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Digital Assets, Web 3.0 and NFTs

By Alek Sawchuk, CFA, CIM 1 September 2021 8 min read

Understanding Cryptocurrency navigates the cryptocurrency space, its inherent risks, blockchain technology and compares Bitcoin versus gold. But just how far does the concept of “digital assets” branch out? Cryptocurrencies are only one part of a much broader digital asset taxonomy. Should you consider these unconventional digital assets for your investment portfolio? This article defines digital assets and their various typologies, risks and upcoming market trends which will likely surface in this ever-expanding-- and rather unconventional, asset space.

We don’t use the word “unconventional” (or assorted synonyms) lightly in this article. Perhaps you’ve stumbled across the term NFTs, or “non-fungible tokens” in the news. Would you be surprised to hear that digital NFT cat pictures have sold for the equivalent of $1,000,000 Canadian dollars? We certainly were! Should these assets be considered strategic long-term investments, speculative gambles, or perhaps very creative money laundering techniques?

It may be too early to say at this point, but in the meantime, meet Genesis:

 

Source: CryptoKitties


Genesis is a CryptoKitty that was born on November 22, 2017 and sold a few weeks later. Apparently it has not been put up for sale since.

The owner of Genesis purchased this CryptoKitty for roughly 247 Ethereum (about $120,000 CAD in 2017). This much Ethereum is currently worth close to $1,000,000 Canadian dollars (at the time of writing).

Since then, other CryptoKitties have popped up in these bizarre “markets”, going for prices in excess of $1,000,000. The NFT descriptions of these Kitties exhaustively outline everything from their birthdays, behaviours, and ancestry (yes, we know this sounds crazy) to their likes and dislikes. So how did we get to this point in the development of NFTs as a digital asset that range from cats, online social media posts and tweets, baseball cards and artwork, just to name a few.

Although cryptocurrencies hold the largest market share of the digital asset space, digital assets can be more broadly described as files created electronically including hand-written notes, social media tweets, artwork and much more. NFTs, which include the most bizarre discussion -inspiring content like virtual “cats” , such as Genesis, being sold online in excess of $1,000,000!  In referencing the visual provided below, we use market capitalization as a proxy for the size of cryptocurrency market share under the digital asset umbrella. Although we do not have a direct market capitalization figure for NFTs specifically, DappRadar-- which tracks sales data across multiple blockchains, shows sales volumes hit close to $2.5 billion in the first half of 2021. 

Top Cryptocurrencies by Market Capitalization (USD denominated)

As of August 25, 2021

Source: Coindesk - https://www.coindesk.com/coindesk20


Here’s a brief history of Web 1.0 to Web 3.0 and how digital asset blockchain technology fits in.

Source: ATB Wealth


Web 1.0 (1989-2005) 

In the early days of the web, there were no algorithms for searching relevant information and users had limited interaction with each other. Static information could be read but was not often updated or transferred. Let’s all take a moment to reminisce about the dial-up internet sound during a time when most were still comfortable calling friends and family on home phones (or maybe from your flip-phone if you were lucky enough to own one).


Web 2.0 (2005-2021))

Facebook and Google, anyone? Social media sites, search engines and their various scripts and algorithms that made user interaction and searching easier and faster are the foundation of Web 2.0 which has allowed users to share information worldwide in a timely manner.    


Web 3.0 (2021 and beyond)

This is where machine learning or Artificial Intelligence (AI) comes into play. Users are still interconnected, but in a more decentralized way, and there is not as much reliance on centralized search engines. Web 3.0 operates through decentralized protocols, the founding premise of blockchains and the foundation of cryptocurrencies. AI and blockchain capabilities could progress to create a web with a more intimate understanding of what you convey in text or voice. AI requires data to analyze, classify and make predictions while blockchain technology enables secure sharing and collaboration of this data. Overall this makes AI more capable. 

An example of this in practice would be if your toaster was connected to your decentralized applications (dApps) and taught itself over time how to prepare different items to suit your preferences without your direct input. This is done through the continuous collection of data. Each time you press your bagel down after it pops to toast it a bit longer, the appliance is communicating that information to the dApp and analyzing the data to come up with the precise cooking time you require. Web 3.0 focuses on decentralization, the Internet of Things, virtual reality and more. It also helps to explain the underlying blockchain technology used by digital assets in the transition to Web 3.0.

How are digital assets bridging the gap between Web 2.0 to Web 3.0?

