Types of Crypto Assets1
Crypto assets are defined broadly as digital records that use cryptography, consensus algorithms, peer-to-peer networks, distributed ledgers and/or smart contracts to function as a store of value, medium of exchange, unit of account or decentralized application. The distributed ledger records all transactions on a blockchain network. The blockchain is maintained and updated via the use of a consensus mechanism, such as proof-of-work or proof-of-stake. This section explores the wider spectrum of crypto assets currently available on the market; however, the list is not exhaustive. Crypto assets may encompass non-government backed (private) crypto assets (liabilities) and central bank digital currencies (CBDCs).
Non-government Backed (Private) Crypto Assets
Cryptocurrencies
Cryptocurrencies, also called “payment tokens”, are an alternative to a government-issued fiat currency, a general-purpose medium of exchange independent of central banks, and a store value. Cryptocurrencies have no inherent value and are not backed by a central bank, government or underlying asset. The perceived value is based largely on network effects, which affects the supply and demand in the market. That is, as more users join the network (i.e., more demand), the network’s liquidity increases and the cryptocurrency’s price increases. As the network grows and improves, it attracts more buyers in a self-reinforcing cycle of user growth.
Utility tokens
Utility tokens are offered by a holder in exchange for a product or service and are usually limited for use within the issuer’s network. An example of a utility token is Brave’s Basic Attention Token (BAT), which can only be used to tip content creators through the Brave browser or other applications that have integrated BAT wallets. Utility tokens are usually pre-mined and distributed in a manner chosen by the team behind the project.
Security tokens
Security tokens are similar to digital stocks, whereby the holder usually obtains a stake in the company or project and additional benefits (e.g., profit sharing, voting rights or dividends). Security tokens are also tradable and, therefore, similar to any other type of security. They are usually auctioned through an initial coin offering that allows the business to raise money to fund an idea or business model. Security tokens are usually valued based on the underlying business.
Non-fungible tokens (NFTs)
NFTs record ownership of a unique tangible or intangible object on the blockchain. These can include items such as a song, artwork or a digital image. NFTs cannot be exchanged for one another because each NFT is unique. NFTs can only have one official owner at a particular point in time and are secured by the blockchain. However, NFTs also allow for fractional ownership to allow for greater liquidity of very high-value items that cannot be liquidated easily.
Hybrid tokens
Hybrid tokens may have two or more characteristics (i.e., security token, utility token and/or payment token features). Ongoing innovation in the crypto-asset ecosystem continues to produce hybrid tokens with multiple features.
Asset-backed tokens
Asset backed tokens represent a claim on an underling asset in the real world. The underlying asset may include a physical or financial asset, such as gold or stocks, which are recorded as a token on a distributed ledger. Asset-backed tokens streamline trading through faster settlement of transactions and eliminate the need for a reconciliation process.
Stablecoins
Stablecoins were created to manage price swings often seen in other more volatile cryptocurrencies and to facilitate fiat-based payments outside of the traditional financial system. Stablecoins are neither pre-mined nor minable. Instead, the total stablecoin supply constantly changes and reacts to the movement in the market. Stablecoins play a critical role in the crypto infrastructure and maintain the capital within the crypto ecosystem. So, when participants seek to liquidate their crypto-asset holdings to safely store value during times of high volatility, they no longer need to move their capital back into the traditional financial system to hold its value relative to fiat currency. Stablecoins have their value pegged against stable assets, such as precious metals or fiat currencies. As a result, stablecoins have incentivized innovation and addressed some of the inefficiencies experienced by the traditional financial system, such as the instant settlement of national and international transfers. However, not all stablecoins are created equal and, depending on their categorization, this will indicate the assets backing them and their respective risk profile. Stablecoins pegged to a fiat currency can be categorized as:
- fiat collateralized;
- crypto collateralized; or
- non-collateralized or fractional algorithmic.
