Crypto asset’s quoted price on DeFi: which fair value level under IFRS 13?
The application of the “fair value” method to the accounting valuation of crypto-assets has been called for, for several years, by many companies and professionals in the field of accounting. Most of them would like to see rules more adapted to the accounting of capital gains and losses effectively applied to the accounting of this class of assets that make up their portfolio — which is not allowed by their categorization as “intangible assets” [1]. And that is about to happen, as the FASB has officially declared that companies should use “fair value” to value bitcoin and other crypto assets[2] — and is currently working on a draft standard to endorse what is currently only a recommendation.
While this announcement is positive, the application of international accounting standards such as IFRS 13 to determine the fair value of a crypto asset is not without some questions. In principle, according to a three-level hierarchy set out by IFRS 13, the use of a “quoted” price in legal tender allows for the highest level of reliability of an asset’s fair value to be determined (we will come back to this point). However, there are assumptions where crypto assets do not benefit from a fiat currency pricing, as they are only traded against other crypto assets. For these assumptions, IFRS 13 remains silent as it stands. This remains problematic when a “principal market”[3], the criterion for determining the source from which the fair value of a (crypto) asset should be derived, takes place within a DEX (decentralized exchange); in other words, where there can be no price directly expressed in legal tender. In the silence of the texts, we must then seek, by analogy, what would be the most reliable hypothesis resembling that of a “quoted price” in legal tender on an active market. In this case, given the imperatives of risk management, how should we consider a price expressed, for example, in “stablecoin” — a crypto-asset that is intended to be as close as possible to the value of legal tender — within the hierarchy of fair values?
In order to answer this question, we will first give a brief description of this hierarchy according to IFRS 13, before being able, by means of a syllogism identical to that presented in the aforementioned classification, to make a few reflexive proposals about the level of stablecoin price data.
“Fair values hierarchy” under IFRS 13
Let’s take a few moments to review the notion of the fair value hierarchy:
· Level 1 fair value: a quoted price (unadjusted) available in an active market:
According to article 76 of the EU regulation adopting certain international accounting standards[4], including IFRS 13 (we will refer to it as the “IFRS 13”), Level 1 inputs are considered to be “quoted prices (unadjusted) that are available to the entity at the measurement date in active markets for identical assets or liabilities” — a quoted price would, again according to IFRS 13, provide “the most reliable evidence of fair value” [5]. As described in the IFRS 13 letter through various illustrations, this is typically a price for an asset made available in the “TradFi” markets[6].
· Level 2 fair value: an observable input other than a Level 1 input:
Very simply, IFRS 13 gives a negative definition of Level 2 fair values. They represent inputs “other than quoted prices included in Level 1 inputs that are observable either directly or indirectly” [7]. It also sets out a non-exhaustive list of different types of inputs that may be considered Level 2: “quoted prices in active markets for similar assets or liabilities; quoted prices in markets that are not active for the same or similar assets or liabilities; inputs other than quoted prices that are observable for the asset or liability (for example: observable interest rates and yield curves at customary quotation intervals, implied volatilities, and credit spreads); market-corroborated inputs” [8].
· Level 3 fair value: an unobservable input:
Finally, Level 3 inputs are “unobservable inputs for the asset or liability” [9]. In other words, these are situations where price data cannot be publicly available or audited (for example, the value of a share of an unlisted company), and requires the application of approaches other than market analysis to determine the fair value of an asset or liability.
Seeking a “quoted price” in DeFi in the face of risk management
Based on this definition grid, we were able to observe that the most reliable fair value is based on the use of a “quoted price” for an asset or a liability. This notion of “quoted price” is therefore central in determining the level of fair value. In other words, it is a decisive criterion for measuring the risk that the use of a fair value represents in the accounting valuation of a (crypto)asset. This quoted price is classically understood as the price of an asset or a liability on a stock market, and where this same price is naturally expressed in legal tender.
