Bitcoin was the first popular open distributed ledger, or more specifically blockchain, created anonymously right after the 2008 subprime mortgage crisis when there was a lack of faith in regulating bodies and what precisely was being traded by the investment banks at the time. For Bitcoin, any transactions or changes must be agreed and verified by consensus on the network before being implemented, where they are viewable by anyone and immutable the change, which is a very handy concept for essentially any transactional agreement and the antithesis of the opaque CDOs (collateralized debt obligations aka the repackaged bundles of subprime mortgages in 2008 with intentionally misleading valuations allowing leverage far beyond what regulations stipulated).
Bitcoin was designed originally to work as a currency where there was total transparency and immunity to any manipulation without the need for relying on third parties to ensure no double spending or misrepresentation. This ability to execute trustless transactions was revolutionary, as the notion of trusting an entity to uphold their end of the bargain or a third party to quality check and arbitrate became superfluous; the concept of trust was removed from the equation entirely as everything is now directly verifiable by any party at any time. A transaction is coded onto an open ledger for anyone to see and impossible for anyone to manipulate, by nature of the network itself.
Potential applications for blockchains, beyond simply sending money back and forth, became apparent and so the concept of smart contracts was born, which was one of the main features built into blockchain Ethereum, and many subsequent blockchains. Futures trading with securities and commodities, insurance contracts, and virtually any transactional agreement can be coded into a smart contract, which is executed automatically when conditions are met, and verifiable by any party, immune to manipulation, allowing any company to remove elements such as counterparty risk, misrepresentation and so on.
Open distributed ledgers with smart contract functionality is a way to grease the wheels of financial transactions of virtually any sort, saving dramatically on time and money for all parties involved. Or so is the claim of many crypto enthusiasts.
How do transactions and securities currently work so reliably?
Currently, when you use a credit card, buy a stock, send money and so on, there are multiple parties responsible for ensuring there is no double spending and all accounts are properly settled. Most transactions appear instantaneously for the user, but the actual assets are not moved or settled until much later.
This is where multinational organizations like SWIFT come in, with which essentially every bank must comply to operate. They stipulate the standards for how banks are to operate and transact with one another, and every bank from JPMorgan Chase, Bank of America, Barclays, Citibank, BNP Paribas, HSBC, Deutsche Bank, Wells Fargo etc. are all members of SWIFT – SWIFT being the backbone of how banks operate seamlessly among each other. SWIFT is so integral to banks being able to operate that one of the main ways sanctions are enacted against a nation (e.g., most recently Russia) is by barring their entry to the SWIFT network.
Then there are the clearing houses such as the DTCC (Depository Trust and Clearing Corporation) which is the main body in the US responsible for tracking, settling and clearing securities aka the stock market and is the backbone for how the world markets can smoothly operate. The DTCC cleared $2.5 quadrillion dollars in settlements last year alone (to put this in perspective the value of all stocks combined in the world in 2022 was 100 trillion dollars). Apparatuses such as SWIFT and DTCC among others are how the financial world operates as it currently does with the level or reliability it currently has despite the Byzantine complexity of global markets.
The importance of securitization of markets and its implication on the tokenization of markets
Back to smart contracts, for assets outside of cryptocurrencies themselves to be implemented into these smart contracts, they need to be tokenized or essentially turned into a cryptocurrency with an immutable pairing to their real-world counterpart. This concept of pairing real-world assets to a token representing them is not unprecedented and is in fact how finance currently functions anyways, by virtue of securities where shares correspond to real world assets.
The securitization of markets is when companies, mortgages, debts, and assets can be packaged into securities and sold or traded among investors. This democratized finances for the world and allowed mass participation, where previously the barrier to entry was too high for normal people. For example, people no longer need to own a company outright to profit from it but can now own smaller shares of a company and still see profit. The securitization of markets led to an explosion of wealth and financial participation in markets. The next step is believed to be the tokenization of markets, further democratizing markets and increasing liquidity in a similar manner to how securitization of markets has done since the 1960s.
