• Stable coin: An anchor in a sea of volatility
Articles:

Stable coin: An anchor in a sea of volatility

07 December 2020

Shehnaaz Suleman, Associate Director, BDO Financial Services
Vikash Mistry, Accounting Trainee,
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It was on the 3rd of January 2009, that Satoshi Nakamura mined the first Bitcoin bringing forth into existence the first block of Bitcoin – the Genesis Block. The intention was to create a decentralized alternative medium of exchange to fiat currency (“paper” money not backed by a scarce commodity but rather by Governments and issued by Central Banks). The value of Blockchain – and most crypto currencies are tied to their durability, liquidity, fungibility, visibility, scarcity and the ability to be accepted as legal tender.

In our previous article, “Financial Evolution: The new world of Crypto” we talk about buying Lamborghini’s and pizzas using Bitcoin, where the merchant would need to perform a conversion between Bitcoin and the relevant Fiat currency at the daily spot rate. Now, wouldn’t it be easier to simply denominate the price of a Lamborghini in Bitcoin or another crypto currency?

Society and businesses in general, thinks in terms of attaching “Dollar” or “Rand” values to goods. We don’t generally think in terms of units of crypto when attaching value to goods (not yet, anyway!). Consequently, the value of crypto is left to be determined by volatile market forces of supply and demand. This price volatility is then compounded by speculators buying and selling off their investment in crypto at the first scent of profit. This makes it difficult to price goods in crypto reliably.

So what is a Stable Coin?

A Stable Coin is a crypto currency that is pegged to a relatively stable underlying asset or commodity. Stable coins may fall into three categories:

  • Fiat Collateralized Coins
  • Crypto Collateralized Coins
  • Non- Collateralized Coins

Fiat Collateralized Stable Coins

These stable coins are backed by a stable Fiat Currency like the USD or the Swiss Franc. Each stable coin issued must be backed by the currency in a 1:1 ratio – the collateral. The currency is deposited with a custodian (this can be any trusted third-party or registered financial institution like a bank) who then issues the Stable Coin. Should the user decide to liquidate their stable coin, the custodian will return the proportionate value in fiat and destroy the stable coin.

In many ways, this type of stable coin functions as a digital version of Fiat currency with transactions recorded on a blockchain based ledger. The benefit of this type of coin, is that it allows for the development of applications like smart contracts around blockchain technology and crypto currencies that require price stability over the term of the smart contract. It is also relatively liquid, allowing for an easy exit from the investment. Currently, the most prominent Stable Coin of this nature is Tether but tokens like Gemini USD and Paxos Stable coins exist which are regulated, with rights to forfeiture embedded in the source code.

The trade off in this scenario, is that the cryptocurrency is no longer decentralized. This led to the development of Crypto- Collateralized coins.

Crypto-collateralized Stable Coins

Instead of Fiat reserves, these coins are backed by reserves of other crypto currencies, ensuring the integrity of a decentralized system. Crypto-collateralized coins address volatility through over-collateralization. This means that for every one Dollar of Stable coin issued, there will be more than one Dollar worth of Crypto maintained, as underlying collateral. The collateralized reserves are then adjusted, as the price of the collateralized crypto varies, to maintain price stability. As a result, there will always be more crypto maintained in the reserves than issued. This relationship is quantified by the collateralization ratio.

How does this work you may ask?

Assume that a collateralization ratio is set at 1:2 due to historic volatility. This means that for every stable coin issued, cryptocurrency twice the value of the issued stable coin, will be kept as a reserve. This provides a bandwidth (200% in our example) within which the price of the underlying cryptocurrency, can fluctuate without impairing the value of the issued Stable coins. The end result is that a higher ratio is required, the more volatile the cryptocurrency.

The exit for a user is quicker than a fiat collateralized coin, as the entire process of liquidating a coin into the underlying crypto is done on the blockchain based ledger, with lower costs. There is a crypto- collateralized stable coin that goes by the name of Maker’s Dai. This coin is structured so that one Dai coin, will always have a 1 US Dollar face value, and is backed by Ethereum as collateral.

In contrast, there are stable coins that are non-collateralized as well.

Non- Collateralized Stable Coin

These coins are not backed by any commodity or currency. They are technology driven coins with the aim to simulate and automate the function of a Central Bank. As the price of a crypto currency fluctuates due to supply and demand, an algorithm – known as an “Oracle” that perpetually monitors the price of the Stable coin. This technology automatically regulates the quantity of this type of stable coin in the market. This means that it would increase the quantity of the coin in the market, when the demand increases or - buy back and destroy coins when the demand decreases.

As these coins attempt to remove the human element in its operations in an effort to mitigate the inherent risk of human manipulation or error, it would represent the closest attempt at an independent and decentralized Stable coin of all the options presented. A Stable coin that is attempting to achieve this is the Basis Coin (a type of non-collateralized coin).

What are the Risks to consider? Fiat Collateralized Stable Coins

  • These are still centralized and require an external third party to store the collateral. There is also the risk that the collateral is vulnerable to theft (physical and digital). This results in additional costs for storage and security.
  • Another key risk is that the collateral may be mismanaged or misappropriated. In order to mitigate these risks, regular independent audits would need to be conducted and strong internal control protocols put in place.

