The Digital Asset Ecosystem: A potted history and some terminology

In the beginning

The origins of crypto assets trace back to the cypherpunk movement of the 1980s and 1990s. The cypherpunk movement was rooted in libertarian principles with a group of cryptographers, programmers, and privacy advocates who believed cryptography could be a tool for social and political change. They championed the idea of using encryption to protect individual privacy and resist surveillance. Among their goals was the creation of decentralised digital money, free from government control. This vision laid the groundwork for Bitcoin, which was introduced in 2008 by the pseudonymous Satoshi Nakamoto as a peer-to-peer electronic cash system built on cryptographic principles and a decentralised ledger, the blockchain. 

In the aftermath of the Global Financial Crisis (GFC) the climate was perfect for the deployment of new technology that could by-pass the traditional financial services ecosystem, including the banks, much blamed for the dubious practices that played their part in causing the general global turndown. 

The technologies that have evolved into this space are novel and have facilitated the creation of new markets which, as intended, initially sat outside of the remit and oversight of the central banks and other authorities.

However, regulatory approaches are now adapting to these innovations and are starting to regulate them alongside traditional financial services products with the intention of providing a safe, stable and sustainable way for them to thrive as part of the wider financial services ecosystem. These technologies have the potential to have beneficial impacts on the future of financial services, including in the retail space, by for example, speeding things up, lowering costs, increasing efficiencies, improving customer choice, improving functionality, and enabling better transaction monitoring.

Satoshi Nakomoto

In 2008 a mysterious entity (possibly an individual or group of persons the identity of whom is still unknown) created a way to transfer value that relied upon trust being placed in the underlying technology and not in a person or entity. This technology does not require banks, central banks, or central authorities. In this sense, it is “trustless”, it is the technology that provides all requisite validation. 

Bitcoin 

Bitcoin was the first blockchain to emerge, with the genesis block being mined in January 2009. A bitcoin (BTC) is a token or unit of digital currency used within the Bitcoin network. BTC in its simplest form, is a digital store of value. BTC has a fixed supply of 21 million coins. Research indicates that 19,919,465.625 Bitcoin have been mined to date, which leaves 1,080,534.4 left to mine. This is anticipated to happen in 2140, that is in 115 years. The price of BTC has experienced wide fluctuations, but since its inception has presented, overall, an upward trajectory. 

Blockchain

In simple terms, a blockchain is a database, a form of storing data. A blockchain is a type of digital ledger that records transactions in a secure, transparent, and tamper-resistant way. It is made up of a chain of blocks, where each block contains a list of transactions and is linked to adjacent blocks using cryptography.

Distributed Ledger Technology (DLT)

Blockchain is one of many kinds of DLT. DLT is an umbrella term for a system which uses a ledger or database that stores and records data, for example, of dealings and transactions, which is shared and synchronised across multiple computers (or nodes) in a network. It is simply software plus a data structure. As the ledger is stored and maintained across multiple servers by multiple people (i.e. distributed), there is no central or “master” copy of this ledger but instead, many identical copies which are simultaneously updated. In other words, it is a decentralised database. 

Who has access?

The security of DLT derives from protocols or rules and from encryption written into the software. Everyone who has access to the data must follow the rules applicable to the data block, everyone shares the same data, and the data cannot be amended without being shared or validated by everyone who has access to it. “Everyone” for these purposes means the members or participants of the network on which the DLT runs. 

Each blockchain will enforce differing consensus mechanisms which set the parameters of who can validate transactions, add blocks of data, read the data, and the authentications required. Most data validation processes use “hash technology” to validate data through the consensus mechanism. 

Cryptocurrency

Cryptocurrency is a form of digital rights or digital value. Typically, cryptocurrency uses DLT to store data across networks of participants. There are various forms of cryptocurrencies based on their intended use cases, such as stablecoins which are pegged to fiat currencies or commodities, utility tokens used to access and transact on native blockchains, governance tokens for voting on-chain, security tokens representing real-world securities, privacy tokens for anonymous transactions. One prominent cryptocurrency is Ethereum (a utility token), which utilises a proof of stake consensus mechanism for its blockchain enabled by smart contracts that activate on the occurrence of agreed pre-conditions (for example, payment on receipt of goods). 

Mining

The term “mining” refers to the process by which new tokens are created, and transactions are verified on a proof of work blockchain (such as Bitcoin). Miners compete to solve mathematical calculations that validate transactions and entries on the ledger. 

