Crypto Assets: A Very Short Introduction

Crypto assets are an exciting new asset class that high-net-worth individuals (HNWIs) and their family offices need to know about. In this article I will attempt to give an overview of the two most important crypto assets and will explain how they should be custodied.

Typology of crypto assets

A popular website lists approximately 10,100 crypto assets,^[1] a bewildering menu which causes quite some initial consternation for the beginner. In this essay, I will limit myself to the top two crypto assets, viz. Bitcoin (“the king of crypto”) and Ether (“the queen of crypto”). When speaking of the top two crypto assets, I am referring to the market capitalization. The market capitalization of a crypto asset — similar to stocks — results from multiplying the circulating supply by its respective price.

Of all crypto assets, Bitcoin has the largest and Ether the second-largest market capitalization. Another interesting metric is market share: The market share of a crypto asset results from the ratio of its own market capitalization to the market capitalization of all crypto assets.

Currently, Bitcoin and Ether together have approximately 65.2% market share. By way of comparison, the next three crypto assets have market shares of 7.6%, 2.9%, and 2.5%. Thus, for many investors new to the crypto space it could make sense to limit oneself initially to investments into Bitcoin and Ether, since these are by far the largest players.

Bitcoin

Bitcoin^[2] is the original crypto asset and the most well-known. Bitcoin was originally conceived as electronic cash that can be sent directly from user to user without the need for intermediaries, with transactions being recorded in a decentralized database (namely, the blockchain). It is not yet considered as money, since its functionality as (i) a store of value; (ii) a medium of exchange; and (iii) a unit of account is still weak. Bitcoin has peculiar properties distinguishing it from traditional (namely, fiat) money:

• Fiat money is issued by a central bank. Bitcoins, on the other hand, are created by a decentralized network.
• Fiat money has a money supply based on a discretionary (political) decision. Bitcoin, on the other hand, has a money supply determined by an algorithm; it is therefore fairly easy to predict how many Bitcoins will be in circulation in a month, in a year, or in a decade.
• Fiat money can be multiplied at will and (if things continue this way) may one day be worthless. Bitcoin, on the other hand, has an upper limit of 21 million, which acts as a protection against debasing.
• Fiat money cannot be transferred electronically without intermediaries (for example, banks, credit card companies, PayPal, Stripe, Apple Pay, and so on). Bitcoin, on the other hand, does not need intermediaries; everyone is their own bank and payments are made directly from one user’s address to another user’s address.
• Fiat money transactions intended by the transferor may ultimately not be carried out by the interposed intermediary, either for arbitrary or for legal reasons (for example, the application of money laundering regulations, sanctions or restrictions on the movement of capital). Bitcoins, on the other hand, are transmitted without intermediaries; nobody, therefore, can censor (namely, suppress) a planned transaction.
• Fiat money is normally held with banks, but opening a bank account normally takes a long time, among other things, due to the need to comply with legal provisions relating to money laundering and the financing of terrorism as well as the automatic exchange of information on financial accounts. Typically, many pages of forms need to be filled out. Finally, a bank can sometimes simply refuse to open a bank account. Bitcoins, on the other hand, are held directly by a user on an address (see below); the generation of a Bitcoin address is extremely simple and does not require the consent of third parties.
• Fiat money held with a bank can be lost due to attachment, expropriation, or bankruptcy of the bank. In the latter case, sometimes a state deposit guarantee scheme gives some protection. Bitcoins, on the other hand, do not constitute claims against an intermediary. As long as the private key for a specific address is not disclosed, nobody can access the Bitcoins stored at this address. If you lose the private key, there is no deposit protection and that is the end of the story.
• Fiat money transfers recognize national borders: international transfers are slower and more expensive than domestic transfers. Bitcoin, on the other hand, is an electronic money system that makes no distinction between domestic and foreign recipients.
• Fiat money transfers are usually reversible: Credit card payments can for example be reversed weeks later. Bitcoin, on the other hand, has — in principle — irreversible transactions: As soon as a transaction has been included in a block of the blockchain (namely, the decentralized transactional database), the process cannot normally be reversed.
• Fiat money is divisible to two decimal places (a hundredth). Bitcoins, on the other hand, are divisible to eight decimal places (a hundred millionth).

Over time, Bitcoin’s purpose has somewhat morphed from digital cash to digital gold. As such, it does not have any real competitors in terms of brand and market share. It is interesting to note that not only have well-known billionaires and hedge funds started dipping their toes into Bitcoin as an inflation hedge in turbulent times, but that there are a number of public companies holding Bitcoins in their treasuries (for example, MicroStrategy Inc. holds nearly USD 4 billion in Bitcoin).

Ether

Bitcoin, which I just described above, is a safe, efficient, resilient, and decentralized system, which has been working for more than a decade without any downtime. It is, however, also simple, meaning that Bitcoins cannot be sent subject to a predefined condition being met — they can only be sent or not sent. This limitation led to the development of Ethereum, a blockchain-based compute platform, on which programs of arbitrary complexity can run in a decentralized manner. The advantages of such programs (so-called smart contracts) are:

• They do not run or store their data on a central server.
• They cannot be subsequently modified or interfered with.
• They can dispose over assets stored on the blockchain.
• They can be reviewed by the public at large.

