Digital Asset Markets: Five Important Topics

Digital assets have gone through an uphill journey over the past year. Several centralized crypto firms have failed, from hedge fund Three Arrows Capital to FTX, while the Securities and Exchange Commission (CFTC) and other US agencies have launched a regulatory offensive against cryptocurrency-related firms. Moreover, amid soaring inflation, a banking crisis, and a possible recession, all risk assets face an uncertain macro future.

But we cannot forget the long-term asymmetric opportunity that digital assets may provide. Fundamental investors are looking for digital projects that have the best chance of mass adoption despite the negative burden. With this in mind, five important themes have emerged in the digital asset markets that could lead to broader blockchain adoption in the medium to long term.

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1. The Big Players Are Here: Web2 Partnerships and the Next Wave of Web3 Users

Until now, adoption of digital assets has been mostly the domain of Web3’s original creators. To continue along this curve, more early adopters need to join. Many companies with pre-crypto assets made significant progress in 2021 and 2022 with initiatives that helped expand Web3’s user base beyond the original cryptocurrency.

Four projects in particular have leveraged Polygon, an Ethereum-based scaling solution, to facilitate these efforts.


Polygon + projects


In many of these cases, customers do not even know they are interacting with blockchain technology. Web2 companies have effectively stripped the blockchain. So far, Web3 onboarding has been fairly technical; By reducing this, brands can help encourage mass adoption.

Google and Amazon have also noted the value of partnering with blockchains to run nodes. Amazon Web Services is paired with Avalanche and Google with Solana.

Why are all these brands implementing Web3 plans? To improve user experience and customer relationships, attract Gen Z digital natives, and open up alternative revenue streams, among other causes.

Amid continued positive momentum in 2023, we expect more major brands to follow suit and develop their own blockchain initiatives.

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2. Ethereum dominates, but must scale to serve mass adoption

With 60% of the total value of decentralized finance (DeFi) locked (TVL) and 85% of NFT transaction volume, Ethereum is the clear leader among smart contract platforms. However, should millions of people flock to Web3, the Ethereum network could be flooded and the price of transacting on the blockchain could become prohibitively expensive. So, how can blockchains scale? We see three possible approaches.


Three types of Blockchain

Diagram depicting three types of blockchain

  1. Monolithic Blockchain Like Solana, it offers enforcement, reconciliation, consensus, and data availability in a single device. Applications are built directly on top of the blockchain. But this can lead to scalability problems – the so-called blockchain trilemma – if the blockchain is decentralized and highly secure.
  2. Standard Blockchain Like Ethereum 2.0, layers of implementation, settlement, consensus, and data availability are separated. Layer 2s, which take the form of sidechains and blockchains, scale the original Layer 1 blockchain without sacrificing decentralization or security. Applications are built on top of both layer one and layer two.
  3. The interconnected worlds of blockchains Such as Cosmos are ecosystems with relatively secure inter-blockchain communication protocols, so different blockchain networks can exchange data and value between them.

Given the influence of Lindy and the current dominance of Ethereum and its layer 2 in launching new projects, we expect the modular blockchain to prevail. Although smaller positions in other blockchain scale models, especially those with strong tokens and attractive relative valuations, may be a good hedge.

Handbook illustration of artificial intelligence and big data applications in investments

3. The token will bring various external assets onto the chain

The token creates digital representations of various assets, from securities and money to artwork and other collectibles, and is among the hottest current Web3 narratives. The benefits of asset tokenization explain why this topic has gained such traction.


Coding benefits

symbolic
Guarantees
symbolic
funds
real symbolic
Real estate and the arts
Other holdings
better
Accessibility
Opens
security markets
to a global gathering
from investors
makes institutions
private market strategies
easier
Individual investors
with less investment
Minimum, improvement
on board and
Liquidity could be better
allowed to
hash
better
efficiency
Increased liquidity
faster settlement,
lower costs
turns relatively
liquid resources
In easily negotiable items

The opportunity is huge. According to HSBC estimates, the token market size will reach $24 trillion by 2027.

How is this theme expressed in wallets of liquid tokens or non-fungible assets (NFAs)? Through smart contract platforms that provide public blockchain and settlement infrastructure for these token assets. KKR tokenized its $2.1 billion healthcare fund and Hamilton Lane flagship fund through Avalanche and Polygon, respectively. Decentralized applications (DApps) — Maker, Centrifuge, Maple Finance, and Ondo Finance, for example — help users connect real-world assets (RWAs) to DeFi.

4. RWAs can help combat DeFi circularity

DeFi’s “self-referencing” has been one of the sector’s perceived shortcomings. For example, a DeFi user might take out a loan on the Aave lending protocol for leveraged trading of assets on the Uniswap decentralized exchange.