Crypto-Collateralized Stable coin

  • As these stable coins are tied to an underlying crypto currency (or basket of crypto currencies) they are less price stable. Thus, greater oversight is required over the collateralization ratio. If the management of the ratio is automated, auditors would need to inspect and perhaps stress test the source code to confirm that the appropriate parameters are adhered to and operating as intended.
  • Crypto collateralized Stable coins are intimately tied to the health of the underlying crypto, meaning that if the Crypto currency crashes, the collateral is lost. This type of Stable coin requires constant growth and crypto adoption to prevent price crashes and fuel demand. Auditors would need to assess this risk and perhaps formulate a model based on crypto adoption, transaction volumes and average price movements - to perform a pseudo- ‘going concern’ or viability assessment of the underlying crypto.
  • These Stable coins are also programmed to automatically liquidate the coin, in exchange for the underlying crypto when the price drops below a predetermined value. This process would then return to the holder of the stable coin, the underlying crypto currency and with that, all the related volatility.

Non- Collateralized Stable Coin

  • There is a risk that these coins could crash to nil value as there is no collateral. While the ultimate goal of stable coins is to mitigate volatility – it cannot hedge all currency risks.
  • An area of focus for public scrutiny should be the source code of the automated central banks or “Oracles”. A method to enhance transparency, efficiency and accountability – a key characteristic of cryptocurrency – is to consider the development of it in an open source environment.

How do you account for Stable Coins? Crypto Currencies

Presently, crypto currencies are recognized and measured in accordance with IAS 38: Intangible Assets. The reasons are twofold:

  1. On the surface, it may appear that crypto currencies meet the definition of cash in terms of IAS32 having being used to facilitate transactions as a medium of exchange. Diving in however, reveals that there is some complexity to this. While crypto currencies are increasingly being used as legal tender, the use is not as widespread relative to fiat currencies. Additionally, there may be certain jurisdictions that do not have requisite legal frameworks to recognise crypto currencies as legal tender.
  2. As crypto currencies are still subject to significant changes in value due to its volatility, it does not meet the requirements to be recognised as a cash equivalent in terms of IAS 7. This accounting standard defines cash equivalents as being “short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value” .

Stable Coins

Despite the fact that Stable Coin exists and achieves its objective to mitigate volatility, it is not widely used as legal tender in South Africa and around the world. For this reason, it will not meet the definition of cash as outlined in point 1 above. However, certain collateralized Stable Coins may meet IAS 7’s definition of a cash equivalent. In the event that a collateralised stable coin is seen to be a cash equivalent, these coins are likely to fall into the scope of IFRS 9 Financial Instruments.

Entities should assess their use of the Stable Coin in the context of their business model which would then advise the appropriate accounting policy. The following summarises a high level analysis of each type of stable coin discussed earlier:

Fiat collateralised stable coins
These are pegged to the value of a fiat currency in a 1:1 ratio – the value of the Stable coin mimics the value of the fiat currency precisely.

These Stable Coins can be redeemed for the proportionate value of Fiat currency that each Stable Coin represents and is highly liquid.

These Stable Coins may be considered to meet the definition of a cash equivalent as defined in IAS 7 as they can be redeemed for cash (Fiat). This could result in this type of stable coin being accounted for in terms of IFRS 9 Financial Instruments.

Crypto Collateralised stable coins:
While the stable coin itself may address the IAS 7 requirement for stability, the underlying crypto currencies do not presently meet the definition of cash in terms of IAS32 or IAS 7. In assessing the appropriate accounting treatment, an evaluation regarding the derivative definition in IFRS 9 would likely need to be considered.

Additionally, the Crypto Collateralised Coin may fall out of the scope of IFRS 9, because on liquidation of the coin into the underlying crypto currency there is no contractual right to receive (or deliver) cash, another financial asset or exchange financial assets under favourable (or unfavourable) terms. This may also preclude this type of stable coin from being considered a derivative.

Non-collateralized stable coins
These Stable Coins essentially aim to automate the monetary policy applied in a jurisdiction that would traditionally be driven by a Central Bank.

Since this type of stable coin is similar to traditional cryptocurrency, this is likely to fall within the scope of IAS 38 Intangible Assets (see further explanation below).

Overall

Generally, a holding of cryptocurrency meets the definition of an intangible asset under IAS 38 because it is capable of being separated from the holder and sold or transferred individually. In addition, it does not give the holder a right to receive a fixed or determinable number of units of currency. However, not all intangible assets are within the scope of IAS 38 as the standard is clear that it does not apply to items that are in the scope of another standard.

For example, IAS 38 excludes from its scope intangible assets held by an entity for sale in the ordinary course of business (e.g. exchanges/dealers), which are within scope of IAS 2 Inventory.

In contrast, a crypto-asset will need to represent a financial asset for the holder, to be accounted for as a financial instrument. A crypto-asset, that is not an equity instrument or a derivative would still meet the definition of a financial asset if it is both contractual and embodies a right to receive cash or another financial asset. For example, a crypto-asset that entitles the holder to a cash payment, or the delivery of bonds or shares would meet the definition of a financial asset.

Navigating the seas

The infrastructure being built atop Blockchain technology and around crypto currency, is growing exponentially in size and complexity. While still relatively experimental, the technology behind stable coins and Blockchain is helping unhitch our anchors from murky waters so that we may navigate to a more efficient and transparent financial system.

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