Digital Asset Market Evolution.

• Author: Kaal, Wulf A.

1. INTRODUCTION 910 II. DIGITAL ASSET MARKET 913 1. Bitcoin vs. Altcoins 913 2. Initial Coin Offerings 917 3. Venture Capital 920 4. Initial Exchange Offers 921 5. DeFi 923 a. Decentralized Exchanges ("DEXs") & Protocols 925 b. Lending and Borrowing 925 c. Trading 927 III. DIGITAL ASSET MARKET EVOLUTION 927 1. Market Volatility 928 2. Funding Source Volatility 930 3. Challenges for Early Stage Investors 931 4. Regulatory Uncertainty 932 5. Cyber Security 935 6. Crypto Economics 935 7. Coins of Two Realms 936 a. Private Realm 936 b. Public Realm 937 8. Convergence of Asset Classes 945 9. DeFi Evolution 947 a. Growth Estimates 947 b. Growth Factors 952 A. Decentralization 953 B. Disintermediation Beyond FinTech 954 C. Counterparty Risk Management 955 D. StableCoins 955 E. DAO Prospects 957 c. Growth Limitations 958 d. DeFi Infrastructure Case Study 959 IV. CONCLUSION 963 I. INTRODUCTION

   The market in digital assets continues to evolve. The emergence of the Bitcoin protocol in 2009 (1) inaugurated and gave rise to the market in digital assets. (2) Its rapid proliferation in 2016-18 was followed by significant downward corrections, called the "crypto winter" of 2018-19. The continuing creation of digital assets and the funding for the creation of digital assets is subject to ongoing market changes and changes in investor priorities.

   Digital assets can be narrowly defined and broadly defined. Narrowly construed, digital assets are instantiated through computer code and depend on so-called consensus computer algorithms to trigger and validate a transaction in a given digital asset. Broadly construed, digital assets can include virtual assets such as video games in the broadest sense, and items sold in video games can be virtual assets. Virtual assets do not necessitate a consensus algorithm that validates the transaction or provides a level of security.

   For the purposes of this article, digital assets are defined broadly. Digital assets cover all types of virtual and electronic assets, regardless of how they are otherwise named or categorized by regulatory agencies, including cryptocurrencies, security tokens, utility tokens, virtual assets, virtual collectibles, stablecoins, altcoins, among others. Digital assets can be distinguished from stock because stocks are not inherently digital and have strong ties to the world of hard assets. Bitcoin is a purely digital asset because it only exists in the virtual world.

   Blockchain technology has enabled the emergence of the digital asset market. (3) The digital asset market was possible through a form of upgrading the internet era with decentralized technology and cryptocurrencies. (4) Blockchain technology (5) allows securities offerings and stock transfers with all the characteristics of a physical stock transfer, yet the blockchain-enabled stock transfer is completely digitalized and virtual. Much of the media attention has centered on the uses of decentralized technology to support the issuance and trading of Bitcoin and other cryptocurrencies. (6) Blockchain technology offers a number of attractive features to potential issuers of traditional securities who wish to experiment with digital assets. Benefits to issuers, and to those who process trades in the offering after-market, include lower issuing, operating, and administrative costs. (7) In the securities trading context, blockchain could provide indisputable proof of current ownership of "digital securities," any transaction in those shares, and the resulting changes in ownership of the shares, in a form that is available to multiple securities market participants (e.g., investors, brokers, regulators).

   The nascent digital asset market presents an opportunity for the establishment of a new asset class that attracts mainstream investors. The global consensus record of information and transactions that is enabled through blockchain technology enables the much-needed transparency in finance. At the beginning of the 2020s, investors in the digital asset market range from retail to institutional, as well as exchanges, broker dealers, investment banks, custody providers, IT firms, and other players in the ecosystem. Yet, blockchain technology opens global access to finance, including in areas of the world where the banking system is not readily available and the unbanked constitute large parts of the population. (8)

   The funding sources for digital asset startups have an impact on the digital asset market. Since 2016-17, the funding sources for digital asset startups and blockchain startups moved from equity funding to initial coin offerings (ICOs), to equity offerings, and initial exchange offerings (IEOs), just to return back to equity funding in the early 2020s. Because equity investments in blockchain startups make it less likely and less necessary for the respective startups to issue digital currencies, at least as a funding source, the market for digital currencies and the total volume of issued digital currencies are likely to recede when the funding market moves from ICOs back to equity funding.

