eliminate – the need for a third party intermediary when verifying, executing and enforcing a blockchain transaction. Smart contracts power decentralised finance by running things such as exchanges, derivatives markets and stable coins.
Stablecoins were meant to provide a solution to the problem of volatility seen in cryptocurrencies such as bitcoin. Their aim is to mimic traditional currencies, but with the added benefits of blockchain technology.
Whereas a digital currency such as bitcoin derives its value partly from the costs involved in mining new coins, as well as its relative scarcity and market demand, a stablecoin derives its value from being pegged against a currency such as the dollar.
There are three types of stablecoin: dollar collateralised (where each digital coin is reserved for on a one-for-one basis), crypto collateralised (which are reserved by holding crypto currencies) and non-collateralised (where the peg is managed using financial engineering, algorithms and market incentives).
Many have questioned whether “stable” is an appropriate name for this type of coin, particularly after the recent collapse of UST (an algorithmic stablecoin) in May 2022, which led to the loss of more than $40 billion.
Regulation and central bank digital currencies (CBDCs, explained above) will likely dramatically change the stablecoin landscape.
Digital assets differ from traditional assets as you never actually hold them; they always remain on the distributed ledger. When making a transaction - for example, sending ten coins to your relative - the record of ownership will change from your address to their address within the database, without leaving the ledger. An address is also known as a public key which is somewhat similar to a bank account number.
In order to make the above transaction you must tell the network which public address will transact and validate it with your private key. A private key can be thought of as your debit card pin number. It’s a way of identifying yourself to the ledger to make transaction. This is why you should never share your private key.
Digital asset wallets hold your public and private keys; they don’t actually hold digital assets. Some digital wallets are ‘hot’ as they store your private keys online. Others are ‘cold’ as they are physically disconnected from the internet.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.