Fundamentals of Virtual Assets
Virtual or digital assets utilize distributed ledger technology, such as blockchain, to represent value and ownership in digital form. Cryptocurrencies, like Bitcoin and Ethereum, are the most widely recognized forms of these assets.
In recent years, price surges in cryptocurrencies such as Bitcoin have brought these digital assets into the spotlight as a well-known asset class for investment. Before diving deeper into the cryptocurrency ecosystem, it's important to grasp the common terms and concepts that form the backbone of digital assets.
Cryptocurrencies
Cryptocurrencies are digital assets that exist virtually and are secured with encryption. They function on a decentralized network, bypassing central authorities for their issuance and the processing of transactions.
Blockchain
Blockchain technology, a decentralized ledger spread across a global network of nodes, serves as the foundation for cryptocurrencies. Blockchain technology enables distributed storage and peer-to-peer transactions, and is secured by consensus algorithms and cryptography.
Blockchain is known for being decentralized, traceable, tamper-proof, irreversible, transparent, secure, and programmable. Blockchain technology is used not just for cryptocurrency transactions but also in supply chain management, identity verification, and more.
Bitcoin and Ethereum
Bitcoin and Ethereum are leading cryptocurrencies, both are built on blockchain technology.
Bitcoin, created by Satoshi Nakamoto in 2009, was the first cryptocurrency built on blockchain technology. Its supply is capped at 21 million, which makes it deflationary and is not affected by public monetary policy.
Ethereum, proposed by Vitalik Buterin and others in 2014, introduced a different blockchain infrastructure that allows for the execution of smart contracts. These are self-executing contracts that enable the development of decentralized applications, expanding Ethereum's use cases to include financial services, digital identity verification, and more.
Hot Wallets and Cold Wallets
Hot wallets and cold wallets are the two primary methods for storing cryptocurrencies. Their key difference lies in how private keys are stored and whether they're connected to the Internet.
Hot wallets store private keys on devices with internet access, such as computers or smartphones, offering convenience for daily use but higher vulnerability to online threats and hacks.
Cold wallets, such as hardware wallets, keep private keys offline, providing better security against hacking but less convenience for regular transactions.
Public and Private Keys
Users send and receive cryptocurrency assets using their public keys. The wallet address, which can be likened to a bank account number, is derived from the public key. To receive cryptocurrencies, you need to give the sender your precise wallet address. When users are sending cryptocurrencies, it's essential to carefully verify the recipient's wallet address because once the transaction is made, the transaction cannot be reversed, and any mistake could mean the funds are lost permanently.
The private key functions like a password or PIN for your bank card, verifying that you own the assets in your wallet. It's a long sequence of characters that you need to keep safe and confidential. If you lose your private key, you may not be able to access your wallet and hence may lose possession of your cryptocurrencies permanently.
Centralized and Decentralized Exchanges
Cryptocurrency exchanges are categorized into centralized exchanges (CEX) and decentralized exchanges (DEX).
Centralized exchanges (CEX) operate a centralized order book and a centralized platform, requiring users to entrust their funds and trade information with the exchange. These platforms are known for their quick transaction speeds due to efficient matching algorithms. However, users need to be wary of centralized exchanges misusing their power for unethical business practices.
Decentralized exchanges (DEX) operate without a central authority. Instead, trades are processed by smart contracts on a distributed network, allowing users to trade directly and maintain full control over their assets. Transactions on DEXs are transparent and settled on the blockchain, which means they can be slower, as they need to be processed and verified by the blockchain network.
Risk related to the Virtual Asset (“VA”)
VA prices are extremely volatile and affected by numerous events or factors that are unforeseeable and potentially difficult to evaluate. They include changes in overall market sentiment, changes in acceptance of the VA, regulatory changes, security failures of the underlying network or related trading platforms, related fraud, market manipulation, contagious effect from collapses of major players in the VA market and other further development of the underlying network.
In particular, VA is a relatively new innovation and part of a rapidly changing industry. VA and the VA industry are therefore subject to substantial speculative interest, rapid price swings and uncertainty. In addition, VA operates without central authority (such as a bank) and is generally not backed by government. The slowing, stopping or reversing of the development or acceptance of a particular VA may adversely affect the VA’s price.
Regulations on VA are still developing and increasing. Regulatory changes or actions may materially alter the nature of an investment in a VA, restrict the use and exchange of the VA, or restrict the operations of the blockchain network or venues on which the VA trades, in a manner that adversely affects the value of the VA. In extreme cases, governmental interventions may make VA illegal.
VA trading venues are relatively new and, in most cases, largely unregulated.The unregulated trading venues are typically not subject to the same robust regulation as trading platforms in traditional financial markets, and are not typically required to protect customers to the same extent that regulated securities exchanges or futures exchanges are required.The unregulated trading platforms may therefore be more exposed to theft, fraud, failure, security breaches, market manipulation and insider dealing, compared to established, regulated exchanges for securities, derivatives and other currencies. In particular, some VA trading venues collapsed or closed due to the above issues. As a result, the prices of VA may be subject to larger and/or more frequent sudden declines than assets traded on more traditional exchanges.
VA is vulnerable to cybersecurity attack. Cybersecurity risks relating to a VA’s underlying network and entities that custody or facilitate the trading of the VA may result in a loss of public confidence in the VA and a decline in the value of the VA. In particular, malicious actors may exploit flaws in the VA’s underlying network to, among other things, steal VA held by others, control the network or issue significant amounts of the VA in contravention of the network protocols. The occurrence of any of these events is likely to have a significant adverse impact on the value and liquidity of the VA.
Under exceptional market circumstances, the price of VA and hence the price of VA futures may drop to zero in a short period of time. An investor should be prepared to lose the full principal value of their investment in virtual asset futures ETFs within a single day.