Fiat-collateralized stablecoins
Fiat-collateralized stablecoins are usually fully collateralized and are pegged on a one-to-one ratio to fiat currencies like the U.S. dollar (USD). Some fiat-collateralized stablecoins such as Circle’s USDC2 have a redemption feature that allows their users to receive a payout from their stablecoin balance directly to their traditional bank account. Most fiat-collateralized stablecoins, such as USDT and USDC, operate on centralized systems and, therefore, do not have the decentralized characteristics as many other crypto assets. This limitation is one of the main reasons for developing alternative types of stablecoins discussed in the paragraphs below.
Crypto-collateralized stablecoins
Crypto-collateralized stablecoins are backed by other crypto assets and are usually over-collateralized to compensate for the increased volatility in the value of other crypto assets. The stability of these stablecoins depends on a series of complex processes written into the smart contract to regulate the demand, supply and governance of the underlying assets. MakerDAO’s DAI stablecoin is an example of a crypto-native decentralized, over-collateralized stablecoin that attempts to maintain a one-to-one ratio with the USD.
Non-collateralized or fractional algorithmic stablecoins
Algorithmic stablecoins can be non-collateralized or partially collateralized (fractional-algorithmic or hybrid-algorithmic) stablecoins. These stablecoins are governed by complex algorithms that attempt to maintain the one-to-one ratio with the respective fiat currency. Many algorithmic stablecoins are based on Robert Sams’ paper A Note on Cryptocurrency Stabilization: Seigniorage Shares, which describes a two-token system consisting of one pegged asset and a second speculative asset. The goal of the seigniorage shares is for the pegged asset to maintain stability through the speculative asset absorbing the volatility of the system and incentivizing its users to profit from deviations from the pegged ratio.
Frax is an example of a fractional-algorithmic model that uses a hybrid approach to the seigniorage share concept, by being partially collateralized. The pegged asset (FRAX) is partially backed by USDC, with the residual being algorithmically stabilized by Frax Shares (FXS). FRAX is continually minted and burned by arbitrageurs to maintain its USD $1 peg.3
Terra was initially an example of a non-collateralized algorithmic stablecoin model that used a two-token system, with TerraUSD being the pegged asset and LUNA being the speculative token responsible for absorbing the volatility. When TerraUSD is priced above the USD $1 peg, the system expands to print more TerraUSD through burning LUNA. LUNA holders are incentivized to exchange their LUNA for USD $1 worth of TerraUSD through the Terra system, then sell the TerraUSD for the price above the one-to-one ratio on the open market and profit from the difference. The Terra system burns part of the LUNA exchanged for TerraUSD to restore the pegged asset’s one-to-one ratio, while the rest of the LUNA compounds in a community pool. When TerraUSD drops below the one-to-one ratio, the opposite takes place; that is, TerraUSD is exchanged for USD $1 worth of LUNA.4
Although stablecoins may provide safety from the high levels of volatility in crypto markets, they do pose significant risks to their holders. Several attempts to create crypto-native algorithmic stablecoins have failed, resulting in large losses for their holders. The recent May 2022 TerraUSD depegging from the USD and LUNA’s loss of almost 100 per cent of its value shows the risks associated with algorithmic stablecoins.5 MakerDAO’s DAI is also prone to drastic price shocks when the system faces overwhelming pressure from large decreases in the value of the collateralized crypto assets. In March 2020, MakerDAO systematically failed, resulting in 5.67 million DAI in losses.6 Concerns have also been raised about the lack of transparency in Tether’s collateralization, as critics question USDT’s backing by a significant portion of unspecified commercial paper.7
CBDCs
CBDCs are central bank-issued digital money denominated in the national unit of account that represents a liability of the central bank. A “general purpose” or “retail” CBDC is intended to be a digital equivalent of cash for end users. A “wholesale” CBDC is designed for restricted access by financial institutions to settle large interbank payments or to provide central bank money to settle transactions of digital tokenized financial assets in new infrastructures.8
Proof-of-work versus Proof-of-stake Blockchains
The two most common consensus mechanisms used to operate and secure the blockchain are proof of work and proof of stake.
