In a decade, crypto has grown from a niche experiment into a trillion-dollar financial system. For allocators, it is not just a speculative asset class, but an emerging parallel financial system increasingly relevant for institutional portfolios. Yet this fast-evolving landscape remains opaque and risky to navigate.
Rather than dwelling on the technological or ideological underpinnings of crypto1, I will provide a framework for understanding the crypto financial system.
The Twin Pillars of the Financial System: Assets and Infrastructure
At its core, a financial system is essentially two pillars working together:
Financial assets: They are the claims and instruments that embody value - the “what” of finance2.
Financial infrastructure: They are the institutions and mechanisms that allow those assets to be issued, traded, and settled - the “how” of finance.
Four Fundamental Building Blocks of Financial Assets
1. Currency: The Base Layer of Exchange
2. Debt: Shifting Value Through Time
3. Equity: Sharing Risk and Reward
4. Derivatives: Engineering Risk Management
Eight Fundamental Building Blocks of Financial Infrastructure
1. Issuance & Record-Keeping: Bringing Assets into Existence
2. Payments & Settlement: Enabling Value to Flow
3. Custody & Safekeeping: Protecting Ownership
4. Trading Venues: Matching Buyers and Sellers
5. Clearinghouses: Guaranteeing Settlement
6. Credit Intermediation: Channeling Savings into Investment
7. Risk Transfer Mechanisms: Pooling and Hedging Uncertainty
8. Regulatory & Legal Framework: Enforcing the Rules of the Game
Let’s apply the framework above to the crypto financial system. I'll show their crypto-native counterparts, real-world examples and allocator-relevant insights.
Four Fundamental Building Blocks of Crypto Financial Assets
1. Cryptocurrency: The Digital Base Layer of Value
Just as fiat currency provides a common medium of exchange and unit of account in traditional systems, cryptocurrencies fulfill analogous roles within blockchain economies.
Among them, stablecoins (e.g. USDT, USDC) are the dominant medium of exchange and settlement layer, functioning as bridges between traditional and crypto finance by maintaining dollar parity. Bitcoin (BTC) positions itself primarily as “digital gold,” a non-sovereign store of value, while Ethereum (ETH) powers decentralized computation, as ETH is required to pay for gas on the Ethereum network.
Unlike fiat currencies, these assets are not issued by central banks: Bitcoin and Ethereum issuance is governed by open-source protocol rules, while fiat-backed stablecoins are issued by private entities, usually backed by short-term reserves.
Allocator insight: cryptocurrencies’ return profiles reflect adoption dynamics, security assumptions, and macro sentiment, while their risk profiles are shaped by protocol governance, reserve quality (in the case of stablecoins), and evolving regulatory posture (which is turning more favorable in the US).
2. On-Chain Debt: Lending, Staking, and Stable Value
Debt in the crypto system appears primarily through on-chain lending protocols and staking derivatives. Protocols like Aave allow users to lend or borrow crypto assets, with collateral posted and risk managed algorithmically. These structures mirror overcollateralized lending markets in TradFi.
A second category of debt-like assets is liquid staking tokens, such as stETH (Lido). These instruments entitle holders to staking yield while remaining liquid, functioning like floating-rate debt instruments backed by protocol security.
Additionally, stablecoins serve as the crypto analog of risk-free cash equivalents3 — acting as collateral, settlement medium, and liquidity buffer throughout the crypto financial system.
Allocator insight: the crypto debt layer is programmable and transparent but depends on oracle accuracy, smart contract security, and liquidation mechanics. These are debt markets without underwriters, and enforcement is algorithmic not legal.
3. Tokenized Equity: Participating in Protocol Growth
Where traditional finance uses equity to distribute ownership and align incentives, crypto does so through governance and utility tokens. Projects like Uniswap (DeFi Exchange), Aave (DeFi Lending), and Lido (Defi Staking) issue tokens that offer governance rights and, in some cases, access to future fee revenues or yield mechanisms.
These tokens are equity-like in that they represent a stake in the growth and functioning of a protocol. However, unlike traditional shares, they rarely convey legal claims on cash flow, and governance structures are still evolving.
Allocator insight: tokenized equity offers upside exposure to protocol adoption and network effects, but lacks the legal clarity and investor protections of corporate equity. The value is encoded in code and community, not in board minutes or shareholder agreements.
4. Derivatives: On-Chain Risk Transfer and Leverage
As in traditional markets, once cryptocurrencies, on-chain debt, and tokens exist, the need to hedge, speculate, or structure exposure gives rise to crypto derivatives. In crypto, the demand for derivatives has emerged even faster, given the higher volatility and leverage appetites.
These take the form of options, perpetual futures and swaps — a crypto-native innovation — offered on both centralized exchanges (e.g. Binance) and decentralized protocols (e.g. dYdX).
