Crypto-asset: custodian accounting

We’ve all heard stories of people who lost their private key and can’t access their crypto-assets, in some cases losing millions. Now there are custodians, entities who hold crypto-assets on behalf of their clients. How should these custodians account for these crypto-assets? 

Should a custodian account for crypto-assets on or off-balance sheet? In other words, should the custodian entity show the crypto-asset as a separate asset with a corresponding liability? Or should they only disclose the crypto-assets in the notes to the financial statements?

There are several factors to consider. The accounting treatment is complex, involves significant judgement, and there is no specific guidance in the International Financial Reporting Standards IFRS dealing with this matter. In fact, the International Accounting Standards Board (IASB) has yet to issue any guidance on it. The custodian's underlying agreement with the client, applicable laws and regulations and how the crypto-assets are managed must all be assessed.

In applying IFRS, we look to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (IAS) to guide us in developing an accounting policy.

In developing an accounting policy, paragraphs 11 and 12 of IAS 8 requires entities to use “the following sources in descending order:

(a)   the requirements of IFRSs dealing with similar issues;

(b)   the definition, recognition criteria and measurements concepts for assets, liabilities, income and expenses in the Conceptual Framework; and

(c)   recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards’.”

As there is no specific standard on crypto-assets or any similar issue dealt with in IAS 36 Intangible Assets, the Conceptual Framework (Framework’) should be used as a guide. The Framework defines an asset and a liability as follows:

The definition above indicates that an entity recognises the crypto-asset as an asset when the entity controls it.

The custodian usually has access to and can control an investor’s private key; does this mean that the custodian controls these crypto-?

What is a "public key", "private key" and a “wallet"?

The safekeeping of the private key is vital for any crypto-asset investor. The private key is used to transfer ownership of the crypto-asset and cannot be recovered if lost. There is no central authority that can be contacted to recover or reset the private key.

A custodian secures the investor’s private key using various methods. These methods could include storing the private key in a wallet or using centralised public keys.

Centralised public keys pool the crypto-assets of multiple clients into a single public key, thereby limiting the number of private keys the custodian is responsible for. Using their own software the custodian keeps a separate ledger to track and reconcile the crypto-assets held by or on behalf of each investor. While it’s quite clear that the custodian manages the crypto-assets and controls the keys, the assessment of whether or not the custodian also controls the Investor’s crypto-assets is not as Straightforward.

Does the custodian control the crypto-asset?

There are different views on this. Some entities believe that they are only acting as custodian and do not control the crypto-asset; they have no claim to the crypto-asset as it belongs to the client. Others believe that, since they control the private key and will be held liable to the client should the crypto-asset be lost or stolen, they do control the crypto-asset.

This article explores some of the considerations entities need to make when determining whether they control a client's crypto-asset.

The discussion paper, Accounting for Crypto-Assets (Liabilities): Holder and Issuer Perspective July 2020 (Discussion Paper’), released by the European Financial Reporting Advisory Group (EFRAG’) identified three scenarios for the accounting of crypto-assets held by the custodian or intermediary holder on behalf of clients (the depositor client).

The Discussion Paper provided the following summary of the three scenarios:

                                                                                                        (extracted from paragraph 3.82 of Discussion Paper)

Economic control is the power to obtain an item's future economic benefits and restrict others' access to those benefits.

Based on feedback the EFRAG received on the research outreach, one should consider the following indicators in determining whether the custodian has the power to obtain economic benefits from the crypto-asset:

(a) Legal and regulatory frameworks within certain jurisdictions can specify the owner of the crypto-asset. (Refer to (l) below for the Swiss financial markets.)

(b) The terms of the contractual arrangement between the depositor client and the custodian can determine whether the client depositor will pass title, interest, or legal ownership of the crypto-asset to the custodian. If the depositor client contractually passes title, interest or legal ownership of the crypto-asset to the custodian, it indicates that the custodian has economic control over the crypto-asset

(c) The custodian's explicit or implicit right to sell, transfer, loan, encumber or pledge the crypto-asset for its own purposes without the depositor client’s consent or notice. If the custodian can pledge, transfer or sell crypto-assets without the depositor client's consent, it indicates that the custodian is likely to have economic control over the crypto-asset.

