Digital assets should not be dismissed as an asset class
4 min read 14 Feb 2023, 08:46 PM ISTSince digital assets have no underlying cash flows to reward their owners, they are not financial assets
PremiumIt would be an understatement to say that the policy discourse around appropriate regulation of the cluster of technologies clubbed as “web 3" is noisy and polarizing. While India’s digital assets regulatory framework remains a work-in-progress, we need a dispassionate public debate. Digital assets, it has been contended, are not properly assets. The basic tenets of this ‘theory of assets’ could be summarized as follows:
Since digital assets have no underlying cash flows to reward their owners, they are not financial assets. And since they have no utility, they cannot be called commodities. It is a misnomer to call them ‘digital assets’ because unlike other digital goods, like car-hiring software or core banking systems, their electronic code has no utility. And finally, digital assets (like Bitcoin) are rather like a Ponzi scheme (where earlier investors get paybacks from the incoming funds of later investors rather than from organic capital formation through the productive utilization of resources).
While the aforementioned critique of crypto assets is common, we must critically evaluate it in the context of public policy.
Asset ‘creation’ as a organic process: Markets, through institutional capital, attach value to ‘things’ (‘res’ in Latin), and over a time, as participants buy these things for capital appreciation, they become assets. The process of recognizing a particular ‘thing’ as an asset is organic and not deterministic in the way the received narrative would have it. A natural corollary of bottom-up evolution is that any utility of an asset is also a matter for the market to decide.
Art has emerged as an asset class. It has no cash flow, and no utility other than aesthetic value derived from a Monet or a Van Gogh. If the received narrative were true, private equity and other institutional capital would not invest in art. Yet, with an estimated $1.7 trillion in value, it is among the most preferred asset classes, as it preserve capital and often defies other asset-class trends. Gold is another example of a commodity that has no underlying cash flows but is nonetheless treated by people as an asset. While data suggests gold is a poor hedge against inflation, the yellow metal continues to hold sway with large segments of our population. In the same manner, digital assets derive value from expectations of their future value, the variability of which creates a market for these just as differing views of business performance foster the trading of listed stocks.
Do digital assets have any utility?: Independent of what we have suggested above, while cash flows or utility are not necessary conditions to constitute an asset class, there are several digital assets that do have utility within their ecosystems. For example, Bitcoin, the canonical digital asset, acts as an incentive mechanism for validators/miners who solve the so-called double spend problem. Likewise, XRP, another digital asset that’s embedded in the XRP blockchain, serves as a settlement asset for cross-border payments and remittances. Banks across the US-Mexico corridor are using the blockchain to transfer money from Miami to Guadalajara on behalf of migrant Mexicans. Eth, another digital asset, has use cases in automating contingent contracts like escrow arrangements and contingent sales. We could add to this list, but you get the point. So, even assuming utility matters, digital assets are ‘assets’ properly so called.
Are digital assets a ‘Ponzi scheme’?: Before we get under the hood of this question, a brief primer on these. The US Securities and Exchange Commission (SEC) defines a Ponzi scheme, named after an Italian scamster, as a scam where existing investors are paid purported returns from the capital contributed by later investors. A bare perusal of the SEC website would reveal that these schemes can be designed around any asset. The first one, run by Charles Ponzi in the 1920s, was designed around postal stamps. Other examples include digital concierge machines and immigration bail bonds, astrology-based trading, among other things. The other defining feature of a Ponzi scheme is that it typically involves a person vested with fiduciary responsibilities who violates these. Bernie Madoff, a fund manager in the US who was prosecuted for operating a Ponzi scheme with tens of billions of dollars, was convicted in 2009.
To summarize, Ponzi schemes, like any investment fraud, can have any asset at the centre of their deceptive webs, and furthermore, involve fiduciary breach by a natural person towards a class of investors to whom that duty is owed. As we pointed out above, the SEC has prosecuted individuals for Ponzi schemes in traditional assets like bonds and equity. Thus, it is inaccurate to characterize digital assets themselves as an illustration of Ponzi schemes. There is nothing a priori fraudulent about digital assets. Of course, as with any asset, bad actors can always defraud investors by devising a Ponzi scheme around a given digital asset. But that is the subject matter of regulatory jurisdiction, and an appropriate regulator, aided by law enforcement, could prosecute these bad actors.
To conclude, policymakers and regulators would serve India’s public interest best by refraining from metaphors that do not stand the test of rigour in their critique of digital assets and their properties.
Crafting regulatory templates to mitigate market failures and fraud is a better way forward, for it would protect young investors taking their first exposure to this space and will also help safeguard India’s financial integrity by mitigating money-laundering risks entailed by lack of regulation.
Sahil Deo & Mandar Kagade are, respectively, co-founder of CPC Analytics and visiting faculty at Azim Premji University; and founder-principal of Black Dot Public Policy Advisors