However, tokenization has laid the foundations of a new form of digital market for asset exchanges, and with it, a new way of expressing the price. This notion of price in “legal tender” is indeed much more circumstantial, in that the price of a crypto asset is not systematically expressed in fiat currency. If it seems inconceivable to exchange one listed company stock for another in TradFi, it is possible to exchange one crypto asset for another. This is even the principle on which exchanges on decentralized markets or DEX operate today. Given this assumption, could the price of one crypto asset expressed by another crypto asset be considered a quoted price (Level 1 fair value), in line with the traditional IFRS view?
While we can hardly answer this question in the affirmative for most prices expressed in crypto assets such as bitcoin, ethereum or other protocol tokens whose volatility is no longer in question, it is worth pondering this question further under the prism of prices expressed in stablecoin.
A price expressed in stablecoin: a possible new conception of the Level 1 “quoted price”?
As the name suggests, and unlike other crypto assets, these stablecoins tend to represent the value of a legal tender numerically, and are therefore supposed to have a certain “stability” in their price. On the face of it, this would be the most analogous assumption to the price of a traditional asset quoted in legal tender, transposed to Finance 3.0. But can we consider a stablecoin in the same way as a price quoted in legal tender, and of greater a priori reliability, namely as Level 1 input according to IFRS 13? Without getting into the debates about whether or not crypto assets should be considered legal tender, we need to look at the legal side (and not the accounting one[10]!) of the equation to assess the legitimacy of using a stablecoin as a Level 1 measurement value.
Stablecoins are generally issued by legal entities registered with national or even supranational regulators, under the aegis of regulations designed ab initio for traditional financial service providers. Both Circle Internet Financial LLC and Tether Limited are registered as “Money transmitters” [11] under the U.S. “Money Services Business Act” (MSB Act) of 2008, for the USD Coin (hereinafter “USDC”) and USD Tether (hereinafter “USDT”) respectively. Circle is also registered with the Financial Conduct Authority (UK regulator) as an “electronic money and payment institution” under the EU “Electronic Money” Directive[12], the European equivalent of the MSB Act. By virtue of these statutory registrations, these entities are subject to certain prudential rules regarding the protection of their funds[13]. These rules are mainly aimed at guaranteeing that the issuer of electronic money (in this case stablecoins) maintains a sufficient reserve of funds in legal tender to ensure the “nominal value” of the electronic money in circulation. The issuers of stablecoins are subject to periodic and independent audits and controls of these reserves of value. However, it is clear that these audits are not carried out with the same frequency for each stablecoin issuer[14], which can represent a greater or lesser risk. Finally, in the interest of investor protection, these prudential rules ensure that the issuer complies with its legal obligation to redeem the funds in fiat currency[15]; in effect, it is a prudential obligation to maintain reserves, since they need the means to repay stablecoin users, who hold a real claim. NB: while these stablecoin issuers are today, at least for some of them, registered with financial regulators on their own[16], the recent adoption of the European “MiCA” regulation will impose the application of the e-money Directive to issuers of “e-money tokens”[17] (the new legal qualification for stablecoins) that meet the criteria of e-money. This will result in the general application of the above-mentioned prudential rules — at least for entities wishing to issue an e-money token within the European Union.
Prudential rules, a claim to par value, (more or less frequent) audits of reserves, supervision of compliance with legal obligations by a regulator… all these are legal indications that a stablecoin is fulfilling its function as a “digital representation” of a legal tender. The difference between stablecoin and legal tender, beyond the liberating effect of the latter, is that trust in the stability of the former is based on the application of legal norms that protect the claim of the stablecoin user; whereas confidence in legal tender is purely organic and, a fortiori, state-based. In any case, this suggests that a stablecoin could serve as a quotation for a crypto asset in the same way as a price traditionally quoted in legal tender. In other words, a price expressed with certain stablecoins (selected according to different legal criteria to verify their “stability”) could theoretically be classified as Level 1 input, subject to the textual acceptance of a new conception of “quoted price” by the FASB[18].
However, as IFRS 13 currently stands, there are other indications that a price expressed in stablecoin could not legitimately be a Level 1 fair value.
