Stablecoin Failures Highlight Need for Crypto Auditing Standards

The crypto-asset landscape is no stranger to volatility, controversy, and the occasional doom call; it has simply been part of the industry’s business from the start. However, recent developments have reinforced the need and importance of crypto-assets to undergo consistent, comparable and objective audits. Specifically, the spectacular failure of stablecoin Terra, alongside governance token Luna, has pushed the conversation around crypto audits to the fore. While the details, of course, vary from project to project, the underlying fundamentals of an audit are the same. The purpose of an audit is – in large part – to report on the accuracy and completeness of financial information disclosed to the public, whoever that may be.

One thing that needs to be clarified, however, before fuller conversations about crypto-asset audits can be had, is what exactly is meant by an audit in this space. The word audit is fairly tossed about by market players, without all the players concerned necessarily knowing what is meant by this term. An audit is not (yet) a comprehensive review of every transaction and entry into an organization, and is not meant to be taken as a guarantee of success or financial health. On the contrary, and in non-technical terms, an audit is a report indicating whether or not the financial data reported complies with the appropriate accounting standards and rules. Standards may vary from market to market, but the point is the same; to answer the question of whether the information consulted by external users is reported in accordance with the agreed rules.

With calls for crypto audits, and in particular stablecoin audits, on the minds of investors and regulators, it’s worth considering exactly what these changes might mean for the broader crypto-asset landscape.

Audit clarity is necessary. One of the first things to address, among the issues that have been raised during the recent volatility in the crypto market, is what exactly does a crypto audit entail? This is a particularly important point and an area where specification will be needed. Since each crypto-asset operates differently, has different fundamental characteristics, and offers a different value proposition to the market, the specifics of any audit engagement will need to vary from instrument to instrument.

For example, a stablecoin audit could – appropriately – focus on verifying and confirming the underlying assets and reserve balances. Conversely, audits related to decentralized finance (DeFi) protocols could focus on the interoperability and security of the interconnected blockchains that drive DeFi transactions. Audit processes, for organizations holding crypto-assets in reserve and reporting those assets on the balance sheet, might be more interested in determining appropriate valuation methodologies.

In any case, the specifics of the audit process will need to be customized based on the cryptoasset in question.

Consistent standards are needed. One of the most significant barriers to broader corporate adoption of cryptoassets has been the lack of consistent, authoritative accounting standards. While the Financial Accounting Standards Board (FASB) has agreed to move certain aspects of crypto-asset reporting to its research agenda, this is only the first of many steps toward rule-making. authoritative for the profession. These initial steps are encouraging, but come several years later when they ideally would have been implemented.

The crypto-asset market has exploded in terms of valuation, usage, and adoption among individuals, businesses, and nation states, with the accountancy profession seemingly left behind in the process. Crypto-assets can indeed represent new and innovative financial instruments, but must ultimately respond to the same economic law as any other asset class. Focusing on developing consistent, objective and realistic standards should be an imperative for accounting standard setters in the future.

Additionally, said standards must retain the flexibility to navigate such a fast-paced space.

Iteration is the key to success. Any market participant who has been involved in the crypto-asset industry will, no doubt, be aware of the reality that this space has evolved via a back-and-forth of unbridled enthusiasm balanced with potential regulatory reach. What may go unnoticed, on both sides of the equation, however, is the need for iterative improvements and the mechanisms that will enable those improvements. No asset class can move from the edge of the internet to a multi-trillion dollar valuation without some evolution along the way.

Auditing standards should not be different. Although the definition of what exactly an audit means may differ, the reality is that market participants, investors and regulators all want the same thing; consistent and understandable information. While various methodologies and options – including the Proof of Reserve (PoR) option which was recently introduced to the market – continue to proliferate, it must be recognized that this process will take time.

In other words, many audit-related solutions will be offered – with many failures along the way – before definitive solutions are found.

Crypto audits and audit-related issues periodically move from fringe conversations to items discussed on mainstream media trade networks, reflecting the dynamic nature of the industry as a whole. Regardless of the position of a specific person or institution regarding the merits or validity of auditing cryptoassets, the reality is that it is a market expectation. Crypto-assets have arrived, permeate institutions and countries around the world and continue to drive market conversations; it is time for the accounting and auditing profession to keep pace with these innovations.

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