Icewater
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Icewater

Stablecoin Accounting

The following is a thought experiment, and should not be taken as accounting or investment advice.

The fundamental accounting equation states that the value of a company’s equity (E) is equal to its assets (A) minus its liabilities (L):

E = A - L

Let’s see how this plays out for a two token stablecoin. Let’s say the first token is an ownership/governance token called E-token. The second token is the stablecoin. Let’s call it L-coin. The reason for this is that we are going to treat the stablecoin as a liability of an algo-bank.

Why should we consider the coins as liabilities? Before the advent of fiat currency, banks would take deposits of collateral (say, gold) and issue notes that entitled the bearer to get that much collateral back. Thus, banknotes are liabilities. For a stablecoin, the algorithmic central bank may not literally give back collateral in exchanged for people turning in coins, but it has ultimate responsibility for making sure that people can exchange their coin for something of value somewhere else.

So E-token represents equity, and L-coin represents the liabilities of the contract. Now let’s kick things off by issuing 100 E-tokens via airdrop to random addresses. Since no one paid anything for them, the par value of each E-token is $0, and the total amount, E, is also still $0.

Let’s also assume that this is a very stable stablecoin, run by a competent and responsible team. So L-coin maintains a constant, positive value (say, $1 per L-coin) as long as it is able to keep its books balanced. But, since E = 0, L must also be 0. So to maintain balanced books we must have exactly 0 supply of L-coins in circulation. In fact, let’s suppose for a moment that L is able to maintain stability (via some unknown mechanism) as long as it balances its books.

Now, suppose some savvy investors decide that the idea and the team behind L-coin is very promising, so they buy up all the E-tokens at a total price of $100 (i.e., $1 per token). We can model this as an acquisition of the stablecoin entity. When the acquisition happens, there is a disconnect between the actual market value of the entity ($100), and the book value ($0).

To address this, we need to introduce something called goodwill. Goodwill is an intangible asset that arises when a company is acquired. According to Wikipedia:

Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business...Examples of identifiable assets that are goodwill include a company’s brand name, customer relationships, artistic intangible assets, and any patents or proprietary technology.

So now we have an asset, goodwill, worth $100. But let’s suppose these savvy investors realize that a stablecoin is no good if there are no coins in circulation. So they issue 100 L-coins and issue 1 L-coin to each E-token holder, who then trades them off on the open market (for $1 each).

Since they don’t have a mechanism for collecting collateral, that just adds $100 to the liability column. Now we have:

Liabilities (L) = 100 L-coins = $100

Assets (A) = $100 (goodwill)

Equity = A - L = $100 - $100 = 0

That is, after the acquisition the entity gave away a bunch of coins and go nothing in return, so the overall value of the entity is back to $0.

After that, an even more savvy group of investors decides that they know better than the first group of savvy investors, so they buy up all the E-tokens from the first group for $1 each. The first investors think this is a really good deal, since they spent $1 per E-token and then already got $1 back (from selling their L-coin). So if they exit now at $1 they essentially doubled their money.

So now we have to add more goodwill because there has been another acquisition at a higher price than the balance sheet suggests. That is, currently E is back to 0, and the deal is for a total of $100. So we need to add another $100 in goodwill. And, once again, immediately after buying the E-tokens, the new investors issue themselves 1 L-coin each (a total of $100). So the balance sheet goes back to zero, like this:

Liabilities (L) = 200 L-coins = $200

Assets (A) = $200 (goodwill)

Equity = A — L = $100 — $100 = 0

And the cycle continues, with each new group of investors adding goodwill, and taking newly minted L-coins in return. And that, my friends, is how stablecoin accounting works!

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Icewater builds blockchain technology for the future. Our primary product is H2O, a stable coin that focuses on long-term stability

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Redbeard

Redbeard

Patent Attorney, Crypto Enthusiast, Father of two daughters

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