(d) The rights of the depositor client in the event of bankruptcy or liquidation of the custodian. If the depositor client has no preferential claim on the crypto-asset held by the custodian and instead has a similar status to that of an unsecured creditor, the custodian most likely has economic control over the crypto-asset.

(e) The ease with which the depositor client can move the crypto-asset to another exchange or another address or wallet indicates their economic control over the crypto-asset.

(f)  The ability of the depositor client to withdraw the deposited crypto-asset at any time for any reason. If the depositor client can easily remove the crypto-asset from the custodian's wallet, it indicates that the depositor client has economic control. It would help to consider contingencies associated with the right to receive deposited crypto-assets and technological factors in the absence of such a right.

(g) Side agreements which can affect the depositor client and custodians' rights and obligations.

(h) "Off-chain" transactions recorded outside the underlying blockchain. An “off-chain” transaction means a move of the crypto-asset value on a cryptocurrency network without the transaction being recorded and verified on a blockchain e.g. when parties swap or exchange private keys to an existing wallet, it is still linked to the original address, but another person is now holding the private key. Control over the private key to a wallet could indicate control over the crypto-asset.

(i)  The party who bears the risk if the crypto-asset is not retrievable due to a loss of the private key as a result of an operation breach, cybersecurity attack, theft or fraud can indicate economic control. If the custodian has the responsibility to indemnify the depositor client in the event of a loss of the private key, the custodian likely has economic control over the crypto-asset.

(j)  The custodian's ability to prevent the depositor client from receiving all the economic benefits from controlling the crypto-asset. If the custodian can retain some economic benefits, it could indicate economic control by the custodian over the crypto-asset.

(k) The type of wallet and signatories to the wallet in which the crypto-assets are held. If the crypto-asset of the depositor client is held in a multi-signature wallet, the arrangement as to who has the keys to the wallet and who the signatories are can indicate who has economic control. Crypto-assets can be held in different types of wallets e.g. a "hot wallet" or "cold wallet", which will have different requirements as to the number of signatories.

(l)  Segregation of depositor clients' crypto-assets and compliance to segregation requirements. If the custodian holds the client's crypto-assets separately, for example, if the crypto-asset can be traced to a wallet dedicated to the blockchain address of the depositor client, it indicates that the depositor client has economic control. If the depositor client's crypto-assets are commingled or pooled with those of other depositor clients or with those of the custodian, it indicates economic control by the custodian over the crypto-asset. According to the Swiss Financial Market Supervisory Authority, as a general rule in Switzerland, custodians may only apply off-balance-sheet accounting treatment of the crypto-assets held on behalf of depositor clients, if the crypto-assets can be clearly separable per client. For the asset to be clearly separable per client, the crypto-assets of different clients may not be pooled together using the same public key, even if a separate ledger is compiled to keep track of the ownership of the individual crypto-assets.

(m) The entity who will benefit from a hard fork can also be an indicator of economic control. A hard fork is when the blockchain diverges into two or more paths. This happens as a result of a disagreement amongst network participants. The fork results in an alternative software protocol that requires all nodes on the network to upgrade to the latest version of the software protocol. The EFRAG discussion paper mentions an investor possessing new tokens (i.e. hard fork dividends) as a result of a hard fork. The depositor client could decide whether or how to distribute the new tokens which indicates the depositor client’s control over the crypto-asset.

(extracted from paragraph 3.84 of Discussion Paper)

No single factor above is considered determinative. The research project did not conclude if certain factors could play a more significant role in deciding which party has economic control over a crypto-asset. It is, however, clear from the EFRAG research project, that control over a private key is not the only factor that indicates control over the crypto-asset.

The indicators of economic control can be summarised as follows:

(a)  Enforceability of contractual terms and conditions between the client and the custodian and how enforceable these are;

(b)  Juristic laws and regulations; and

(c)  The manner in which the custodian manages and stores the crypto-assets, with specific consideration to the degree of segregation of crypto-assets between clients.

(extracted from paragraph 3.83 of Discussion Paper)

There is no ‘one size fits all’ approach for the accounting of crypto-assets by custodians. Crypto-currencies are still evolving, changing and being explored, resulting in different views and diversity in practice on who has economic control over crypto-assets.

Whichever route the custodian takes in reporting the crypto-assets held for clients, the custodian’s accounting policies should clearly reflect whether they account for the client’s ' crypto-assets held on- or off-balance sheet, together with the judgement applied in reaching that conclusion.