On 22 May 2010, Laszlo Hanyecz bought two pizzas in Jacksonville, Florida, for 10,000 BTC. This was the first transaction made using bitcoin - and the value of this transaction is over 2 billion ZAR today, making those the most expensive pizzas in the world. Cryptocurrency is now widely accepted in a variety of African countries such as Morocco, Nigeria, Namibia, Zimbabwe and South Africa. More increasingly, Cryptocurrencies are also being accepted into the retail sectors.
In early 2018, digital currencies, such as Bitcoin or other cryptocurrencies, were banned in Canada and were considered not to be legal tender. Only the Canadian dollar was considered official currency in Canada. Similarly, around the same time, countries like Pakistan, sought to reduce perceived levels of crime such as money laundering and terrorist financing by banning cryptocurrency trading. However, during 2020 these bans have now been lifted and a number of cryptocurrency exchanges have popped up to allow for cryptocurrency trading across these jurisdictions. Since then, plans to introduce a licensing scheme to govern and regulate the transactions processed by the cryptocurrency exchanges are well underway.
What is it?
Cryptocurrency can be seen as a traditional currency, like the Rand or US Dollar, however it can also be seen as a commodity. A commodity is defined as “a raw material or primary agricultural product that can be bought and sold, such as copper or coffee.” Whereas a “currency” is defined as “a system of money in general use in a particular country.” The concept of cryptocurrency brings these 2 concepts together and results in cryptocurrencies being viewed as both a currency and a commodity. Its value is affected by external forces – for example the gold price, or a global pandemic. It is a borderless currency in that your location does not impact its value, i.e. the value of the US Dollar is not the same in South Africa and the EU.
One needs to remember that “Bitcoin” is a type of cryptocurrency and more exist, e.g. Ethereum, Ripple XRP, Litecoin, NEO etc. Bitcoin has just gained popularity by virtue of being the first cryptocurrency, which introduced the underlying blockchain technology upon which cryptocurrencies are built. Each cryptocurrency is run by a different set of rules and it is wise to have all the facts about the different cryptocurrencies that exist before making a decision to invest in a cryptocurrency.
Understandably, a lot of countries are shying away from cryptocurrency because they are not technologically equipped to manage and monitor its usage and movement, leaving them exposed to a number of cybersecurity threats. Another major part of countries’ reluctance is the establishment of digital identities (which come with the digital wallets). A normal person in South Africa, when born, is given an identification number. This number is used by banks and creditors to monitor monetary movements of their clients and potential clients. A similar system, which is as secure, would need to be developed in order to manage and track the finances of those using cryptocurrencies. Platforms that enable people to create said identities exist, but outside of the banking sector entirely, making the banks quite nervous about their place in a digital world.
The Financial Action Task Force (FATF), a global money laundering and terrorist financing watchdog, is an inter-governmental body that sets out international standards aiming to prevent these illegal activities. They have provided direction on the treatment of crypto assets, which requires jurisdictions to regulate crypto assets and crypto asset service providers (CASPs) for anti-money laundering and combatting the financing of terrorism (AML/CFT). Further, jurisdictions are now required to ensure that CASPs are licensed or registered, and subject to effective AML/CFT systems for monitoring and supervision. In the Republic of South Africa (RSA), there are currently no dedicated laws or regulations that specifically govern the use of cryptocurrencies and therefore, no regulatory compliance requirements exist for local trading of cryptocurrencies in RSA. Legal protection or recourse to users, traders or intermediaries dealing with cryptocurrencies is therefore dependant on general common law principles.
How do you account for it?
From an accounting perspective, intuitively, one would think that a cryptocurrency should be viewed as a financial instrument (i.e. the contractual right to receive cash or another type of asset). This is based on the assumption that if we give away a Bitcoin, the receiver has a contractual right to receive cash at some point in the future. However, “cash” has a very specific definition as defined by the International Financial Reporting Standards (IFRS): it is a commonly accepted medium of trade. The “commonly accepted” element of this definition is where this gets tricky. Currently, coins and paper money is commonly accepted as a medium of exchange and is the medium used by entities to present information in their annual financial statements. From a cryptocurrency perspective – we are just not quite there - yet. As cryptocurrency becomes more widely adopted, accounting professionals may begin to challenge whether cryptocurrencies are “commonly accepted”. Currently, cryptocurrencies are treated as intangible assets (e.g. software), thus falling under IAS38 IFRS standard. An intangible asset is an asset that you control, as a result of a past event and from which you expect to receive economic benefits from in the future. Given the current shift to all things digital, and as cryptocurrencies becomes more widely accepted, it could potentially fall into the financial instruments standards where it will be governed by IFRS 9, which talks to contractual rights to receive cash or becomes cash itself; aligning with the existing definition of cash. In terms of the South African Reserve Banks (SARB) position, virtual currencies are not considered to be legal tender in RSA and any merchant or beneficiary may refuse to accept virtual currencies as a means of payment.