Proof of work
Under a proof-of-work consensus mechanism, computers (miners) compete against each other to be the first to solve complex puzzles. If the miner solves the puzzle, they are permitted to create a new block (i.e., a grouping of transactions) and broadcast it to the network of nodes, which will then individually audit the existing ledger and the new block. If the transactions in the block are verified, the new block is “chained” onto the previous block, creating a chronological chain of transactions. The miner is then rewarded with bitcoins for supplying their resources (energy). This is commonly referred to as “mining”. Mining consumes extensive electricity to secure the network by ensuring that only those that can prove they have expended resources are granted the right to append a new set of transactions to the blockchain. This design ensures that it is difficult, time-consuming and expensive to attack a proof-of-work blockchain.9
Proof of stake
Proof of stake is an alternative consensus mechanism that has a reduced energy-consumption profile than proof of work. Under proof of work, miners who expend computing power but fail to be the first to solve the puzzle receive nothing. Under proof of stake, validators are algorithmically selected to confirm new blocks and earn the associated rewards. Validators can increase their odds of being selected by staking more of the blockchain’s tokens to the network rather than having an arbitrary competition between miners to determine which node can add a block. This staking structure secures the network by requiring the potential validator to spend money and dedicate financial resources to the network in the form of native tokens to the network. Therefore, validators have a vested interest in the network’s continued success and can lose their staked tokens through a process known as “slashing” for misbehaviour.10
Layer One, Layer Two and Decentralized Applications
Layer-one protocols
Layer-one protocols are the primary blockchain layer or the “foundation” of all other blockchain layers, such as Bitcoin, Ethereum or Solana. Layer-one blockchains are directly responsible for maintaining the distributed ledger, validating transactions and securing the network. Some common consensus mechanisms used on layer-1 blockchain networks include proof of work, proof of stake and delegated proof of stake.11
Layer-two protocols
Layer-two protocols build on layer one and rely on it to finalize its transactions. Therefore, layer two can reduce the congestion on the layer one by providing a secondary framework where transactions can take place before being finalized on the layer-one protocol. Bitcoin’s Lightning Network is an example of a layer-two protocol that allows users to make faster transactions before being recorded on the Bitcoin blockchain.12
Layer-two protocols can issue their own tokens and allow for more complex projects known as “decentralized applications” (DApps).
Decentralized Applications (DApps)
DApps are applications built on a decentralized network that combines a smart contract and a front-end user interface. They are usually open source and cryptographically secure.13
Decentralized Autonomous Organizations and Decentralized Finance
Decentralized autonomous organization (DAO)14
A DAO is collectively owned by its members. The blockchain-governed organization works toward a shared mission. DAOs are governed by smart contracts, which are self-executing pieces of code that run on a blockchain. The smart contracts define the rules of the organization and hold the treasury.
DAOs do not require a central authority. Decisions are made collectively, and payments are automatically authorized when votes pass. DAOs usually make decisions through voting mechanisms based on governance tokens that are usually issued via a governance-token sale.
Currently, in most jurisdictions DAOs are not required to produce financial statements in accordance with a generally accepted accounting principles framework.
Decentralized finance (DeFi)
DeFi refers to financial applications that build on decentralized ledger technology, enabling the delivery of financial services without the traditional centralized intermediaries.15 DeFi uses open protocols that allow financial services to be programmatically combined in flexible ways.16 DeFi comprises six service categories: stablecoins, exchanges, credit markets, derivatives, insurance and asset management.
DeFi staking and lending platforms17
Staking and lending are similar. In both cases, the lender sends their crypto asset to a DeFi protocol to hold, and in return they receive a relatively consistent yield. The yield is usually in the form of a small percentage of the original investment.
The difference between staking and lending arises based on how the crypto assets sent to the protocol are being used by the protocol. Under crypto-staking arrangements, the protocol uses the crypto asset’s proof-of-stake blockchain as a validator or as a staking pool to improve their odds of being selected as a validator. Lenders (stakers) providing their crypto assets to a staking pool often receive the staking pool’s native tokens representing their staked tokens. The staking rewards earned by the validator or staking pool are then used to compensate the staker for their crypto assets lent to the protocol. In the case of most staking pools, these rewards are usually paid to the stakers in the form of the staking pool’s native token, which can be redeemed from the protocol for the original crypto asset staked. The staking pool’s native tokens may lose their value should the staking pool suffer a hack, a slashing event or a general decline in popularity. The staking pool’s native tokens are generally also tradable for other crypto assets and may be lent to a lending platform to generate an additional return.
