Alternatives Knowledge Base

Digital Assets

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descriptionAn introductory overview of digital assets as an alternative investment, covering types of exposure, custody and operational risk, valuation challenges, regulatory uncertainty, and institutional due diligence considerations.
tagsdigital-assets, cryptocurrency, blockchain, tokenisation, custody

6 min read

Digital Assets

Important caveat: Digital assets are a rapidly evolving area. Regulatory frameworks vary widely across jurisdictions and are changing. Market structure, custody solutions, and the institutional landscape all differ materially from traditional alternatives. Treat all information here as introductory only. Nothing in this file is investment advice or a view on the merits of digital asset investing.

What It Is

Digital assets are assets that exist in digital form, typically on distributed ledger (blockchain) technology. For investment purposes, the main categories are:

Cryptocurrencies — Native digital currencies (Bitcoin, Ether, and thousands of others). Decentralised, speculative, and highly volatile. Bitcoin is the largest by market capitalisation and is most commonly referenced in institutional contexts.

Stablecoins — Cryptocurrencies pegged to a fiat currency (commonly USD). Used primarily for settlement and liquidity within crypto markets, not as a store of value investment in themselves.

Tokenised real-world assets — Traditional assets (bonds, real estate, private credit, commodities) represented as blockchain tokens. An emerging and growing area. The investment merits depend on the underlying asset; the tokenisation adds transferability but also new operational and legal complexity.

Digital asset funds — Hedge funds, venture funds, and index products that invest in crypto and blockchain assets, using LP or open-ended structures depending on the strategy. These allow institutional investors to access the asset class through familiar fund vehicles with professional management and custody.

Types of Institutional Exposure

Direct token ownership — Purchasing and holding cryptocurrency directly, either through a centralised exchange or a custodial wallet provider. Requires resolution of custody, KYC/AML, and regulatory questions.

Regulated fund vehicles — Investing through a managed fund (hedge fund, closed-ended VC-style fund) removes some operational complexity but introduces dependence on the fund manager’s custody and risk controls.

Infrastructure and venture exposure — Investing in blockchain infrastructure companies, crypto exchanges, wallet providers, or early-stage blockchain protocol developers. This is venture-capital-style investing with technology risk rather than token price risk as the primary driver.

Exchange-traded products (ETPs) — Regulated listed wrappers providing exposure to Bitcoin, Ether, or diversified crypto baskets. Available in some jurisdictions; regulatory approval varies.

The choice of access route significantly affects the risk profile, liquidity, regulatory treatment, and operational burden.

Custody: A Critical Operational Distinction

Custody for digital assets differs fundamentally from traditional asset custody. Understanding this is essential for institutional due diligence.

Private keys — Ownership of a cryptocurrency is controlled by a private cryptographic key. Whoever holds the private key controls the asset. Loss or theft of the private key means permanent loss of the asset — there is no central authority to recover it.

Hot wallets vs cold wallets — Hot wallets are connected to the internet and allow rapid transactions but are exposed to hacking risk. Cold wallets (hardware devices, air-gapped systems) are offline and more secure but less accessible. Institutional custody typically uses a mix.

Centralised exchanges — Crypto assets held on an exchange are technically held by the exchange, not the investor. Exchange failures (including insolvency and fraud) have resulted in total loss of investor assets held on-exchange. Exchange risk is counterparty risk, not custody risk in the traditional sense.

Regulated custodians — Specialist digital asset custodians offer segregated custody using cold storage and multi-signature authorisation (requiring multiple key-holders to approve transactions). Institutional investors should insist on regulated, purpose-built custody rather than exchange wallets for significant holdings. See Operational Risk.

Valuation and Liquidity Challenges

Valuation — For listed cryptocurrencies, market prices are observable 24 hours a day, 7 days a week. However, reported market prices may not be achievable in size — large orders can move markets. For illiquid tokens or tokenised real-world assets, observable prices may be thin or misleading.

For funds investing in early-stage blockchain infrastructure or private protocol tokens (not yet listed), valuation is model-based and shares the same challenges as venture capital or Level 3 private asset valuation. See Valuation Risk.

Liquidity fragmentation — Despite trading 24/7, liquidity in crypto markets is fragmented across dozens of exchanges and geographies. In stress events, liquidity can evaporate rapidly and bid-ask spreads can widen to levels that make orderly exit impossible at stated market prices. See Liquidity Risk.

Regulatory Uncertainty

Regulatory frameworks for digital assets vary by jurisdiction, asset type, and use case. At a general level:

  • In some jurisdictions, certain cryptocurrencies are treated as commodities; in others, as securities; in others, they fall into no clear category.
  • Crypto funds may or may not be subject to fund regulation (e.g., AIFMD in the EU), depending on structure and strategy.
  • AML/KYC requirements for crypto exchanges and custody providers are developing and inconsistently applied globally.
  • Tax treatment of crypto gains, losses, and income is jurisdiction-specific and frequently changing.

Regulatory developments can materially affect the value and viability of specific digital assets. Institutional investors must obtain jurisdiction-specific legal advice before making allocations. See Regulatory Risk.

Institutional Due Diligence Considerations

Due diligence on digital asset funds and managers requires additional steps beyond standard alternatives DDQ:

  • Custody review — Who holds the assets? How are private keys controlled? What multi-signature and cold storage arrangements are in place? Has an independent custody audit been conducted?
  • Exchange counterparty risk — Which exchanges are used for trading? Are assets segregated from exchange liabilities? What happens to investor assets if the exchange becomes insolvent?
  • Regulatory status — Is the manager regulated? Under which framework? Is the fund registered or exempt?
  • Technical risk — Smart contract bugs, protocol upgrades, and consensus mechanism failures represent risks with no equivalent in traditional finance. Has the manager engaged independent technical due diligence on specific protocols or contracts?
  • Valuation policy — How are illiquid or non-listed digital assets valued? Is there independent valuation oversight?

These questions are in addition to — not instead of — the standard operational DDQ. The AIMA DDQ for digital assets provides a framework. See AIMA Due Diligence Questionnaires.

Key Risks Summary

  • Extreme volatility — Drawdowns of 50% or more are not uncommon over short periods. See Volatility.
  • Custody and key risk — Loss, theft, or mismanagement of private keys can result in permanent, total loss of assets.
  • Exchange and counterparty risk — Centralised exchanges have failed with significant investor losses.
  • Regulatory risk — Adverse regulatory changes can affect asset prices, market access, and fund operations.
  • Valuation risk — Fundamental valuation of most cryptocurrencies is highly contested. See Valuation Risk.
  • Liquidity fragmentation — Market depth can evaporate in stress events.

Manual Review Notes

  • Digital asset regulation, market structure, and custody practices are changing rapidly. Specific claims about regulatory frameworks or custody products may have changed since this file was written.
  • Bitcoin ETFs and ETPs have been approved in some jurisdictions and remain unavailable in others. Do not assume any specific approval status from this file.
  • This file avoids statements on the investment merits or long-term viability of any specific cryptocurrency or protocol.

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