We are optimistic about the opportunities that break this circular problem by integrating outside information and “real world” use cases into closed blockchain networks. There are many recent examples of non-crypto businesses that have switched to DeFi.

Through Maker Lending Protocol, users can borrow their DAI stablecoins by locking collateral into Maker smart contracts. Based on Ethereum, Maker determines the collateral they accept as well as collateral percentages for each type of collateral. Most of the collateral on Maker today is in the form of stablecoins, such as USDCs pegged to the US dollar, but RWAs are a fast-growing segment. At the start of the fourth quarter of 2022, RWAs accounted for just 2% of warranties on Maker, but this has increased to 13%, and RWA revenue currently accounts for more than half of Maker revenue. In fact, RWA’s collateral now includes US Treasury bonds through MIP65, loans from Pennsylvania’s Huntingdon Valley Bank, and asset-backed securities through BlockTower Capital.


RWA Activity

Chart showing RWA activity: assets for each type of DAO
Graph showing RWA activity by Maker
Digital Asset Markets: Five Important Topics 11 Accounting, Tax, & Insurance Services

Maple Finance is built on top of the Ethereum blockchain and Solana, another lending protocol that provides the infrastructure for credit experts to run cross-chain lending businesses. Earlier this year, it announced a $100 million receivables financing pool, enabling Intero Capital Solutions to borrow USDC against receivables and investors to lend USDC for a target return of 10%.

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5. NFTs: The Upside of the Underappreciated

NFT business boomed in 2021 as sales volume and unique buyers grew 41,784% and 6,959%, ​​respectively, according to cryptoslam. In 2023, NFT activity is on the upswing again thanks to two significant events: the disruptive launch of Blur, the Ethereum NFT market, and the explosive popularity of bitcoin ordinal, with which users can record text, images, and other data on satoshis, or smaller bitcoins.


NFT activity

weekly volume by source Smaart Company Accounting, Tax, & Insurance Services Smaart Company Accounting, Tax, & Insurance Services
Digital Asset Markets: Five Important Topics 12 Accounting, Tax, & Insurance Services

The 2021 boom refers to initial coin offerings (ICOs) in 2017 and serves as a proof of concept for DeFI. “Profile Picture” NFTs of cartoon monkeys and pixelated villains although we believe a much larger digital collectible market spans the following industries:

  • the games: Through NFTs, players can fully own their in-game lands, avatars, and other assets that they have acquired and invested in. Game NFTs can be sold, exchanged, and transferred between different metaverses so that users can move their digital assets from game A to game B instead of starting from scratch.
  • musicFans can invest in and support their favorite music artists through NFTs. For example, they can buy a share of an artist’s song that gives them royalties whenever that song is played on streaming services. NFTs can also unlock real-world experiences for fans, such as early access to new track releases or artist encounters.
  • the tickets: NFTs also have applications in the live event industry. With Ticketmaster’s partnership with the Flow blockchain, event organizers can now issue NFTs around live shows. Similar to music NFTs, these apps can enhance fan experiences and serve as digital collectibles. Ticketmaster now features an NFT wallet and marketplace so collectors can participate and trade.
  • Social mediaWeb2 centric social media giants profit from content they don’t create. Because of the current social media advertising-driven business model, actual content creators are paid little or not paid at all. By storing their social media on a public blockchain through NFTs representing profiles, likes, comments, and other activities, content creators can, through social tipping and secondary markets for profiles and other concepts, get better value for their work.
  • domain names In Web3, such as runa.eth, they are similar to their Web2 counterparts such as runa.com: they can serve as websites and email addresses. These domain names are technically represented as NFTs on blockchains and offer additional use cases — to store data, for example, so that users can then grant applications permission to access certain information. In this way, users can transfer their data across the web via NFTs and fully own their online identity.
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The digital asset space is certainly still in an early stage of its development. While it is no longer in its infancy, it is far from a mature market. As such, they are still very speculative and ripe with potential.

That’s why it’s worth paying attention — and treading with caution.

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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Photo credit: © Getty Images / spainter_vfx


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Alex Butt, CFA

Alex Botte, CFA, CAIA, is the Head of Client and Portfolio Solutions at Runa Digital Assets, an investment firm specializing in digital asset portfolios. In this role, she is responsible for the investment risk framework, chairs the risk committee, and contributes content, portfolio analytics, research, and client engagement. Bott was previously Vice President at Two Sigma, where she produced investment management-related content and helped develop the company’s factor-based risk analysis platform, Venn. Prior to joining Two Sigma, she was at AQR Capital Management, where she most recently worked as a Product Specialist for the firm’s global asset allocation strategies. Prior to AQR, I worked for Prime Services at Barclays. Butt holds a Bachelor of Science in Applied Economics and Management from Cornell University.

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