A price quoted in stablecoin on a DEX: an inevitable Level 2 or even Level 3 fair value?
The acceptance of a stablecoin price as a Level 1 fair value under IFRS 13 comes up against a major requirement: in all cases, the asset or liability will ultimately have to be recorded in legal tender. The various conversion steps (1: crypto A to stablecoin, 2: stablecoin (crypto B) to fiat) are effectively assessed in determining fair value. More specifically, the existence of such a plurality of conversions in practice affects the level of the input used to determine fair value.
Some auditing firms, like PwC[19], believe that it is undeniable that crypto-to-crypto market peers (stablecoin or not) should be considered only as Level 2 input. PwC justifies this, on the one hand, by the fact that the price of the first conversion step is adjusted by the price of the second step, added with the transaction fees (Level 2 input) that apply to each conversion step in case of sale of the asset; and on the other hand, the existence of a “spread”, i.e. a risk of exchange rate mismatch between the different transaction steps, does not allow in fine to reflect the same fair value of the crypto asset A as if its price had been observed directly in fiat currency.
We might ask: would a price that is not “directly observable [in legal tender]” [20] necessarily be “estimated using another valuation technique” [21], implying in addition an adjustment to the level 1 input (application of a second conversion step)? In other words, should the application of this double conversion necessarily be considered as an adjustment lowering the level of fair value within the meaning of article 79 (a) of IFRS 13, in that the addition of a conversion step does not seem to correspond to any of the “other techniques” mentioned by the said standard? The answer is certainly yes: the various conversion steps (even fictitious ones) used to determine a price in legal tender increase the risk of price variation from one converted asset to another, because they take place over a longer period of time than the application of a single conversion (crypto-to-fiat).
Finally, although there is no provision in IFRS 13 that seems to take transaction costs into account in assessing the level of a fair value, but only in assessing the choice of the “most advantageous market” [22], the multiplicity of these costs will have an influence on the NAV calculation.
Conclusion
In the end, although theoretically conceivable, a new concept of “quoted price” that would allow a stablecoin price to be defined as Level 1 input is not possible in practice. However, a revision of IFRS 13 to adapt certain provisions to the technological particularities of tokenized assets traded on new markets seems desirable, in order to clarify the level that should be given to each type of price (directly quoted in legal tender or in a crypto asset (stablecoin or not)) and according to a typology of market structures (CEX, DEX, etc). The clarification of this classification of fair values, on the cusp of our reflections on the level of quotation in stablecoin, will be all the more necessary as the economy becomes tokenized and legal currencies can only be “represented” by new digital assets. It remains to be seen whether the next revision of IFRS 13 will be generally applicable, or whether the FASB will maintain its recently announced policy of excluding NFTs and stablecoins from fair value treatment[23].
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[1] This results in the application of an impairment loss, and not in the discounted recognition of a positive or negative change in the value of the asset (except in the case of a sale). For more information on the treatment of intangible assets, see. IAS 38 standards (and IAS 36 for the impairment loss).
[2] https://www.wsj.com/articles/fasb-settles-on-fair-value-accounting-for-measuring-crypto-assets-11665614205
[3] Cf. art. 24 of IFRS 13: « Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (ie an exit price) regardless of whether that price is directly observable or estimated using another valuation technique. »
[4] Commission Regulation (EU) n°1255/2012 of 11 December 2012 amending Regulation (EC) n° 1126/2008 adopting certain international accounting standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament and of the Council as regards International Accounting Standard 12, International Financial Reporting Standards 1 and 13, and Interpretation 20 of the International Financial Reporting Interpretations Committee. https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32012R1255&from=FR
[5] Cf. art. 77.
[6] Article 78 uses the example of “different exchanges” to refer to the assumption that there’s a plurality of active markets for the same asset, Article 79 (b) refers to “the close of a market” as applied to regulated stock markets, and Article B34 (a) uses the example of “Exchange markets” as the markets on which Level 1 input can be observed.