   The emerging market for DeFi has the potential to impact the overall digital asset market. Proponents of DeFi often claim that DeFi involves the development of an upgraded monetary system built on public blockchains. (9) The expected customer base of such an upgraded and distinguishable monetary system could involve the 1.7 billion unbanked individuals plus the crypto communities of the western hemisphere. In the early 2020s, most DeFi applications are built on open-source networks such as Bitcoin and Ethereum, which enable such decentralized applications (Dapps) to disintermediate financial activities via permissionless and censorship-resistant blockchains. (10)

   Normatively, this Article points out that the expected growth rate of the DeFi, according to diverse sets of estimates, is substantial enough to call into question the long-term viability of the decentralized technology infrastructure without core infrastructure improvements. The author provides a case study to illustrate the possible shortcomings of the existing DeFi infrastructure.

2. DIGITAL ASSET MARKET

   Throughout history, evolving markets were subject to evolution and de-evolution cycles. (11) The nascent market for digital assets is no exception. The emerging market for digital assets follows a similar evolution and de-evolution pattern. Since its inception in 2009, the rapid proliferation of the digital asset market in 2016-18 was followed by significant downward corrections in 2018-19 (called the "crypto winter"). (12)

   Digital assets and decentralized cryptocurrencies are different from fiat currencies. Key differences include what their respective values attach to, the supply level, and the respective storage methods. The value of fiat currency, once backed by gold, is tied to the trust citizens have in their country's economy, government, and central bank. In theory, decentralized cryptocurrencies, such as Bitcoin, are different. They are often designed with a fixed supply to be anti-inflationary. Cryptocurrencies can be stored and transferred without any central entity involvement. They are designed to bypass existing financial intermediaries.

   1. Bitcoin vs. Altcoins

      The evolution of digital assets (13) started with Bitcoin, the first digital asset, launched in 2009. (14) Bitcoin's blockchain consensus mechanism, Proof-of-Work, uses a 256-bit signature secure hash algorithm that was first designed by the NSA to solve computationally investment puzzles that validate transactions and create new blocks. (15)

      Bitcoin's design prevents double spending, (16) a situation where a sum of money is illegitimately spent more than once. (17) Bitcoin had no financial backing or intrinsic value and no centralized issuer or controller (18) and facilitated peer-to-peer transactions. (19) Bitcoin was first traded in 2010. (20) The Bitcoin whitepaper published by Satoshi Nakomoto outlined the technical foundations and blockchain technology underlying Bitcoin. (21) Each Bitcoin represents a transaction that is registered on a public open ledger. (22) In order for a new transaction to be added to the block, it must be approved by the miners. The transaction is then linked to a chain comprising all the previous blocks--that is how the blockchain is formed. Any changes to the data on a blockchain are made by consensus among all members of the decentralized network, thereby eliminating the need for an intermediary between the originator and recipient. (23) In its limited supply by design and growing marginal production cost, Bitcoin resembles a commodity. (24) Bitcoin has a maximum supply of 21 million units. (25) "Bitcoin's monetary base is pre-programmed to grow at a predictable, decreasing rate that will reach zero in 2140." (26)

      The success of Bitcoin has inspired the introduction of other digital currencies, called alt-coins. (27) A coin is a cryptocurrency that can operate independently; a token is a digital unit that provides to its holder access and use of a larger cryptoeconomic system with no independent store of value but instead holds utility value. (28) Altcoins have grown to represent as much as 60% of cryptocurrency market capitalization. (29) Between 2014 to mid-2017, approximately seven cryptocurrencies launched per week while roughly the same number of cryptocurrencies were abandoned at the same time. (30) As of May 2017, approximately 1,500 cryptocurrencies had been introduced to the market, 600 of which were actively traded at that time. (31) As of October 2018, the cryptocurrency market consisted of more than 212 coins and tokens, (32) which jumped to over 5,300 cryptocurrencies as of April 2020. (33)

      The second most important cryptocurrency in terms of market capitalization after Bitcoin is the Ethereum network's token Ether, which launched in 2016. (34) As of October 2018, an average daily transaction count for Bitcoin was 200,000 and...