Module 84.
1: Distributed Ledger
Technology
LOS 84.a: Describe financial applications of
distributed ledger technology.
Digital assets are assets that can be electronically created, stored,
and transferred. This relatively new alternative asset class includes
cryptocurrencies, tokens, and digital collectibles. A digital asset is
secured and validated using distributed ledger technology (DLT),
also known as blockchain technology. Cryptocurrencies have their own
blockchains, while crypto tokens are built on blockchains that already
exist.
A distributed ledger is a database shared among market participants.
It maintains a record of all transactions, which allows each participant
to have an identical copy of the database. DLT benefits include
accuracy, transparency, and security; rapid ownership transfer; and
peer-to-peer (P2P) interactions for creating, trading, and monitoring
digital assets. DLT disadvantages include data protection concerns,
potential privacy violations, and the large amount of computational
power needed for verifying transactions.
A DLT network consists of a digital ledger, a consensus mechanism,
and a network of participants. A consensus mechanism establishes a
common state of the ledger, which involves validating transactions and
updating the ledger. These two steps generate records that are
immutable (i.e., unchangeable) while providing transparency for all
network participants. DLT uses cryptography to encrypt data, which
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prevents unauthorized parties from accessing data.
DLT can also implement smart contracts, where a computer program
self-executes based on predetermined terms and conditions.
Automating contingent claims and collateral transfers during default
events are examples of smart contract applications.
A blockchain is a digital ledger that records information sequentially
within blocks. These blocks are linked together (i.e., chained), and
information is secured using cryptographic techniques. Blocks within
the chain contain a group of transactions as well as a secure link
(known as a hash) to the previous block. A newly created transaction is
only added to a chain after it has been validated by authorized
participants.
Consensus Protocols
Consensus protocols determine how blocks are chained together.
They are structured to protect against market manipulation. The main
types of consensus protocols are proof of work and proof of stake.
For the proof of work (PoW) protocol, when a transaction takes place,
miners use computers to solve a cryptographic problem, which then
verifies the transaction. Blocks are validated and locked into the
blockchain thanks to powerful computers that use massive amounts of
energy. This process rewards the miners with cryptocurrency. The
resources required for mining impose substantial costs on any attempt
to manipulate the blockchain's historical record. To do so would require
one party to control most (i.e., 51%) of the network. For this reason, a
blockchain is more likely to succeed when there is a large number of
network participants. PoW is the most widely used consensus
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mechanism.
The proof of stake (PoS) protocol is an emerging consensus
mechanism in which certain network participants pledge collateral (a
process known as staking) to guarantee the validity of a block. These
participants, who are known as validators, use their stake to signal to
the network that a transaction is ready to be added to the blockchain.
Additional validators will then verify that the transaction is, indeed,
authentic. Validators also protect the network from potential malicious
attacks by controlling most of the network's computational power.
Validators are rewarded with a return on their staked collateral.
Permissionless and Permissioned Networks
The two forms of DLT networks are permissionless and permissioned.
In permissionless networks, transactions are visible to all users within
the network, and any user can execute a transaction. In addition, all
network functions can be performed by any network participant.
Bitcoin is considered a permissionless network, as are many other
types of cryptocurrency.
An advantage of a permissionless (i.e., open) network is that
transactions are confirmed or denied through consensus mechanisms
rather than by a centralized authority. Blockchain transactions cannot
be manipulated once they have been added to the ledger, which
creates an immutable record of all transactions. Transacting parties do
not have to trust each other in permissionless networks.
In permissioned networks, users may be restricted from some
network activities. Permissions (or controls) can modify the level of
ledger accessibility. These levels range from adding transactions (for
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network participants) to viewing only the transaction history (for
regulators). Because permissioned blockchains have stronger
restrictions, they are more cost effective than open and decentralized
permissionless networks.
Digital Asset Categories
DLT has many potential applications within the financial industry,
including the creation of digital assets and the delivery of more efficient
financial services. Types of Digital Assets outlines the main types of
digital assets currently available.
