Cryptocurrency and Blockchain

Introduction to Cryptocurrency and Blockchain

Given the recent decline in the value of crypto assets, it is essential to clarify how these new digital currencies impact the accounting industry. This article aims to define cryptocurrency, outline potential risks, and explain how blockchain still impacts the accounting and financial sectors.

What is Cryptocurrency?

After the financial crisis in 2008, there was significant interest in creating an alternative currency that was not beholden to government control and didn’t rely on financial institutions to verify transactions. As a result of this, the desire for peer-to-peer lending and decentralized finance such as cryptocurrency was created. Peer-to-peer lending allows two parties to enter a loan agreement and loan funds to each other without an intermediary (e.g. banks). A cryptocurrency is a digital asset that functions similarly to fiat currency and received its name due to the process of using encryption technology for its creation. They may act as both a payment and a virtual accounting system due to encryption technology. A cryptocurrency wallet is necessary to utilize cryptocurrencies. A distributed public ledger known as a blockchain, powers all cryptocurrencies by facilitating the transaction and ownership verification. This helps to verify transactions and keep financial data decentralized since no one institution has exclusive access.

Can Cryptocurrency replace fiat currency?

Many authorities and regulators broadly define money as something that serves as a medium of exchange, a store of value, and a unit of account. For over 1,000 years, fiat currency, also known as real money or physical money, has met all three requirements.

However, most developed countries have already started to reduce their need for real money. Debit cards and electronic money transfers will replace physical cash in a system where governments, banks, businesses, and individuals transfer payments to third parties. The operating costs of these financial systems are substantial and require third parties to ensure the legality of transactions.

These third parties create the need to trust someone else with your money. This trust is often broken. Illegal acts by third parties are contributing to financial crises around the world. Using cryptocurrencies alleviates the need for a third party to verify transactions and vouch for their accuracy. Each party is accurately credited or debited due to the automated consensus process and blockchain technology's ability to validate transactions.

The current virtual currency transcends national borders, laws, and regulations and has advantages and disadvantages. It is not subject to central bank scrutiny or influence like fiat currencies in developed countries.

Interest rates and open market operations are two ways central banks use monetary policy tools to influence employment and inflation. These tools are eliminated by one of the guiding concepts of cryptocurrencies: decentralization. The impact of a complete fiat currency replacement is still being researched and evaluated. This move will either bring about a period of complete global stability or severely affect economic and financial stability.

Due to price volatility, the International Monetary Fund (IMF) advises against using cryptocurrencies as a primary domestic currency. The organization also believes it is vital to address the threat of macro-financial stability and lack of consumer protection. However, the IMF acknowledges that adoption will be faster in countries where Bitcoin's risk is an upgrade to the current financial system.

Risk to uninformed investors

Inadequate regulations:

There is a high degree of unpredictability such as price volatility and manipulation when there are no regulatory frameworks. Entrepreneurs and investors are also concerned about future regulations that might significantly lower the value of cryptocurrencies or even result in their outright prohibition.

Recently FTX, a cryptocurrency exchange filed for bankruptcy. One of FTX’s service offerings is risky trading options which are not legal in the US. The new Chief of FTX revealed various blunders under the previous chief which includes misusing customers' funds. When Binance announced that it will be selling its FTT tokens (a token native to FTX that improves the utility of FTX such as reducing transaction fees, rebates, etc.) due to several revelations, traders rushed to withdraw from FTX. A staggering amount of $6 billions over 3 days was being processed. However, FTX faced liquidity issues in meeting this request.

Market recognition:

For a variety of reasons, including regulatory uncertainties, technological limitations, market volatility, misunderstandings among the general public, and the fact that cryptocurrencies and the underlying blockchain technology that underpins them are still relatively new, market adoption is still low.

Privacy, protection, and consumer rights:

It can be dangerous to store cryptocurrency and other digital assets. Significant fraud and theft have occurred in the past. If cryptocurrencies are not correctly stored and protected, hacking continues to be a problem.

Price volatility & manipulation:

Cryptocurrency prices fluctuate a lot. Investors who have witnessed huge gains and losses over the last decade are baffled by the booms, busts, violent swings and frauds.

For example, the coin metrics chart below compares BTC (red) and the S&P 500 by 30d daily return volatility. Due to the volatility fluctuations of Bitcoin (BTC) and other crypto assets, building trust and securing profits is challenging for investors, especially retail investors.

Figure 1.0

To conclude, cryptocurrency can be a suitable investment for those with a high-risk appetite who have complete knowledge of the risks involved. The possibility of crypto replacing fiat depends on its acceptance and legalization. Due to the fact that it isn't pegged or backed by reserves (an exception is stablecoins which are crypto coins pegged to some stable currency e.g., US dollar) and its high volatility, economies are concerned about its stability and future. Cryptocurrency is still in its infancy and needs to evolve to accommodate these requirements.

Crypto in Accounting

Although cryptocurrencies are a form of currency, they cannot be accounted for as cash or digital currency due to their volatile nature. At the moment, there are no established accounting rules for cryptocurrencies. Therefore, accountants are constrained to use standards that already exist. Since cryptocurrencies do not have a physical form, it is best classified as intangible assets. Intangible assets may be valued or assessed at a cost under IAS 38.

While it is debated how crypto fits into financial statements, a more critical point for the accounting industry is the underlying blockchain technology that crypto introduces. With the inception and growing use of blockchain/smart contract tech, accounting firms are poised to adopt it.

Blockchain promises the benefit of increasing accounting information reliability by reducing transaction processing time and counter-party risk (Pugna & Duţescu, 2020). These benefits are gained due to how a smart contract operates. A smart contract automatically executes a transaction when a predefined event occurs, such as a deal closure or crypto purchase, minimizing turnaround time and the risk of counter-party disputes. However, as the technology becomes more widespread, so should the practice of auditing these contracts. The goal of auditing a smart contract is to find any potential bugs and security holes in the code and make improvements and suggestions for how to address them. Smart contract audits are commonplace in the Decentralized Finance (DeFi) industry.

Even if this signifies more work for accountants and auditors, if blockchain's potential advantages materialize, they could more than offset the adoption cost.

Conclusion

Although cryptocurrency often takes the media spotlight, the blockchain technology it introduces could have a far more significant impact than these novel digital assets. While crypto and other digital assets have undergone scrutiny for their volatility by regulators, the potential benefits for the accounting and finance industry as a whole could increase efficiency substantially with smart contracts. While most mainstream media focuses on the crypto news, the more mundane blockchain technologies could significantly impact the industry.

Bibliography

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Härdle, W. K., Harvey, C.R., & Reule, R. C. (2020). Understanding cryptocurrencies. Journal of Financial Econometrics, 18(2), 181-208.

Pugna, I. B., & Duţescu, A. (2020). Blockchain – the accounting perspective. Proceedings of the International Conference on Business Excellence, 14(1), 214–224. https://doi.org/10.2478/picbe-2020-0020

Reiff, Nathan, and Somer Anderson. “Will Cryptocurrency Replace Fiat Currency?” Investopedia, 29 April 2022, https://www.investopedia.com/tech/bitcoin-or-altcoin-can-one-them-replace-fiat/. Accessed 14 November 2022.

Huang, Kalley. “Why Did FTX Collapse? Here's What to Know.” The New York Times,

18 November 2022, https://www.nytimes.com/2022/11/10/technology/ftx-binance-crypto-explained.html. Accessed 1 December 2022.