Who is claiming tokenization is the next logical step? That annoying guy who never stops talking about Bitcoin? Well yes, but they are no longer the only ones. Larry Fink, CEO of Blackrock, the largest fund in the world, claims “I believe the next generation for markets... for securities, will be tokenization of securities” when speaking about blockchain in early 2023 and praising the ability for instantaneous and trustless settlements. The WEF (World Economic Forum) estimates tokenization will account for 10% of the global GDP by 2027. The BCG (Boston Consulting Group) estimated there will be 16 trillion dollars (~15% of global GDP) of tokenized real-world assets onchain by 2030. Citigroup put out a report in March 2023 detailing how they believe anything with monetary value (houses, stocks, carbon credits, bonds, gold, artwork, patents etc.) can be tokenized and predict securities will largely move to distributed ledgers (e.g., blockchain) in the future, estimating (more conservatively than WEF or BCG) up to $5 trillion in new securities flowing onchain before 2030. SWIFT also believes tokenized digital real-world assets to be the new frontier of finance and have devoted much of their R&D to implementing blockchain into their inter-banking systems since 2017, their results have been the main topic at every annual SIBOS convention since.
The DTCC has also been devoting significant R&D to bringing assets onchain and tokenizing them for increased efficiency, working with SWIFT on the same initiatives, with intent to launch its own blockchain. JPMorgan Chase has put together multiple initiatives since 2022 exploring tokenizing US Treasurys and money market funds to use as collateral in the decentralized finance space of cryptocurrency. JP Morgan Chase and Barclays have already created a private fork of Ethereum called Onyx where they have already successfully tokenized Blackrock shares and used it as collateral in various financial arrangements. The popular consensus is that most institutions will have their own private blockchains but will interact and settle transactions with one another on public decentralized chains so as to maintain the properties which make an open distributed ledger so attractive in the first place, trustless immutable transactions.
U.S. Treasury bills have already been tokenized in many forms, as the backing behind stable coins (cryptocurrency with a 1:1 valuation to the USD) and more recently, smaller onchain treasuries like Ondo Finance and MakerDAO for the public use. Yield from the tokenized US treasury bills is used to create tokens with sustainable APR which can then be used as yield-bearing collateral for loans, similar to how CDOs worked except this time the underlying assets are verifiable and transparent, making it much easier to limit and regulate without leverage going uncontrolled like it did with the previous banking crisis. As more and more securities, such as ETFs, real estate, commodities and so on become tokenized, the volume of value flowing onchain will likely increase dramatically.
How does one capture this incoming value to cryptocurrencies?
This is the trickiest part as the space for cryptocurrency remains rife with scams and hacks. One could simply buy bitcoin as many institutions now are seeking to offer spot ETFs for Bitcoin, but that still ignores the tokenization of real-world assets narrative. Many of these assets moving onchain will be hosted on private blockchains but will still need to settle and interact with public chains and each other on settlement layers, or layer 1 blockchains. So, it behooves one to own cryptocurrencies that are Layer 1 blockchains with smart contract capabilities where settlements are likely to take place: Ethereum (the current standard) along with Solana, Cardano, Avalanche, and many others.
There is a risk that any of these could easily become worthless; generally, the lower the market cap the higher risk the chain could become a “ghostchain” that no one uses for settlements. Ethereum does not scale well with massive volume so there are Layer 2 blockchains that work on top of Ethereum such as Polygon, Optimism, Arbitrum, etc. which decrease operational costs of executing smart contracts on Ethereum. These networks all collect fees with use, which are essentially distributed to holders who secure the network via staking and other mechanisms, basically meaning the higher the utilization of the network the more the price of their tokens go up, where the tokens themselves are used to generate revenue, as they are the gas the powers the smart contract machine, incidentally this makes many of these projects fairly viable for passive income, as they generate income by simply holding and staking them in the various protocols (another topic for another time). That said, most price action is still driven by speculation rather than the revenue a project generates.
Next there are the utilities involved with getting the actual data from the real world onto blockchains in a decentralized and secure manner akin to the blockchains themselves. Just using something like an API or centralized entity to connect data to the real world would defeat the purpose of using a blockchain in the first place as it would reintroduce the risks associated with trust, hacking vulnerability and so on. So there are solutions called oracles, which include projects like Chainlink, Tellor, Band Protocol, among others.
Then there are interoperability projects to ease communications and transactions between chains (private institutional chains and public settlement layers), which would include projects like Chainlink (again), Cosmos, Quant and LayerZero among others. All these projects similarly use their tokens to power their functionality, meaning that as their utilization goes up, it is expected the value of their native tokens goes up.