Cryptocurrencies Tokens
Bitcoin
Altcoins Nonfungible tokens (NFTs)
Other cryptocurrencies (e.g., Security tokens
Ether) Initial coin offerings
Stablecoins (e.g., Tether) (ICOs)
Meme coins (e.g., Dogecoin) Utility tokens
Governance tokens
Central bank digital currencies
(CBDCs)
A cryptocurrency is a digital currency issued privately with no backing
from a central bank. By using this digital medium of exchange, parties
can execute near-real-time transactions without the need for an
intermediary. Cryptocurrencies commonly limit how many currency
units can be issued. The objective of this supply limit is to maintain the
unit as a store of value; however, many cryptocurrencies still
experience extreme price volatility.
Various cryptocurrencies exist because their blockchains are designed
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and optimized differently. As the most widely traded cryptocurrency,
Bitcoin has influenced the development of many other types of digital
assets. Alternate cryptocurrencies, known as altcoins, are based on
the technology used by Bitcoin. The most well-known altcoin is Ether,
which is built on the Ethereum network. The Ethereum blockchain
allows users to develop applications (i.e., smart contracts) to secure
and validate transactions. Therefore, the value of Ethereum and other
programmable blockchains extends beyond being only a store of value.
To date, Bitcoin and Ether are the two most popular cryptocurrencies;
as of July 2022, they made up more than 80% of the total
cryptocurrency market.
Stablecoins offer stable digital currency values. These coins are linked
to the value of another asset, such as the U.S. dollar, and secured by a
basket of assets. The value of stablecoins is protected from price
volatility through this reserve basket, which minimizes risk from
potential transaction failures. Smart stablecoins or algorithmic
stablecoins control their supply by using algorithms to mint additional
assets when demand increases. Stablecoins cannot be exchanged for
fiat currency, and they have no legal or regulatory backing. One of the
most popular stablecoins is Tether, which is pegged to the U.S. dollar. A
special case of stablecoins is an asset-backed token, which maintains
price parity with a target asset, such as gold. We will discuss these
tokens in more detail later in this reading.
Professor's Note
The TerraUSD stablecoin was pegged to the U.S. dollar
"algorithmically" instead of being directly linked to the underlying
collateral value. In May 2022, the 1:1 peg failed after significant investor
withdrawals and its value collapsed, resulting in a run on several
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stablecoins.
In general, meme coins are launched for entertainment purposes. In
some cases, their rapid rise in popularity has allowed early purchasers
to sell these coins for a quick and significant profit. The most popular
meme coin is Dogecoin, which is based on a popular internet meme. In
May 2021, Dogecoin saw a dramatic increase in market value thanks to
social media endorsements. However, a year later, its market value
dropped sharply as its usefulness came into question.
As mentioned, governments do not currently back or regulate
cryptocurrencies. Nevertheless, central banks are currently exploring
the potential benefits of cryptocurrency equivalents as alternatives to
physical currency. A central bank digital currency (CBDC) is
essentially a digital version of a banknote or coin issued by a central
bank.
When physical assets like real estate change hands, considerable work
is required to verify ownership. Tokenization uses DLT to streamline
this process by digitally tracking the historical record of ownership. A
nonfungible token (NFT) is an example of tokenization in which a
digital asset is linked to a certificate of authenticity. The key difference
between NFTs and "fungible" tokens is that each NFT represents a
distinct object. For example, digital artwork is a common application for
NFTs.
A security token digitally tracks ownership rights in publicly traded
securities. A blockchain can facilitate the custody, settlement,
recordkeeping, and post-trade processing of security tokens. With this
single ledger technology, participants can perform various transactions
more easily and with more transparency. An example of a security
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token is an initial coin offering (ICO), which is an unregulated process
in which companies offer crypto tokens in exchange for money or other
cryptocurrency. In an ICO, tokens are issued to investors for future
purchases of products or services. An ICO is an alternative to regulated
initial public offerings (IPOs). ICOs are potentially less expensive and
take less time to raise capital compared to IPOs; however, most ICOs
do not have attached voting rights. Many jurisdictions are considering
regulating ICOs due to an increase in fraud connected to these
offerings.
Utility tokens provide network services, such as service payments and
network fees. In contrast to security tokens that may pay dividends, a
utility token only compensates investors for network activities.
Governance tokens are offered on permissionless networks and act as
voting rights to determine how networks should operate. For example,
a network can maintain stability and integrity by voting on solutions for
a technical issue.
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