Under crypto lending arrangements, the crypto assets lent are included in the protocol’s pool, which the protocol uses to provide loans to other users in return for an interest payment. Similar to staking, the lender receives tokens minted by the protocol of equivalent value to what they deposited, and rewards generated by their deposit. The difference is that the rewards from a lending arrangement is derived from the interest received from other users rather than from rewards for validating new blocks.
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Notes
- Definitions are derived from the following sources: “Cryptoasset,” Glossary, CoinMarketCap Alexandria, accessed August 17, 2022, https://coinmarketcap.com/alexandria/glossary/cryptoasset; “Crypto-assets — the global regulatory perspective,” EY, 2021, https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/banking-and-capital-markets/ey-crypto-assets-the-global-regulatory-perspective.pdf?download; “Crypto Assets and Cryptocurrency,” New Brunswick Financial and Consumer Services Commission, accessed August 17, 2022, https://www.fcnb.ca/en/investing/high-risk-investments/crypto-assets-and-cryptocurrency; and Brian Nibley, “What Is a Utility Token?,” Social Finance Learn, December 22, 2021, https://www.sofi.com/learn/content/what-is-a-utility-token/.
- Circle is the principal operator of USDC, a regulated and fully reserved dollar digital currency.
- “Introduction,” Frax: Fractional Stablecoin Protocol, Frax Finance, last modified July 2021, https://docs.frax.finance/overview.
- David Liebowitz, “Algorithmic Stablecoins Breakdown: Attempting to Fulfill Satoshi’s Dream,” The Defiant, June 10, 2021, https://thedefiant.io/why-algorithmic-stablecoins-will-fullfill-satoshis-dream/.
- Leibowitz.
- Leibowitz.
- Nikhilesh De and Marc Hochstein, “Tether's First Reserve Breakdown Shows Token 49% Backed by Unspecified Commercial Paper,” CoinDesk, May 13, 2021, last modified September 14, 2021, https://www.coindesk.com/tether-first-reserve-composition-report-usdt.
- Codruta Boar and Andreas Wehrli, “Ready, steady, go? – Results of the third BIS survey on central bank digital currency,” Bank for International Settlements 114 (January 2021), https://www.bis.org/publ/bppdf/bispap114.pdf.
- Luke Conway, “Proof-of-Work vs. Proof-of-Stake: Which Is Better?,” Blockworks, accessed August 17, 2022, https://blockworks.co/proof-of-work-vs-proof-of-stake-whats-the-difference/.
- De and Hochstein.
- “Introduction to DAPPS,” Ethereum, last modified July 11, 2023, https://ethereum.org/en/developers/docs/dapps/.
- Excludes funds borrowed by staking protocols.
- “Introduction to DAPPS,” Ethereum, last modified July 11, 2023, https://ethereum.org/en/developers/docs/dapps/.
- “Decentralized Autonomous Organizations (DAOs)” Ethereum, accessed July 14, 2023, https://ethereum.org/en/dao/.
- William Peaster, “What is DeFi? Understanding Decentralized Finance,” DeFi Pulse, August 31, 2022, https://defipulse.com/blog/what-is-defi/.
- Wharton Blockchain and Digital Asset Project and World Economic Forum, DeFi Beyond the Hype: The Emerging World of Decentralized Finance, (Philadelphia: University of Pennsylvania, 2021), https://wifpr.wharton.upenn.edu/wp-content/uploads/2021/05/DeFi-Beyond-the-Hype.pdf.
- Matt Hussey, “How to Invest In Cryptocurrencies: Staking and Lending”, Decrypt, January 27, 2021, https://decrypt.co/resources/how-to-invest-in-cryptocurrencies-staking-and-lending