[7] Cf. art. 81.
[8] Cf. art. 82.
[9] Cf. art. 86.
[10] There is a difference between the legal and accounting definitions. According to the accounting definitions, and especially the one set out in IFRS 32, a stablecoin would probably be a financial instrument (cf. ISDA, Accounting for Digital Assets : Key Considerations, report, 2022, p. 13 : https://www.isda.org/a/88VgE/Accounting-for-Digital-Assets-Key-Considerations.pdf), while crypto assets other than security tokens (including stablecoins) are explicitly excluded from the scope of the “MiFID 2” regulation and therefore from the legal regime of financial instruments (cf. art. 2–2 of recently adopted Regulation of the European parliament and of the Council on Markets in Crypto-assets, and amending Directive (EU) 2019/1937, or « MiCA »). Thus, accounting standards do not really measure the potential stability and reliability of a stablecoin because of this qualifying dissonance, only the way in which these assets should be recorded and treated in accounting.
[11] To find extracts from the MSB Register maintained by FinCEN: https://www.fincen.gov/msb-state-selector
[12] Directive 2009/110/EC of the European parliament and of the Council of 16 September 2009 on the taking up, pursuit and prudential supervision of the business of electronic money institutions amending Directives 2005/60/EC and 2006/48/EC and repealing Directive 2000/46/EC, or « electronic money directive ».
[13] See. art. 41(a)(i) of « Money Services Business Act », and art. 3, from 4 to 7, and 10 to 12 of « electronic money directive ».
[14] To repeat the examples of Circle and Tether, see respectively: https://www.centre.io/usdc-transparency (monthly audit reports on legal tender and equivalents reserves of Circle) https://tether.to/en/transparency/#reports (quarterly audit reports on legal tender and equivalents reserves of Tether).
[15] Cf. art. 11 of « electronic money directive ». This legal obligation is de facto and de jure a contractual obligation between the stablecoin issuer and the investor.
[16] NB: as we recalled above, these regulations are now transitive, in the sense that they do not apply to issuers of stablecoins because stablecoins would fall under the qualification of “electronic money” (which is not the case, in the European Union at least, cf. “MiCA”), but because these same issuers have adopted a proactive approach to register with the regulator under the umbrella of a regulation that does not apply rationae materiae to stablecoins.
[17] Cf. point 10 of preamble and art. 2–2 (b) of MiCA Regulation. For the « e-money token » definition, see art. 3–1 (4) of MiCA Regulation.
[18] Acronym of “Financial Accounting Standards Board”.
[19] “Any cryptographic assets that are not directly convertible into fiat at an active market do not fulfill the criteria of a fair value level 1 asset, as defined by paragraphs 76–78 of IFRS 13, because there will always be some additional implied fee or spread to exchange into fiat. Where this implied fee or spread is observable (for example, because the cryptographic asset held is convertible into fiat through another cryptographic asset, which trades into fiat in an active market), the fair value of the cryptographic asset held will likely qualify as a level 2 asset in the fair value hierarchy”: PwC, Cryptographic assets and related transactions: accounting considerations under IFRS, “In depth: A look at current financial reporting issues”, report, 2019, p. 19. As for considering a price in crypto asset as a Level 3 input, this could be possible only when a price data in legal tender is absolutely unobservable; in other words, if there is no way to convert the asset in fine into legal tender: “Cryptographic assets that cannot be readily converted to fiat will likely qualify as a level 3 asset”: PwC, Cryptographic assets and related transactions: accounting considerations under IFRS, p. 19.
[20] Cf. art. 24 of IFRS 13.
[21] Ibidem.
[22] Cf. Appendix A of IFRS 13, see « Most advantageous market ». NB: by the way, this would also amount to adjusting a price directly quoted in legal tender, since conversion fees will apply anyway to the only transaction of selling the crypto asset against fiat currency.
[23] https://www.wsj.com/articles/fasb-excludes-nfts-some-stablecoins-from-crypto-accounting-project-11661976742?mod=article_inline.
