Cryptocurrencies, blockchain and, more recently, stablecoins have been at the center of accounting and financial conversations in virtually every format for the last several years. The conversation has evolved and differentiated as more mainstream organizations across different industry verticals have invested billions of dollars and thousands of human hours into various blockchain initiatives. Stablecoins—a class of cryptocurrency backed by a reserve asset— represent merely one offshoot of the much broader blockchain and cryptoasset conversation, but it is one that is of particular importance to accounting and financial services professionals. Aside from the price stabilization aspect of the conversation—the most obvious component of how stablecoins operate—there are other factors that need to be considered when analyzing, implementing or working with stablecoins. No single article can be entirely comprehensive or all-inclusive; rather, this piece should be used as a starting point for a robust and constructive analysis of this class of cryptoasset.
Libra may be the most high-profile stablecoin scheduled to be issued and governed by a consortium of organizations, in this case, the Libra Association, but it seems that this is the beginning of trend rather than a one-off occurrence. While traditionally decentralized cryptocurrencies seem to be struggling to obtain mass adoption and usage—due to price volatility, tax and accounting uncertainty, regulatory ambiguity and the lack of a centralized support structure—a stablecoin issued and governed by a group of entities may help address some of these critically important issues. Drilling down to the core issues for accountants, a question that is beginning to be asked is whether stablecoins will encourage a more mature conversation around cryptoassets at large.
Perhaps the most important consideration that is beginning to enter the accounting and broader financial services conversation as its connected to stablecoins is whether the controls in place around the stablecoins themselves are appropriate. No matter if the stablecoin in question is connected to Gemini, Paxos, the Facebook Libra coin or some other future coin that has not yet entered the marketplace, there are a few foundational controls and policies that need to be put into place. The following are three questions to be answered:
1. Are there firewalls in place between the financial information of the individuals or institutions that use, or invest in, the stablecoin, and potential other areas of business connected to the stablecoin? It is important to note, and to communicate to clients, that the handling of financial information necessitates compliance with a variety of regulations, including know your customer (KYC), anti-money laundering (AML) and/or Office of Foreign Assets Control (OFAC) regulations. Every stablecoin is different, and is issued by a different organization, and understanding these controls to safeguard client and other financial data is an important first step.
2. Does the issuing entity have the capacity to handle the changes and updates related both to the underlying blockchain that supports the stablecoin, and to need to keep pace with future changes to financial regulations? With the Bakkt bitcoin futures product approved in August 2019, and increasing IRS enforcement efforts from a tax collection perspective—in July/August 2019—there does appear to be a shift toward increased regulation and standardization in the cryptoassets and cryptoproduct space. This is encouraging from a regulatory and reporting perspective, but it does increase the importance of client firms and practitioners remaining up to speed on these rapidly evolving issues.
3. Are the disclosures and compliances processes ready to be updated as needed? The handling of financial information requires disclosures and compliance processes to be updated and modified to reflect the fact that both blockchain and cryptoassets are already having a fundamental impact on how the data is reported to the marketplace. Additionally, and specifically focusing on the accounting practitioner, the impact that these changes will have on System and Organization Controls Report (SOC) 1 and SOC 2 engagements is still being analyzed and remains uncertain. In either case, the development and implementation of next-stage controls and processes must be a part of the broader stablecoin conversation. For practitioners and firms seeking to offer services in this space, being able to update and modify current services offerings is a critical first step.
Wallet Considerations
An additional area that represents both an opportunity and challenge for practitioners seeking to have constructive and comprehensive conversations with clients is the differences among wallet options in the marketplace. The May 2019 hack of Binance, where over $40 million of bitcoin was stolen via the hot wallets utilized by investors, and the entire conversation surrounding the Calibra wallet to be launched by the Libra Association, raise several significant questions. First, are investors and other users of cryptoassets such as stablecoins fully aware of the risks that are connected to using hot wallets to store key or other ownership linked information? Engaging with clients on this issue, even if might seem tangential to traditional services, does represent a fiduciary responsibility of practitioners, especially given the reality that the vast majority of cryptoassets are not eligible for Federal deposit Insurance Corp. (FDIC) or other types of investor insurance.
