Ways to invest in digital assets: direct and indirect

How do you invest directly?

Direct investment means buying digital assets on a digital exchange so that ownership is recorded on the blockchain. A cryptocurrency wallet (on a website or a mobile app) stores the public and private digital codes needed to reach the holdings. Most exchanges are open 24 hours a day, every day.

Digital asset investment formsdirect means you hold the keys; indirect means someone else does

• Direct Memorize ownership recorded on the blockchain
  • Coins and tokens held in a wallet bought on a centralized or decentralized exchange
  • ICO tokens and NFTs tokens from an initial coin offering, and non-fungible tokens: the token itself is yours
• Indirect Memorize exposure through another vehicle, usually for a fee
  • Coin trusts shares of a trust that holds the cryptocurrency
  • Cryptocurrency futures exchange traded, usually cash settled
  • Cryptocurrency ETFs often hold futures and cash, not coins
  • Cryptocurrency stocks exchanges, payment firms, miners, hardware makers
  • Crypto hedge funds long-only, long/short, quantitative, multi-strategy
• Digital forms of non-digital assets Use it real assets put on a ledger
  • Asset-backed tokens digital claims on gold, property, equities
  • DeFi applications financial services run by smart contracts

There are two kinds of exchange.

A centralized exchange is a privately held trading platform. It offers volume, liquidity and price transparency, and trading is electronic and direct. It is hosted on private servers, which is its weakness: if the servers are compromised the whole system can be paralyzed, trading halts and sensitive user information, including keys to custodial wallets, can leak. Some centralized exchanges are regulated, as exchanges or as other financial intermediaries, depending on the jurisdiction.

A decentralized exchange works like the blockchain itself, on a distributed platform with no central coordination. If one computer is attacked the exchange stays up, so attacks are very hard to carry out. The same feature makes it hard to regulate, because no individual or organization controls it, so users can trade with no regulatory scrutiny, which allows illegal activity.

Both types can suffer fraud and manipulation. They are not overseen as stock and futures exchanges are, so individuals or groups can manipulate prices, for example by using social media to hype a coin.

Direct ownership carries its own risks.

• Fraud in many forms: scam initial coin offerings (ICOs), market manipulation, theft, phishing for wallet credentials, and schemes such as pump and dump , where early holders talk an asset up, sell into the rush of buyers, and leave the latecomers with steep losses.
• Lost keys. A wallet opens only with a unique passkey. Lose it and the holdings cannot be retrieved. Roughly a fifth of all Bitcoin is reported to sit in lost or abandoned wallets.
• Concentration. Smaller cryptocurrencies are often held by very few owners. Whales are holders large enough to move the price on their own, which is easy in a thin market.
• Platform failure. Customers who leave coins on a centralized exchange can lose them if it collapses. Coins you hold in your own wallet are not exposed to the exchange.

How do you invest indirectly?

Indirect routes give exposure without owning coins or managing keys.

• A coin trust holds a large pool of a cryptocurrency, and investors buy its shares. The shares trade over the counter and behave like closed-end funds. There is no wallet or encryption to manage. Fees are substantial (in some cases above 2% a year), and the shares may trade at a premium or discount to net asset value.
• Cryptocurrency futures are agreements to buy or sell a set amount at a set price on a future date. They are exchange traded, usually cash settled (no coins change hands) and inherently leveraged. The market is newer than established futures markets, so it may be less liquid and more volatile.
• A cryptocurrency ETF is bought in a brokerage account, so no exchange account or wallet is needed. Typically it does not hold the coins. It uses cash, money market instruments and cryptocurrency futures to replicate returns.
• Cryptocurrency stocks give indirect exposure through businesses tied to digital assets: exchanges, payment firms, companies that accept, hold or mine crypto, and makers of the hardware used to run blockchains. Returns also depend on company-specific factors and the stock market.
• Crypto hedge funds include discretionary long-only, long/short, quantitative and multi-strategy funds. Some mine Bitcoin as well, and they may trade derivatives and lend or borrow coins.

How is a coin trust’s premium or discount calculated?

Use it

A coin trust’s net asset value (NAV) is the value of the crypto it holds per share. Because the shares trade in the market, their price can differ from NAV. The gap, as a percent of NAV, is the premium (price above NAV) or discount (price below NAV).

$$\text{Premium or discount} = \frac{P - NAV}{NAV}$$

Exam tip The base is always NAV, never the market price. Positive means premium, negative means discount.

What are digital forms of non-digital assets?

Asset-backed tokens are digital claims on physical assets, financial assets or financial instruments. They are collateralized by the underlying asset and take their value directly from it: tokenized gold, crude oil, real estate and equities are examples. They can raise liquidity through fractional ownership : a high-priced asset such as a house, a work of art or a precious metal can be split so that several investors each hold a fraction. A ledger record of ownership is transparent and cuts transaction, intermediary and record-keeping costs. Regulators usually classify these tokens as securities, because the holder has an ownership interest in the underlying asset.

Many are issued on Ethereum or other smart-contract platforms, where decentralized applications (dApps) let transactions happen and be recorded on the chain with no central coordinator. The movement to build financial dApps from open-source building blocks is decentralized finance (DeFi) : a marketplace of applications that can act as money, store value, tokenize assets and keep records, with smart contracts handling lending, trading, settlement and payment. Advocates point to faster settlement and lower risk, but the idea is still developing, and most dApps so far have been used to extend leverage for investing and speculating in digital assets.

Go deeper Why customers of a failed exchange can lose their coins

On a centralized exchange, the platform often holds the keys for customers (a custodial wallet). The customer has a claim on the exchange, not coins in a wallet only they control. If the exchange is hacked, mismanaged or fails, those customers may be left as creditors in a bankruptcy and recover only part of their money. In one well-known collapse, an exchange’s liquidity problems became a run on withdrawals within days. The lesson for the exam: convenience and liquidity on a centralized platform come with a single point of failure.

Go deeper Lending and liquidity mining in DeFi (recognition only)

DeFi applications let holders lend coins to a smart contract for interest, or add coins to a trading pool and earn fees. These are the on-chain versions of lending and market making. They are paid for by taking risks: coding errors, thin liquidity and the leverage built into many of the applications. At Level I you only need to recognize that DeFi applications offer lending and trading without a central coordinator.