The definition of cash is quite broad, but it is important to note that there may be a new definition or separate regulation established to deal with cryptocurrencies. The two separate definitions could run concurrently and perhaps one overtakes the other as we step into the new world of digital money. This will be accelerated as a result of Fintechs, open banking and digital innovations which are exponentially changing the banking world. COVID 19 is a further accelerator as a result of consumers needing an electronic way to transact.
How does it work?
Say you want to buy a Lamborghini (fun fact: Lamborghini officially accepts bitcoin as payment!) - you go to the dealership and say you want to make the purchase. They would say that it’s going to cost you 10,000 bitcoin (based on whatever the spot rate is on the day; the spot rate is dictated by just normal supply and demand economic principles). At that point, you would transfer the amount of bitcoin required to settle the transaction. What happens next, is that the transaction gets recorded on an open ledger (open: because anyone can view it and is not editable). Bitcoin therefore allows for a transfer of value from one party to another without having to go through a centralised trusted third party provider and represents the first digital transfer of value from one party to another without going through a centralised third party (e.g. bank).
People around the world then start to validate this transaction by decrypting it and solving for “hashes”. A “hash” is basically a digital fingerprint made up of a unique sequence of numbers and letters in a specific sequence. People who solve for hashes are called miners. Miners need computers that have heavy duty computing skills and power to go through every single possible sequence of characters until they get to the right combination. Miners get rewarded for contributing computing power to the network to solve these algorithms and the first miner to correctly solve the algorithm get rewarded in the form of cryptocurrency in a proof of stake consensus mechanism which is what Bitcoin is.
Once a miner validates the transaction, the miner gets a reward for validating the transaction - which is a number of bitcoin. The miner who validates the transaction in the quickest time, gets the reward. To maximize the chances of being the first to get the golden ticket – i.e. validate the transaction and get the reward, miners need to have as much computing power as possible. Having this much power in one place, results in a lot of heat being generated. For this reason, “crypto farms” were created where all this equipment is stored in one place, where the temperature can be regulated to keep the computers cool. For this reason, a lot of crypto farms are housed in colder areas like Russia and Iceland. There’s also cheap and stable electricity in the areas where crypto farms are set up - because the farms can’t afford power outages (like load shedding).
A lot of miners in the cryptocurrency space have dropped out of the crypto mining industry because the cost to keep these farms running is starting to outweigh the value. In Wuhan China, the outbreak of COVID-19 and social distancing meant that miners could not physically go into work and mine currencies, creating higher costs than returns. The increase in popularity for this new digital currency has meant that more and more transactions are being made, which means that hashkeys become longer and more complex to solve, a further deterrent for miners. Mining rewards have decreased due to the Bitcoin halving however due to the fact that the number of bitcoin available in the world is limited to 41 million means that this “currency” is not subject to inflation resulting in this scarce resource gaining value when benchmarked against fiat currencies due to its scarce nature.
What does this mean for you?
The world of cryptocurrency has and will continue to evolve, which in turn forces all industries and sectors to re-evaluate how they do business. Governments and industry leaders have begun consultations in an effort to better understand its implications and ensure that they will not lose control as by its nature, cryptocurrencies and distributed ledgers allow power and control to be transferred away from central third parties and decentralise the control to the masses.
Industries and business models that can be disrupted as a result of blockchain and distributed ledgers is:
- Governments
- Exchanges
- Banks
- Central Banks
- Insurance companies
- Credit Bureaus
As cryptocurrencies become investment grade instruments which corporates begin to trade, hold and transact with, there will need to be robust discussions around accounting treatments and accounting policies. This will have an impact on liquidity, capital adequacy and credit risk as new business models are being investigated as to the use cryptocurrencies as collateral. It is only a matter of time for the first client attempt to disclose their AFS with “Bitcoin” as their functional currency which could require the IASB to relook all accounting standards with regards to its applicability to crypto currencies and the new business models which are being attempted by entrepreneurs.
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