Second, even if a cold wallet—widely considered thought to be more secure than a hot wallet—is utilized by a client or client firm, there has to be an analysis and discussion around control factors linked to cold wallets. As evidenced by several headlines surrounding the possibility of viruses and other malware embedded into the hardware itself, the risk of cold wallet hacks is not a theoretical one. Executing appropriate due diligence prior to the implementation of a cold wallet is a responsibility of both CPAs and clients. Even if a paper wallet—a physical representation of keys not connected to any computer—is utilized, physical controls and safeguards must be instituted and maintained. While physical and access controls are perhaps most familiar to most clients and practitioners, they must still be analyzed and discussed prior to adopting a paper wallet for crypto storage purposes.
Stablecoin Redeemability
If a stablecoin, regardless of how it is issued and maintained, becomes part of the conversation and examination, there are several factors that need to be taken into account and built into any implementation strategy. Every stablecoin is different, but the core functionality of price stability and liquidity are embedded in every stablecoin offering, and the issue of redeemability is increasingly also entering the conversation. Redeemability is something that is often discussed with regard to stablecoin functionality, and while this may seem like a technical conversation, it is also one that requires input from CPAs and other financial practitioners. Several coins, including Libra, are publicized as being supported, pegged or otherwise connected to underlying fiat currencies or other external assets. Although redeemability is often publicized and put forward as an asset and advantage for these specific stablecoins, the issue of redeemability must be one that is further discussed and analyzed.
Redeemability can mean several different things depending on the context surrounding the stablecoins, and while not claiming to be exhaustive, three general categories have appeared to manifest throughout the marketplace at large. These are:
1. Direct 1:1 redeemability directly from crypto to fiat or other underlying assets. This might be what many practitioners and investors assume they are signing up for when investing in an asset- backed coin, but that is not always the case. Even when a coin or other cryptoasset is backed and redeemable for the fiat equivalent, there may be several intermediary steps that need to be completed prior to redemption. These steps may add cost, time and complexity to the process of redemption that can burn valuable resources.
2. Redemption or support through FDIC insurance. FDIC insurance is often thought of as the gold standard for stablecoin support, but even this seemingly simple and well-known concept is not as clear as it might initially appear. If a stablecoin, or other cryptoasset, is purporting to have FDIC insurance, an analysis might be conducted to understand what that exactly means. For example, an organization issuing a dollar-backed stablecoin that is advertised as having FDIC coverage may actually mean something else. In essence, instead of dollar assets—or the stablecoin itself—being eligible for FDIC insurance, a bank or network of banks will have custody over the underlying fiat assets. Through the purchase of several classes of instruments, these financial institutions—and not the issuer of the stablecoin—are directly eligible for coverag.
3. Nonredemption, or the ability to redeem only certain stablecoins for the underlying asset in the case of bankruptcy, organizational failure or some other external shock or incident. This is perhaps the type of support that should be examined most closely. For example, and staying away from bankruptcy for the sake of brevity, a stablecoin or cryptoasset that is backed by physical gold reserves may sound like a relatively simple concept. However, if these stablecoins are redeemable only for a gold exchange-traded fun (ETF) or other investable product, that is clearly not the same thing as being redeemable for the gold asset itself. Even more importantly, this distinction may not be clear to investors as these investment options are being considered.
Clearly, the blockchain and broader cryptoassets space represent fast-moving and rapidly changing subsets of the technological and financial economy, and stablecoins represent an interesting application worthy of further analysis. While stablecoins have attracted a large amount of attention, investment and analysis from various market participants, there are several considerations and factors that require further examination if clients or firms are seeking to invest in these assets. Regardless of how the specific stablecoin or cryptoasset functions on an individual level, CPAs and other financial practitioners have a fiduciary and professional responsibility to be well informed and able to discuss these issue with clients now and going forward.
Sean Stein Smith is an assistant professor of business and economics at Lehman College, part of the City University of New York, and is also a visiting research fellow at the American Institute of Economic Research. He can be reached at sean.steinsmith@lehman.cuny.edu.