Allocator insight: crypto derivatives are critical for risk management, yield enhancement, and structural exposure, but they come with underdeveloped infrastructure, fragmented liquidity, and complex interdependencies. Understanding the funding mechanisms, collateral architecture, and exchange integrity is essential.
Eight Fundamental Building Blocks of Crypto Financial Infrastructure
1. Issuance & Record-Keeping: Token Creation and Ledger Integrity
In crypto, assets are issued natively on-chain. Instead of government agencies or corporate registrars, issuance occurs through smart contracts, minting tokens directly onto a public ledger. The blockchain itself, maintained by decentralized consensus mechanisms, becomes the single source of truth for asset ownership.
Protocols like Bitcoin and Ethereum serve as programmable platforms where tokens are launched and records are kept transparently and immutably. No central authority is required to validate ownership.
Allocator insight: this is both powerful and risky. The ledger is public and verifiable, but any vulnerabilities in the smart contract or consensus layer can compromise the integrity of asset records permanently.
2. Payments & Settlement: Transferring Value Across Chains
Where TradFi relies on intermediated payment systems like SWIFT, crypto enables peer-to-peer settlement through blockchain transactions. A transfer of stablecoins or tokens is final and irreversible once confirmed on-chain.
Projects like Ethereum, Bitcoin, and Layer 2 rollups function as global, programmable settlement networks. Cross-chain bridges (e.g. Wormhole) connect different blockchains, though they remain among crypto's most vulnerable infrastructure components and are frequently targeted by hackers.
Allocator insight: crypto settlement is fast and transparent, but bridge hacks, confirmation lags, and network congestion can introduce new failure modes. Settlement finality exists, but its security is only as strong as the chain it settles on.
3. Custody & Safekeeping: From Private Keys to MPC
In crypto, custody is not only a legal framework but a deeply technical challenge. Because digital assets are bearer instruments, whoever controls the private key controls the asset itself. Institutional custody has evolved beyond simple self-custody into more sophisticated models such as multi-signature wallets, multi-party computation (MPC), and regulated third-party custodians.
Increasingly, institutions are also adopting tri-party custody arrangements—structures where a neutral custodian holds collateral on behalf of both trading counterparties. This mirrors TradFi collateral management practices and helps mitigate counterparty risk, a key lesson from past exchange and lender failures.
Specialist providers like Fireblocks, Anchorage, and Coinbase Custody have pioneered secure key-management infrastructures combined with compliance frameworks that meet institutional requirements. At the same time, traditional custodians are entering the space: global banks such as BNY Mellon, State Street, Standard Chartered, and Citigroup now offer or are developing crypto custody services, often in response to institutional demand and regulatory clarity.
Allocator insight: the custody decision is existential: the loss of keys or compromise of wallets is irreversible. Infrastructure must balance security, accessibility, and operational workflows; it is a very different paradigm than the layered, account-based custody chains of traditional finance. The increasing convergence of crypto-native and TradFi custodians—alongside the adoption of tri-party structures—signals growing legitimacy and infrastructure maturity.
4. Trading Venues: Centralized and Decentralized Markets
Crypto trading occurs through both centralized exchanges (CEXs) like Binance and Coinbase, and decentralized exchanges (DEXs) like Uniswap. While CEXs resemble traditional brokers, DEXs are automated protocols that use liquidity pools and smart contracts to match orders.
CEXs offer high liquidity and fast execution, but involve counterparty risk. DEXs are trust-minimized and transparent, but can suffer from front-running, slippage, and oracle dependencies.
Allocator insight: understanding execution pathways such as slippage, venue fragmentation, and custody implications, is key to navigating crypto’s market microstructure.
5. Clearing Mechanisms: Smart Contracts as Settlement Engines
Unlike TradFi, there is no independent clearinghouse in crypto financial system.
On centralized platforms, the CEX itself acts as trading venue, clearinghouse, and custodian - all in one.
On decentralized platforms, crypto uses automated clearing logic built into protocols. DEXs settle trades atomically, as both sides of the transaction occur simultaneously or not at all. Margin systems on DEX such as dYdX or Deribit rely on collateral thresholds and liquidation bots to enforce solvency. Risk is managed by code, not by mutualized clearing funds.
Allocator insight: this structure introduces both efficiency and systematic deleveraging risk. With no delay between trade and settlement, liquidation events can cascade quickly, especially in leveraged environments. This dynamic was clearly demonstrated in 2022.
6. Credit Intermediation: Lending Without Banks
Instead of banks or broker-dealers, crypto uses lending protocols like Aave, Compound, and MakerDAO to connect lenders and borrowers directly. These systems operate with overcollateralization and transparent rules, enforced by smart contracts.4
Borrowers post crypto collateral to borrow other assets, often stablecoins. Interest rates float algorithmically based on supply and demand. Liquidations are triggered automatically when collateral falls below required thresholds.