Staking

Staking on a Proof of Stake (PoS) network is a process where participants lock up a certain amount of cryptocurrency to collateralise through this trustless consensus mechanism validating ledger transactions. In return, they can earn rewards.

Liquid Staking

Liquid staking is a form of staking that allows users to earn rewards on staked assets while still maintaining liquidity. Instead of locking up tokens in a traditional staking setup, users receive a tokenised representation of their staked assets (often called a "liquid staking token") which can be traded, used in DeFi protocols, or transferred, giving flexibility without sacrificing staking rewards.

Slashing

Slashing is a penalty mechanism where a portion of a validator’s staked tokens is slashed by the network due to misbehaviour or failure to follow protocol rules, such as double-signing or node inactivity. It is designed to incentivise honest and reliable participation in securing the network.

Stablecoins

Stablecoins are a digital asset designed to maintain a stable value by being pegged to a reserve asset, such as a fiat currency, a commodity, or a basket of assets. 

Some stablecoins are classified as digital settlement assets (DSAs). DSAs are defined in the Financial Services and Markets Act 2023 as “A digital representation of value or rights, whether or not cryptographically secured, that: (a) can be used for the settlement of payment obligations; (b) can be transferred, stored or traded electronically; and (c) uses technology supporting the recording or storage of data (which may include distributed ledger technology).”

At present, in the UK, stablecoins are not subject to regulatory standards equivalent to those applicable to traditional forms of money issued by commercial banks. However, they are subject to recent Financial Conduct Authority (FCA) discussion and consultation papers. 

In summary, the current proposals look at regulatory requirements for fully backed stablecoins pegged to a single fiat currency, with protected rights and abilities to redeem them at par with fiat, clear lines of accountability, and responsibility for risk management and regulatory compliance. 

Smart Contracts

Smart contracts are not contracts in the traditional sense. Smart contracts are a self-executing program stored on a blockchain that automatically carries out actions when certain predefined conditions are met. The technology that stipulates and records the chain of events (including receiving money to certain bank accounts) is embedded in the blockchain.

DeFi

Decentralised Finance (DeFi) refers to a financial ecosystem built on blockchain technology that operates without traditional intermediaries like banks or brokers. Instead, it uses smart contracts to enable peer-to-peer transactions, lending, borrowing, trading, and more. DeFi aims to make financial services more open, transparent, and accessible to anyone with an internet connection.

CeDeFi

Centralised Decentralised Finance (CeDeFi), is a hybrid financial model that combines the benefits of DeFi, such as transparency, accessibility, and blockchain-based smart contracts, with the oversight, user protections, and infrastructure of centralised institutions. In CeDeFi, users access DeFi-like services (e.g. staking, lending, trading) through centralised entities, which often provide enhanced security, compliance, and customer support.

DAO

A Decentralised Autonomous Organisation (DAO) is a blockchain-based entity governed by smart contracts and community voting, rather than a central authority. Members use tokens to vote on proposals, enabling transparent and democratic decision-making.

The 2022 crypto winter

The term "crypto winter" refers to a prolonged period of declining prices and negative sentiment in the cryptocurrency market. Prominent crypto winters have occurred in 2018 and 2022. 

Between 2020 and 2021 the nascent cryptoasset markets experienced a boom. As in the traditional financial markets, bust follows boom, and a number of significant market shocks were experienced in the cryptoassets sector during 2022. 

In May 2022 the TerraUSD stablecoin and sister token LUNA collapsed causing billions in losses and destabilised trust in algorithmic stablecoins. Terraform Labs, is at the centre of multiple investigations and legal proceedings and is facing charges in the US, including for fraud, criminal conspiracy, and money laundering. This collapse led to a mistrust of algorithmic stablecoins and triggered a liquidity crisis across DeFi and CeFi platforms. In addition, several crypto hedge funds and platforms (including Three Arrows Capital, Voyager, and Celsius) were heavily exposed and later collapsed.

In November 2022, FTX a major exchange, also collapsed when it was revealed it was misappropriating customer funds to its sister company Almeda Research leading to a bank run. FTX was unable to meet withdrawal demands and filed for bankruptcy on 11 November 2022. 

These two major events caused shockwaves through digital asset markets. Several well-known stablecoins temporarily lost their pegs to the US dollar exposing vulnerabilities in stablecoin design, governance, and market dependencies. In addition, some crypto exchanges such as BlockFi and Celsius froze withdrawals and subsequently declared bankruptcy due to liquidity issues. Some lenders to the sector (including many well-known banks) which had significant exposures to tech start-ups and crypto firms also had to file for bankruptcy such as Silicon Valley Bank. This period is known as the “2022 crypto asset winter” and it had the effect of highlighting the risks associated with the crypto markets and knocking market confidence.