There are many startup projects already moving directly to minting real-world assets, such as Synthetix and Frax, which both use the aforementioned Chainlink oracle services to bring data onto the Ethereum chain to accomplish the minting. Centrifuge brings structured credit markets onchain which can be used as collateralized yield. Ondo Finance tokenizes U.S. Treasury bonds, corporate bonds among other things onchain which can then be used as collateralized yield in decentralized finance (an entire separate but related topic); they are now managed by Blackrock. Projects like Ripple or XRP seek to perform a function similar to what SWIFT currently does. These are only a small sliver of projects out there working on real solutions with real institutions.
What are the caveats?
Much like the publicly traded companies during the Dot Com bubble, the overwhelming majority of cryptocurrencies will probably be completely worthless in ten years, including some of the projects mentioned above. Relatively speaking, the larger the market cap the “safer” the investment, though the less dramatic the potential profits.
Although simply sorting cryptocurrencies by market cap is no guarantee either; in the top 20 cryptocurrencies by market cap, two of them are explicitly jokes with no utility or purpose other than the humor of their own existence, which demonstrates the market is far from a rational place. Though are some “bluechip” cryptocurrencies such as Bitcoin and Ethereum among others that will almost certainly rise with the tide of incoming value over the years.
Given the high risk associated with cryptocurrencies, they should make up only a small allocation in any investing strategy. The principle of dollar-cost averaging is paramount if one wishes to build a position in any cryptocurrency to mitigate “buying at the top” which too often happens when novice investors first decide to take a more active approach to investing. This means that instead of investing large lump sums into cryptocurrency, one should determine what % of their overall portfolio they want in cryptocurrency and then invest accordingly every paycheck or every month, regardless of whether prices have gone up or down significantly. As with stocks, short-term price movement rarely makes sense.
Soon Blackrock will likely go public with its Bitcoin spot ETF with Fidelity and Goldman Sachs both expressing heavy interest in offering one as well. An Ethereum spot ETF is sure to follow, which will likely offer best exposure to the tokenization of real-world assets thesis for those wishing to stay within their existing financial accounts. Prices are likely to climb prior to ETFs going public meaning there is an opportunity cost with waiting for ETFs to formalize exposure to these crypto assets.
But the appropriate risk profile for everyone is different. If one wants to wade into the bloodbaths of buying cryptocurrencies directly there are a few key recommendations to keep in mind:
- Dollar cost average into any position, markets are volatile and will drop deeper than one thought possible just as they can go up beyond what one thought possible, dollar cost averaging mitigates this volatility.
- If the value proposition of a project does not make sense, then do not invest.
- If something sounds too good to be true, it likely is too good to be true.
- Do not mistake a token price with market cap, XRP may only be a few cents, but its market cap is nearly 32 billion dollars at the time of this writing, statements like “what if XRP goes to $100?” should be a red flag.
- Most advice surrounding cryptocurrencies is ignorant at best or malicious at worst, take everything with a grain of salt. Treat all advice as though it were a used car salesman speaking with you.
- Trading crypto for another crypto is a taxable event, so do not swing trade unless you are prepared for the tax burden.
- Staked income from crypto is taxed as normal income.
- Despite the fiasco with the FTX exchange going under a few years ago, centralized exchanges like Coinbase are generally considered a very safe place to buy and store crypto. Personal storage with hardware wallets is safer and versatile for participating in decentralized finance, but with a higher learning curve and its own risks such as losing your keyphrase, or entering smart contracts incorrectly, in which case the crypto on that wallet will be lost forever.
Much of cryptocurrency is a zero-sum game with predatory practices designed to take your money, but buried beneath the scams and junk there are many legitimate projects making real exciting changes working hand in hand with the institutions that shape our current financial world which may deserve a place in an aggressive investment portfolio.
The ASA Committee on Young Physicians is pleased to present this monthly article series on personal finance. These articles are not written by hedge fund managers or real estate tycoons but by practicing physicians. Some have business degrees and some do not – but every contributor is an anesthesiologist who has some guidance to offer the rising generation of attending physicians. It is not the intention of the committee to offer definitive financial advice, but rather some pearls of wisdom to consider while developing a personal fiscal plan.
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