As mentioned above, Web 2.0 is largely centralized around major search engines like Google and driven by user-generated content—that is, anything created by an individual and shared on an online platform such as a social media page, online forum or website. A major criticism of Web 2.0 has to do with who owns personal data, how it can be used, and the requirements for privacy protection. If this sounds familiar it might be due to news coverage on the multiple antitrust lawsuits filed against large data collectors such as Facebook, Alibaba and Apple. 

The heightened regulation of “big tech” has incentivized the creation of digital assets that can better maintain user data and confidentiality. A cryptocurrency called BAT (Basic Attention Token) actually rewards users with their utility token (more on this later) for spending time watching verified ads tailored specifically for them. This may be a prefered experience to the all-too-familiar reality we have using centralized search engines to find prices on something as mundane as kitchen tables only to be subsequently bombarded by kitchen table ads on our social media feeds afterwards. The public blockchain ledger allows anyone to verify transactions and data stored on the blockchain without compromising their identity or privacy.


Digital asset typology and asset tokenization 

Digital assets must be recorded on a blockchain. Below are a few categories of digital assets that are fairly standard in the industry:


Payment tokens

These are fairly straightforward. Bitcoin falls into this category. Payment tokens are a means of payment and exchange outside of fiat currencies like USD or the Canadian Dollar which are backed by a centralized authority such as the government. Payment tokens offer an alternative decentralized payment tool for products and services outside of traditional intermediary involvement like banks. 


Stable tokens

These have a similar use as payment tokens, but the prices of these coins are “pegged” to track an underlying asset or security. They are marketed as less volatile cryptocurrency.


Utility tokens

A unique concept token gives the holder the right, but not the obligation, to exercise their token to purchase a good or service. This could be something like being the first in line to purchase a product such as an iPhone, or perhaps a token that gives you a full-service car wash.


Security tokens

These are traditional securities such as stocks and bonds that are “tokenized”—that is, converted into digital assets and then issued on a blockchain so they can be traded. Stock and bond ownership can be automated on a blockchain record keeping system for shareholder voting, dividend payments and more. 


Non-fungible tokens 

And last but not least, we arrive back at NFTs, which are arguably the most complex kind of digital asset. Let’s break down the “NF” or “non-fungible” component first.


Fungible versus non-fungible assets

Fungible implies something is mutually interchangeable; in other words, something that can be replaced with an identical good or service. Bitcoin is fungible in the sense you would be indifferent to receiving one Bitcoin from another. The digital asset itself is identical across the board and worth the same amount. 

A non-fungible asset is unique—something like art, real estate, videos, written or digital messages or our CryptoKitty friends. By using digital ledgers via the blockchain discussed in the cryptocurrency article, non-fungible assets can be put into a digital token form and then bought and sold between online users on a global scale. 

Nonetheless, just because a non-fungible asset is “tokenizable” (that is, it can be converted into a digital token form and then bought and sold), it does not mean that all NFTs are good investments. Even NFTs made of celebrity tweets at one point were worth millions. Despite this evident over-speculation, NFTs also offer some unique advantages like ownership chain records using blockchain to safely store collectibles.

 

Final thoughts

NFTs are digital assets, but they can not be used to make cryptocurrency purchases like payment tokens. Blockchain technology and the digital ledger offer a convenient way of verifying that an asset (such as art) was listed by the owner and authenticated as original. Asset tokenization offers conveniences including authentication of assets and ownership chain verification, fast and seamless transaction speeds, and transfer. 

However, the question of whether these types of digital assets should be included in an investment portfolio is likely to persist. Fear of missing out on what looks like an opportunity to make a quick fortune is a common emotion. Recognizing the benefits that blockchain technology brings to the authentication and transfer of ownership of some of these digital assets in NFT form is important. But before jumping into digital assets like NFTs, the reader is cautioned to perform their due diligence and assess all investment risks. These include but are not limited to user-adaptability and adoption, secure storage, and concerns with regulation and taxation. Antitrust and user privacy laws may also one day eliminate the need for digital assets entirely.

Let us wrap up this discussion with an analogy. Purchasing certain NFTs like tweets, collectibles and select digital artwork is akin to buying lottery tickets. An investor may get lucky with their asset gathering increased attention and speculation from the masses which drives up its value. Conversely, the asset may either fail to catch any attention or may go on to lose its novelty, resulting in a decline in value. Having conviction on an NFT is not inherently wrong, but the investor should understand the risks involved and not invest a material concentration of their wealth in it either. 

Would you ever consider purchasing a physical piece of artwork in your home worth 5% of your net worth? Most of us would probably not and such assets at least have a long track record of holding their values—plus, you don’t need a computer screen to look at it. 

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