The present day and looking to the future

We are currently still in what might be described as an exploratory phase. Developing industries are still relatively nascent. Use cases of these technologies are on the increase but still not widespread. They are sometimes developed and maintained by entities that we may not know much about. They tend to be speculative and volatile, they can de-peg from the assets that they were intended to match, they can be difficult to value from one day to the next, and for these reasons are not yet widely accepted as reliable for everyday use by all kinds of consumers. 

Although these technologies were created to exist outside of the traditional financial services system, the regulation of some of them has the potential to provide more widespread confidence in them and to unlock them for safe and sustainable use by more consumers, including by retail consumers.

The potential benefits of enabling these innovations to integrate with mainstream financial services include boosting economic activity, improving efficiencies, lowering costs, improving convenience and functionality, added resilience and contingencies, and promoting financial inclusion which, in turn, promotes greater economic participation.

Same risk, same regulatory outcome 

The latest regulatory initiatives look to bring fiat denominated fully backed stablecoins into line with accepted regulatory standards to enable them to be widely used in everyday transactions while providing a level of protection against loss of value, confidence to the markets, and financial stability.

The regulatory approach will be intended to promote an environment where the same risks generate the same regulatory outcomes. Accordingly, to the extent that novel products and services present similar risks to traditional ones, they should be subject to equivalent regulatory standards. This does not mean that innovations will be regulated in identical ways to traditional financial products and services, but in a way is flexible and that while it accommodates novelties and differences, ensures equivalent regulatory outcomes in terms of risk resilience.

The FCA’s 2025-2030 Strategy

In 2024 the FCA published a Crypto Roadmap outlining its plans for developing cryptoasset regulations, with the aim of the regime going live in 2026. The proposals are set out against the background of the FCA’s ambition to foster a safe yet competitive cryptoasset sector encouraging innovation while ensuring consumer protection. 

In its latest strategy document, the FCA re-states the importance of strong and innovating financial services together with the need for trust in the sector’s firms, services and regulator. The FCA’s growth strategy is embedded in its secondary objective. The topic is wide and includes many inter-related technology initiatives including:

• Embracing technology and innovation to harness technological advances;
• Transformative AI and machine learning;
• Digitalisation;
• Open Banking and Open Finance; and
• Rebalancing risk.

Other regulatory initiatives

The government has paved the way for the financial services regulators to expand their remits to include stablecoins as part of the wider growth agenda. The different regulators each have different roles in the digital asset ecosystem and different functions and activities will have different regulatory hooks. However, the regulators work collaboratively and have published various discussion and consultation papers alongside each other. This note only skims the surface of the various digital transformation initiatives that are in train across the industry.

You can read our note about the FCA’s recent steps towards the future of digital asset regulation with DP25/1 which looks at coherent activity-based regulation (including crypto trading platforms, custody, lending, staking, stablecoin issuance and redemption, DeFi and credit for crypto purchases) by clicking here. Other initiatives include the Bank of England’s (BoE) collaborative consultation on the use of sterling-denominated stablecoins in the payment system, where they have potential for widespread use in everyday payments. The BoE has proposed a regulatory framework for systemic payments systems and service providers that could address the risks associated with these new technologies and in doing so, unlock innovations in payments.  The BoE has also consulted (jointly with HMT) with industry on the introduction of a digital pound or “central bank digital currency” (CBDC) which could co-exist with and complement existing forms of money, cash and bank deposits, and be widely used for everyday payment requirements. 

The BoE and the FCA have jointly launched the Digital Securities Sandbox (DSS) which provides a live regulated environment in which innovators (as well as existing financial services firms) and new technologies can be tested, and joint and collaborative learning can evolve, in such a way as to support and promote the application of flexible and proportionate regulation to the application of technology to the trading and settlement of securities. The DSS is intended to run to 2029 and will focus on innovation in financial market infrastructure which could improve the trading processes by making them more efficient leading to costs savings across the financial markets, including to pension firms, investment firms and banks. HMT is also running a pilot in relation to a digital gilt instrument (DIGIT) to explore, with industry stakeholders, the use of DLT in the financial markets and in the UK sovereign debt issuance process. This links into a wider initiative to digitalise the wholesale markets and position them to realise the potential benefits of new technologies such as DLT.

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