Balance sheets are among the most used financial statements in the corporate world to assess the financial health of corporate entities.
There are nowadays more and more attempts to reconcile financial communication around DeFi protocols and systems with the standards traditionally used in finance. Stablecoins are no exception.
And there is some logic in this: it's not because financial applications are built within DeFi under a different standard than TradFi that the underlying assessment rules should change.
As put by hexonaut in this tweet, like in physics, you can't magic your way to new rules because an application is on a blockchain. The same constraints that apply to major financial institutions, including the solvability and liquidity constraints also apply to stablecoins.
Applying common standards to financial communication on stablecoins
A balance sheet distinguishes assets (what is owned) and liabilities (what is owed to counterparties).
A balance sheet must be balanced: if assets are greater than liabilities, we include an equity line within the liabilities which in fact corresponds to what the governance of the protocol could safely use for other purposes. If the value of the liabilities is greater than the assets, then the system is insolvent and in an effective bankrupt state.
Understanding the balance sheet of a stablecoin is in fact a matter of understanding what constitutes an asset and a liability for it.
Breaking down the liabilities
Let's start with the easiest: liabilities. In the context of a stablecoin protocol/issuer, regardless of whether it's centralized or decentralized (i.e backed by fiat in a bank account or crypto in smart contracts), the liabilities are always the stablecoins in circulation.
That's as easy as that.
You may break liabilities down depending on the chain where stablecoins have been issued or the module that was used for issuance (like we do at Angle). But in the end, if there are 10m stablecoins in circulation, liabilities will be 10m, as when you hold a stablecoin in a protocol, you should effectively own a claim on some protocol/issuer's asset.
Different types of assets
The most revealing and interesting part to understand is the assets one.
Stablecoins are usually minted following two main ways:
through a deposit in a bank account (for centralized stablecoins) or equivalently in the context of decentralized stablecoins through a price stability module converting stablecoins into another freshly minted stablecoin
through a loan (like in collateralized debt position mechanisms à la Maker) where you put a collateral that leaves you the right to borrow a minted stablecoin.
Both options are conceptually very different in the sense that the former is effectively a swap where the protocol/issuer acquires the collateral, while in the latter the protocol does not own the actual collateral: it's on its contract but it's not something that the protocol can use to do anything with. Collateral assets supported within price stability modules of decentralized stablecoins or within the accounts of centralized stablecoin issuers are assets on the balance sheet.
Maker price stability module supports USDC. If someone comes to mint 1 DAI with 1 USDC, then the protocol has 1 USDC in assets and 1$ in liabilities.
Angle Price stability module, called the Transmuter, supports Euro denominated assets like EUROC (Euro stablecoin) and bC3M (tokenized Euro securities) as collaterals.
Circle accepts USD deposits and uses part of its USD to buy T-bills. The assets within Circle's balance sheet are then composed of the dollars deposited in Circle bank accounts and the securities they buy (with notably Blackrock).
In all cases, if the value of these supported collateral assets decreases, it's a direct loss for the protocol/issuer. There are some protocols (e.g derivatives backed protocols) which accept volatile assets like ETH within their price stability module, but these are usually hedging themselves against the volatility of these ETH by issuing perpetual futures, or opening shorts within other platforms. Others like Tether's USDT are fine holding volatile assets like BTC because they're investing in it money they could afford to lose.
Now and this is where I often see confusions, if you're dealing with a collateral that people can use to borrow, what protocols own in their balance sheet is not the collateral, it's the loan that is taken and due to the protocol.
You may borrow 1 stablecoin with $1bn worth of ETH, the protocol won't have $1bn of asset: it will have a debt of 1 stablecoin secured by $1bn of ETH.
The collateral is the secured loan, it's not the collateral of the loan in itself. This is also why collateral ratio metrics computed using the TVL of a protocol rarely make sense.
What do we do with algorithmic market operations?
You'll sometimes see stablecoins mention the fact that they are engaged in algorithmic market operations (or direct deposit modules) consisting in minting stablecoins in other protocols with no immediate backing collateral. How does it fit within this assets/liability framework?
Let's consider the case of a protocol that mints $1m of its stablecoin on for instance Aave.
The protocol now owns deposit tokens (aTokens) on Aave, but at the same time it has minted stablecoins. So a natural way to account for this would be to count in the assets the deposit tokens (accruing in value as these tokens are borrowed) and in the liabilities the minted tokens.
The thing is that this accounting methodology provides a way for protocols to artificially inflate the assets (and the liabilities proportionally as well) of their balance sheet, because they could technically mint $1bn on Aave.
The better way to account for this is just to mark in assets the debt corresponding to the stablecoins that have been effectively borrowed and in the liabilities the amount of stablecoins borrowed.
This goes against the intuition of 1 stablecoin in circulation = 1 liability as here the pre-minted stablecoins by the protocol on Aave would not be considered in the balance sheet, rather these must be borrowed first to be included. In fact, we can refine the logic to determine what a liability for a stablecoin is with the following rule of thumb: 1 liability = 1 stablecoin that the protocol does not control directly or indirectly.
Now what does the equity have to do in all this?
Stablecoins like many systems may accumulate profit over time from their assets growing faster than their liabilities.
The equity line in a balance sheet is the difference between the assets and the liabilities: this is what would be left to the protocol or to the issuer if all stakeholders redeemed their stablecoins or repaid their debt and withdrew their collateral.
The higher the equity relative to the assets, the more the stablecoin is able to withstand adverse shocks and market conditions leading to a decrease in the value of assets
Angle has a 6.8m€ equity which corresponds to a 31% equity to liability ratio: for every stablecoin in circulation the stablecoin has more than 0.30€ in reserves and the protocol could afford to lose in some way 6.8m€ and still remain solvent.
Assessing risks from a balance sheet
Understanding the basics of how a balance sheet is built is more than 2/3rd of the work to be able to rapidly assess the risk from a stablecoin.
I'll write in more details about the risks you're dealing with with major stablecoins, but here are some first points.
Beyond the equity to liability considerations mentioned above, the key thing to assess when you get the balance sheet is the quality of the assets. Are they from trusted issuers, is there a risk that they go to zero?
Apart from these basic counterparty risk issues, what you particularly need to look into is the liquidity of the reserves as well as their volatility with respect to the liabilities.
If the assets are made up of or secured by illiquid assets that cannot be dumped in the market or opened for redemption to stablecoin holders to claim these reserves, then the asset is not safe.
It's not a bad thing per se to have illiquid reserves, the bad thing is if the share of illiquid reserves is too big with respect to the redemption flows to expect when there is some market turmoil.
Remember what happened to the Silicon Valley Bank? Well, if we had access publicly to the balance sheet, anyone could have seen that it was a bad idea to leave its funds within the bank because of the illiquidity of the assets and the losses that were made when getting rid of them.
Concluding thoughts
With the emergence of regulatory frameworks that provide more clarity for issuers, I expect the amount of stablecoin providers to grow substantially in the coming years.
Hopefully with the multiplication of players, this article provides some guidance for everyone to be able to assess the risks associated with the players that communicate about their balance sheets.
Because yes, there are still some issuers/protocols for which the balance sheet cannot be easily accessed. On another note, there are also some centralized issuers which show up numbers which are not audited by third parties and on which they could very much lie.
DeFi provides the tools to get the balance sheets of protocols (stablecoins or not) publicly and trustlessly available onchain 24/7 (cf Angle Analytics). This transparency is one of the features that makes DeFi systems truly stand out against their TradFi equivalent. Let's use this unfair advantage the best we can and work to raise the standards of accountability for all projects across the space.
