Understanding Fungible Crypto Assets: Types, Risks, and Accounting

Fungible crypto assets are a critical component of the digital financial landscape, offering versatility and liquidity to users. These digital tokens hold the same value at all times and are interchangeable.

In this article, we explore fungible crypto assets, shedding light on their characteristics, categories, risks, and their impact on accounting.

What Are Fungible Crypto Assets?

Fungible crypto assets are digital tokens that are designed to be interchangeable, ensuring that each unit holds the same value at all times. They have become a popular means of exchange in the cryptocurrency world. It’s important to note that all fungible crypto assets are initially issued by private developers or companies. In some cases, these tokens may eventually evolve into fully decentralized coins over time.

Fully Decentralized vs. Private Issuer

To better understand fungible crypto assets, it’s essential to distinguish between fully decentralized and private issuer tokens.

Fully Decentralized:

  • Indicators of full decentralization may include:
    • The developer is unknown or no longer involved in the coin project.
    • The developer cannot make changes to coin operation protocols without a public vote by a quorum of coin holders.
    • The coin has a well-established trading history, enduring a variety of economic conditions.
    • Coin operation protocols and changes are controlled through a distributed autonomous organization (DAO) with no significant majority coin owners.

Private Issuer:

  • All tokens that are not fully decentralized fall under the category of private issuer tokens.
  • Subcategories include utility tokens, stablecoins, and a catch-all category for other types that do not yet merit separation for accounting purposes, including meme coins and illiquid altcoins.

Private Issuer Utility Tokens

Utility tokens are tokens issued for a specific purpose, such as supporting a decentralized autonomous organization (DAO) or a particular application or platform. However, they may also be traded on centralized exchanges or through decentralized finance (DeFi) platforms. Notable examples include Ethereum’s Ether (ETH), which is the utility token for the Ethereum blockchain. Additionally, some NFT tokens are often considered private issuer utility tokens. It’s important to note that the term “NFT token” is somewhat misleading, as it typically refers to fungible coins issued by developers known for their non-fungible tokens (NFTs). For instance, ApeCoin, issued by Yuga Labs, the developer of the Bored Ape Yacht Club NFTs, falls into this category.

Utility Tokens: Native Tokens

Native tokens are a specific type of utility token issued by centralized exchanges (CeFi or CEXs) or DeFi and decentralized exchange (DEX) protocols. Native tokens, however, are often excluded from the issuer’s financial statements, primarily because they share similarities with equity. These tokens are predominantly issued for fundraising purposes and are primarily used for the exchange’s internal settlements. The value of native tokens often depends on the popularity of the exchange protocol, making them inherently riskier. A notable example is FTX’s native token, FTT, which saw its value significantly affected when the exchange’s reputation was challenged.

Stablecoins

Stablecoins are a unique category of fungible crypto assets designed to maintain a 1:1 exchange ratio with a fiat currency. There are two primary subsets of stablecoins:

  1. Asset-Backed Stablecoins: These coins are backed at a 1:1 ratio by fiat currency or other baskets of assets.
  2. Algorithmic Stablecoins: The circulating supply of these coins is controlled by a smart contract algorithm, which mints and burns coins to maintain a specified exchange rate to another crypto asset or fiat currency. Algorithmic stablecoins carry significantly higher risks.

Other Private Issuer Tokens

The category of other private issuer tokens serves as a catch-all for various private issuer coins. Many tokens in this category are illiquid alt-coins, some of which are colloquially referred to as “meme coins” or “sh** coins.” Meme coins are often created based on cultural movements or as jokes. For instance, Dogecoin (DOGE) was originally created as a playful commentary on the crypto market but has since gained significant popularity.

Illiquid Altcoins

Illiquid altcoins are characterized by low market demand and punishing tokenomics, including high sell fees (e.g., 35% of the sale taken as a fee). As a result, the actual realizable value of these coins is often lower than their holding value. While there is no clear-cut definition of what constitutes an “illiquid” coin, some CPAs support reporting these assets at their realizable value rather than their holding value.

Market depth, which indicates how much of a coin can be bought or sold before significantly affecting its market value, varies across different exchanges. Low market depth can make selling large quantities of these coins rapidly drop their price. However, if a coin is primarily intended for use within a specific platform or game, market depth may not be as critical. For example, the “Clash of Lilliput” coin may have a different market dynamic.

There are no prescribed methods for making adjustments when accounting for illiquid altcoins. At a minimum, it’s advisable to disclose the total amount of illiquid altcoins held, either as a percentage of total digital assets or a dollar amount.

DeFi Instruments

Most decentralized finance (DeFi) products fall into the category of private issuer tokens. This category includes derivatives and synthetics, which are crucial components of DeFi ecosystems.

DeFi Derivatives:

  • These include futures, swaps, options, and other financial derivatives built on pools of crypto assets.
  • In the United States, derivatives are regulated by the Commodity and Futures Trading Commission (CFTC), although the CFTC does not oversee or regulate the underlying coin or token.

DeFi Synthetics:

  • DeFi synthetics are tokens that are typically pegged on a 1:1 basis to an underlying asset, often non-crypto assets like company stock shares.
  • The primary purpose of synthetics is to enable stocks, commodities, and other non-crypto assets to be interchangeable with fungible crypto assets.
  • These tokens can be created either by issuing a new token off a liquidity pool of locked or staked assets or by developing a smart contract with a fixed supply of mintable tokens and an algorithm to maintain a 1:1 value with the pegged asset. Synthetics dependent on an algorithm rather than a liquidity pool may pose risks similar to those of algorithmic stablecoins.

Accounting Implications of Fungible Crypto Assets

The accounting of fungible crypto assets poses unique challenges:

  • CBDCs issued by sovereign governments likely meet the definition of cash or a cash equivalent and should be accounted for as such.
  • To maintain proper internal controls, organizations should segregate CBDCs in their accounting records from other crypto assets and fiat currencies.
  • The new Generally Accepted Accounting Principles (GAAP) standard for crypto accounting does not include CBDCs in the category of “fungible crypto assets.”
  • There is currently no specific guidance on how to report CBDCs on financial statements, leaving room for discretion in classification.

Why Did Many CPA Firms Stop Offering Proof of Reserves Reports?

Proof of reserves engagements, often in the form of Agreed Upon Procedures (AUP) engagements, were commonly used by CPA firms to confirm reserve assets of stablecoins or to confirm balances in restricted customer deposits accounts. However, many CPA firms have discontinued offering these reports for several reasons:

  • Limited Scope: AUP reports have a very narrow scope, focusing on a specific area. CPAs agree to provide a report with observations or findings, and sometimes recommendations. They do not carry the same weight as financial audits, which offer a broader examination.
  • Narrow Verification: For Proof of Reserves, CPA firms were essentially only checking that specific restricted accounts held a certain balance. This verification could miss issues such as the use of balances as collateral to obtain loans, which might compromise the reserve.
  • Cost and Efficiency: There are cheaper and more expedient ways to provide continuous on-chain Proof of Reserves, often involving blockchain technology itself. For example, Gemini is known for providing monthly Proof of Reserves reports directly from a CPA firm.

Conclusion

Fungible crypto assets play a vital role in the digital economy, offering interchangeability and liquidity. These digital tokens can be fully decentralized or private issuer tokens, each with its unique characteristics and risks. Accounting for fungible crypto assets requires careful consideration and appropriate segregation in financial records to ensure transparency and compliance. As the crypto landscape continues to evolve, understanding the nuances of fungible assets is essential for all stakeholders in the digital financial realm.