Introduction to Digital Assets

This article was adopted from Thomson Reuters Practical Law Practice Note: "Blockchain and Distributed Ledger Technology (DLT): Overview".

A. Virtual Currency and Cryptocurrency

The terms virtual currency and cryptocurrency are often used synonymously. However, technically, cryptocurrency is a subset of virtual currency. The term cryptocurrency implies the use of encryption to provide the required security for the currency. As a semantic matter, virtual currency may or may not be encrypted. However, as a functional matter, most digital currency usually involves some sort of encryption.

Virtual currencies and cryptocurrencies are digital representations of value that do not have a central issuing or regulating authority like a central bank, but instead use a decentralized system to record transactions and manage the issuance of new units. Many virtual currencies, including Bitcoin, the most well known and commonly used virtual currency, are based on blockchain technology.

Virtual currencies and cryptocurrencies typically:

• Function as a medium of exchange between natural and legal persons that can be transferred, stored, and traded electronically.

• Are issued and controlled by their developers.

• Are used and accepted among members of a specific virtual community.

• Exist in the form of digital tokens or coins.

• Lack legal tender status, unlike fiat currency, which is issued and recognized as legal tender by a government.

• Have a value that fluctuates, often wildly, like precious metals.

• Are encrypted for greater security. However, the blockchains supporting virtual currencies and, more commonly, the exchanges that sell, trade, and hold these currencies, are increasingly being hacked.

Virtual currencies and cryptocurrencies have benefits, including:

• User identity masking. Most cryptocurrencies are likely pseudonymous and not truly anonymous because participants, although often not directly identifiable, may be discernible using additional information.

• Growing acceptance for a wide variety of financial transactions worldwide.

• Political independence, as they are not tied to a single government.

• Unlike other kinds of electronic payments such as credit cards:

• are transmitted instantaneously; and

• have lower transaction fees.

Although virtual currencies and cryptocurrencies have many useful features, because they lack uniform regulation and can facilitate hard-to-trace transactions, they are favoured by criminals engaged in illicit activities, including:

• Tax evasion.

• The sale of counterfeit goods.

• Human and drug trafficking.

• Money laundering.

• Cybercrime.

Virtual currencies and cryptocurrencies are usually acquired either:

• Through an exchange for fiat currency (in other words, by purchase), which can be done in person or through an online exchange such as Coinbase.

• By undertaking activities, such as mining, completing online surveys, or responding to a promotion. As noted above, mining is a process of solving cryptographic strings in order to verify network transactions. Miners are rewarded with a certain amount of digital currency for each block of transactions that are verified.

Virtual currencies and cryptocurrencies are intended to be used anonymously, though transactions may be tracked by IP address and other data. For Bitcoin, every transaction is publicly shared and stored forever on a public blockchain ledger, which is maintained on unidentified computer networks and available for inspection by anyone.

B. Stablecoins

Stablecoins are a type of cryptocurrency that is tied to the value of an underlying asset, most often a fiat currency like the US dollar. While the value of many cryptocurrencies may be volatile, stablecoins are designed to limit volatility by maintaining a fixed relationship (that is, a “peg”) between a specified quantity of the stablecoin and a specified quantity of the underlying asset.

For example, a stablecoin might be pegged to the dollar in a 1:1 relationship. The peg is maintained by collateralizing the stablecoin with reserves of the underlying asset. Stablecoins combine the benefits of cryptocurrency, including transparency, instantaneous transaction processing, low fees, and privacy, with the stability and trustworthiness of fiat currency.

Stablecoins may be backed by:

• Fiat currencies. These are the most common type of stablecoin, which are fully backed by a fiat currency at a specified ratio. In September 2018, the New York State Department of Financial Services authorized the issuance of stablecoins by Gemini Trust Company and Paxos Trust Company, both of which are pegged 1:1 to the US dollar. The issuer of a fiat-backed stablecoin must maintain a reserve of the fiat currency, usually on deposit with a bank or other third-party custodian, equivalent to 100% of the amount of stablecoin in circulation.

• Commodities. These are backed by commodities, most commonly gold. The physical commodity backing the stablecoin is typically stored in a third-party vault.

• Cryptocurrencies. These stablecoins are collateralized by a mix of cryptocurrencies to minimize risk and volatility and are often over collateralized to further buffer against price volatility.

• A mix of fiat currencies, commodities, and cryptocurrencies. Issuers of these stablecoins aim to minimize risk and volatility by diversifying the collateral pool that backs the stablecoin.

C. Digital Tokens

As blockchain technology has developed and proliferated, so have blockchain-based digital tokens. Digital tokens are typically not intended for use as currency or a means of payment, but rather as a means of access to, participation in, and investment in blockchain enterprises.

Digital tokens primarily take the form of:

• Utility tokens.

• Security tokens.

There is often overlap between these.

D. Utility Tokens

A utility token – also referred to as a digital token or, simply, a token – is a digital representation of value or rights that is offered and sold for the purpose of:

• Facilitating access to, participation in, or development of a distributed ledger, blockchain, or other digital data structure; and/or

• Raising capital for the development of the network or platform.

Utility tokens typically provide holders with the ability to access, via encrypted key, a particular blockchain or network for purposes of:

• Accessing certain benefits or functionality on that blockchain or platform.

• Participating in or developing that blockchain or network, or an associated application, enhancement, related functionality, or related product.

E. Security Tokens

Like virtual currency or cryptocurrency, tokens may be issued by blockchain developers in an initial coin offering (ICO) or similar offering. These tokens may have value, and that value may rise or fall as the result of the efforts of other parties. In many cases, therefore, utility tokens may have characteristics of securities. If so, they may be subject to the securities laws.

Edited by Clare Weaver.