Smart contracts thus open up the possibility of making payment instructions conditional upon an external event occurring. While Bitcoin (namely, the platform) allows the unconditional transfer of Bitcoins (namely, the crypto asset), Ethereum (namely, the platform) allows the programable transfer of Ether^[3] (namely, the crypto asset).

Ether are digital assets similar to Bitcoin, but they are also used to pay for the carrying out of transactions on the Ethereum blockchain. Similar to Bitcoins, Ether are transferred peer-to-peer without any intermediaries and are created by a decentralized network, with the money supply being based on an algorithm. In contrast to Bitcoins, there is no upper limit. Recent changes to the system have led to the regular “burning” of Ether, which could offset the inherent inflationary tendency. Interestingly, Ethereum makes it possible to create other assets, so-called tokens. Such tokens basically work in the same manner as Ether.

Ethereum has many competitors offering smart contract infrastructures. As of now, however, they have quite low market caps. Whether they will make significant inroads or whether they will remain niche players remains to be seen.

Other crypto assets

A comparison of Bitcoin and Ether already shows that these are two completely different beasts (digital gold versus compute platform). In the following, I would like to introduce a few other crypto assets, with the goal of showing the immense breadth of this universe (the ticker symbols are mentioned in brackets):

• Crypto currencies which serve as a means of payment, for example, Litecoin (LTC), Bitcoin Cash (BCH), and Dash (DASH)
• Privacy coins, which are untraceable means of payment due to having no public ledger, for example, Monero (XMR), Zcash (ZEC), and Secret (SCRT)
• Stablecoins, which are crypto assets pegged to the US dollar, for example, Tether (USDT), TrueUSD (TUSD), USD Coin (USDC), Pax Dollar (USDP), Gemini Dollar (GUSD), and Dai (DAI)
• Smart contract platforms which are competitors to Ethereum, for example, Internet Computer Protocol (ICP), Avalanche (AVAX), Solana (SOL), and Fantom (FTM)
• Governance tokens of DeFi protocols, which promise dividends similar to shares, for example, Aave (AAVE), Curve DAO Token (CRV), and Sushi (SUSHI)
• Tokens representing venture capital investments into start-ups, for example, Arweave (AR), Helium (HNT), and Livepeer (LPT)
• Collectibles in the form of NFTs, for example, Cryptopunks, Bored Ape Yacht Club, and Art Blocks
• Works of art in the form of NFTs, which are mostly sold on decentralized marketplaces, for example, Mike Winkelmann’s digital work of art “Everydays — The First 5000 Days”, which was auctioned at Christie’s for USD 69 million
• Real estate in the metaverse, an immersive virtual world where people gather to socialize, play, and work and which was familiarized through Mark Zuckerberg's announcement, for example, The Sandbox (SAND) and Decentraland (MANA)
• Fan tokens issued by soccer clubs, which grant certain benefits to token holders, for example, Paris Saint-Germain Fan Token (PSG), Manchester City Fan Token (CITY), and FC Barcelona Fan Token (BAR)
• Meme coins, which are very speculative crypto assets, that have no commercial purpose, that often make fun of themselves, typically cost a fraction of a dollar, and whose price is driven through social media by meme lords such as Elon Musk, for example, Dogecoin (DOGE) and Shiba Inu (SHIB)
• In-game assets in the form of NFTs, which allow players to have real ownership, for example, Axie Infinity (AXS)

Holding of crypto assets: Self-custody versus external custodian

Bitcoins (and this equally applies to other crypto assets such as Ether) are held in addresses, over which one disposes using the associated private key.

• An address is a combination of letters and digits, such as 1F9cZYh3ZB6gdF9mnzLgFn6yqnFvpP9iHn. Bitcoins are stored at an address. The address is thus comparable to the IBAN of a bank account (for example, AT843400000000062679) on which EUR are stored. An address can theoretically be disclosed to third parties (and must be disclosed if one wants to receive funds).
• A private key is a similarly long string, such as 5Kb8kLf9zgWQnogidDA76MzPL6TsZZY36hWXMssSzNydYXYB9KF. There is normally exactly one matching private key for each address. With the private key, one can dispose over the Bitcoins stored on the address. The private key is thus comparable to a PIN code (for example, 83puWz), with which one can dispose over the EUR balance in a bank account. A private key must not be disclosed to anyone else; whoever knows the private key can make a Bitcoin payment from the address to which the private key belongs.

Typical due diligence questions when choosing a crypto custodian

• How long has this service provider been operating?
• Have there been any incidents with this service provider in the past?
• In which jurisdiction is this service provider based?
• Is this service provider subject to regulation and if yes to which?
• What amount of value is this service provider currently holding in custody?
• What type of insurance coverage exists for this service provider?
• What technical and organizational security measures does this service provider use?
• What kind of regular reporting on holdings is provided by this service provider?
• Are the crypto asset holdings, which are custodied by this service provider, regularly audited?
• Does this service provider also offer brokerage/exchange services?
• How does pricing work with this service provider?
• Does the service provider use general terms & conditions or bespoke agreements?
• What anti-money laundering documentation does this service provider require?

Notes:

^[1] https://www.coingecko.com. All numbers used in the following were current in the middle of August 2023.

^[2] Bitcoin's ticker symbol is BTC.

^[3] Ether's ticker symbol is ETH.