Allocator insight: credit in crypto is visible but inflexible: no credit scoring, no forbearance, and no legal recourse, only automated enforcement. Collateral composition and oracle dependencies must be monitored closely.
7. Risk Transfer Protocols: DeFi Insurance and Hedging
Crypto-native risk transfer happens via on-chain options platforms, structured product protocols, and decentralized insurance like Nexus Mutual, Etherisc, and InsurAce. These systems allow users to hedge exposures or pool capital to underwrite risks.
However, most protocols remain early-stage, with limited underwriting capacity and strong correlation to systemic market events. More fundamentally, traditional insurance models don’t translate neatly into code. In TradFi, insurance relies on long-tail underwriting (where risks play out over years or decades) and regulated claims processing (which involves legal frameworks, adjusters, and human judgment). These processes are difficult to encode into smart contracts. Smart contracts, by contrast, excel only at binary, short-dated events. Oracles can feed clear data points, but they struggle with ambiguous, long-dated, or disputed claims.
Allocator insight: risk transfer remains an underdeveloped layer, and reliance on protocol-level protection should be viewed as experimental. Current models are better suited for parametric insurance (automatic payouts on clear triggers) than for replicating the nuanced, regulated, and discretionary processes of traditional insurers.
8. Governance & Legal Frameworks: Code, Community, and DAOs
Crypto lacks centralized regulators. Instead, governance is often delegated to token holders via DAOs (Decentralized Autonomous Organizations). These entities control treasury allocations, protocol upgrades, and fee structures through on-chain voting.
While this enables decentralized decision-making, it also creates ambiguity. Legal recognition of DAOs is still evolving, and smart contract law is not yet enforceable in most jurisdictions.
Allocator insight: this is the most novel and ambiguous layer of infrastructure. Governance risks — from voter apathy to malicious proposals — must be treated with the same seriousness as regulatory risk in TradFi.
Summary Table for Breakdown of Crypto Financial System:
What’s Next
For allocators, it helps to remember that financial assets are sources of return and risk, while financial infrastructure is the source of frictions and systemic vulnerability. Every financial crisis throughout history can be traced back to one of these pillars: either the assets were misunderstood (toxic mortgages, speculative bubbles) or the supporting infrastructure proved fragile (exchange failures, excessive leverage). Therefore, the twin-pillars framework provides the lens for examining crypto’s own turbulent journey.
In the next piece, I will walk through the major crises in crypto’s short history, to uncover what lessons allocators should learn, and what systemic gaps remain unclosed.
Matt Levine’s The Crypto Story provides an excellent broad treatment of the technology, ideology, and financial architecture underpinning the crypto space. This article builds on that foundation and narrows the focus to the issues that matter most to allocators evaluating investments in crypto hedge funds.
This framework intentionally excludes commodities/real assets as a fundamental building block. In traditional finance, commodities (e.g., oil, gold, art pieces) are essential building blocks because they represent tangible stores of value.
In crypto, however, direct linkage to real-world assets has been minimal. NFTs, which provide tokenized ownership of unique digital or physical items, has lost traction. Elsewhere, development has been slow in connecting crypto assets to real-world commodities at institutional scale. For now, crypto remains primarily a system of financial claims and infrastructure, not real asset representation.
As we now see, stablecoins occupy a dual position within the crypto financial system. On one hand, they function as digital cash—a medium of exchange, settlement asset, and unit of account in crypto financial system, much like bank deposits in traditional finance. On the other hand, their economic structure is that of a debt obligation, issued by private entities and typically backed by short-term reserves such as Treasury bills and commercial bank deposits.
This duality is reminiscent of light’s wave–particle nature. It explains why users treat stablecoins as if they were currency, while regulators and risk managers view them more like tokenized money-market instruments: private credit claims whose stability depends not on sovereign backing but on the issuer’s solvency and the quality of its reserves.
One notable absence in crypto is unsecured lending. There are structural reasons for its absence. Unlike traditional finance, where unsecured lending is enforceable through legal contracts, crypto’s design makes such practices structurally fragile. Borrowers are often pseudonymous, legal recourse is weak, and high asset volatility necessitates collateral buffers. DeFi protocols like Aave and Compound are built around overcollateralization enforced by code, eliminating the role of credit models or covenants.
Attempts at undersecured lending in CeFi (e.g., Celsius, Voyager, BlockFi, Three Arrows Capital) ended in systemic failures during 2022, reinforcing why unsecured lending is considered one of the riskiest activities in crypto. While new protocols such as Maple Finance, Goldfinch, and TrueFi experiment with reputation- or underwriter-based credit models, these remain hybrid solutions, blending on-chain execution with off-chain trust, and are far from fully decentralized or institutional-grade.
Nevertheless, in future maybe someone will figure out how to do crypto unsecured lending in a smart way. Never say never.