Stablecoin Failures Highlight The Need For Crypto Audit Standards

The cryptoasset landscape is no stranger to volatility, controversy, and the occasional calls for its doom; that has simply been part of doing business in the sector since the beginning. Recent developments, however, have reinforced the need and importance of cryptoassets to undergo consistent, comparable, and objective audits. Specifically, the spectacular failure of the Terra stablecoin, alongside the Luna governance token, have thrust the conversation around crypto audits back to the front burner. While the details, of course, vary from project to project, the underlying fundamentals of an audit are the same. The objective of an audit is – in large part – to report on the accuracy and completeness of financial information being reported to the public, whoever that public might be.

One item that needs to be clarified, however, before more comprehensive conversations around cryptoasset audits can be conducted, is just what exactly is meant by an audit in this space. The word audit is tossed around quite a bit by market actors, without everyone involved necessarily knowing what is meant when that term is referenced. An audit is not (yet) a total review of every transaction and entry at an organization, nor is supposed to be thought of as a guarantee of financial success or health. Rather, and in non-technical terms, an audit is a report on whether or not the financial data being reported is done so in compliance with the appropriate accounting standards and rules. Standards can vary from market to market, but the point is the same; to answer the question whether the information being seen by external users is reported in accordance with agreed upon rules.

With calls for crypto audits, and especially stablecoin audits, on the minds of investors and regulators alike, it is worth examining just what exactly these changes might mean for the broader cryptoasset landscape.

Audit clarity is needed. One of the first things that will need to be addressed, among the issues that have been raised during the recent crypto market volatility, is what exactly a crypto audit will entail? This is an especially important point, and an area where specification will be required. Since every cryptoasset operates differently, has different fundamental characteristics, and delivers a different value proposition to the marketplace, the specifics of any audit engagement will need to vary from instrument to instrument.

For example, a stablecoin audit might – rightly so – focus on the verification and confirmation of underlying assets and reserve balances. Conversely, audits related to decentralized finance (DeFi) protocols might be centered around interoperability and security of the interconnected blockchains that drive DeFi transactions. Audit processes, for organizations holding cryptoassets in reserve, and reporting these assets on 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 depending on the cryptoasset in question.

Consistent standards are required. One of the most significant obstacles toward wider cryptoasset adoption among enterprises has been the lack of consistent and authoritative accounting standards. While it is true that the Financial Accounting Standards Board (FASB) has agreed to move certain aspects of cryptoasset reporting onto its research agenda this is simply the first of what will be many steps toward defining authoritative rules for the profession. Such initial steps are encouraging, but come several years after when such steps would have ideally been implemented.

The cryptoasset marketplace has exploded in valuation, utilization, and adoption amongst individuals, enterprises, and nation states, with the accounting profession seemingly left behind in the process. Cryptoassets may indeed represent novel and innovative financial instruments, but ultimately must answer to the same law of economics as any other asset class. Focusing on developing consistent, objective, and realistic standards must be an imperative for accounting standard setters moving forward.

In addition, said standards must retain the flexibility necessary to navigate such a fast moving space.

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

Audit standards should be no different. Although the definition of what exactly an audit means can differ the reality is that market participants, investors, and regulators all want the same thing; consistent and understandable information. As various methodologies and options – including the Proof of Reserve (PoR) option that has recently been introduced to the marketplace – continue to proliferate there needs to be an acknowledgement of the fact that this process will take time.

In other words, there are going to be numerous audit related solutions put forward – with many failures along the way – before definitive solutions are achieved.

Crypto audits and audit-related issues periodically swing from fringe conversations to items that are discussed on mainstream media business networks, and that is reflective of the dynamic nature of the sector at large. No matter the position of any specific individual or institution regarding the merits or validity of auditing cryptoassets, the reality is that this is an expectation of the marketplace. Cryptoassets have arrived, are permeating institutions and countries across the globe, and continue to drive market conversations; it is time for the accounting and audit profession to keep pace with these innovations.

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