Financial accounting methods for cyberspace economies
Written by: Emiel Sebastiaan
WEB3SCAN’s mission is to make multi-chain data accessible and understandable. With the Polkascan project, we are working towards a multi-chain exploration and data analytic platform for the Polkadot-ecosystem.
Microeconomic analysis and macroeconomic analysis are well-established fields that provide research and practices for thinking about financial performance of geographically bound economies and their economic agents.
This article explores one such microeconomic analysis method, called: ‘financial accounting’. We introduce the notion of ‘Cyberspace Accountancy’ as a new way to think about financial performance of cyberspace economies and their native constituents. By applying financial accounting practices on blockchains, its multi-chain data is made accessible and understandable for a wide and potentially new audience, beyond the tech-savvy.
1. Cyberspace economies
This article asserts that multi-chains and their respective native economic agents function similarly to regular geographically bound economies and their respective constituent economic agents. Blockchain economies exist in cyberspace and regular economies exist in geographical space. Cyberspace is inherently different from geographical space. That said, at WEB3SCAN we believe it is not a stretch to assert that a blockchain fits the definition of an economy.
1.1. What makes an economy?
An economy is an area of the production, distribution and trade, as well as consumption of goods and services by different agents. Understood in its broadest sense, ‘The economy is defined as a social domain that emphasize the practices, discourses, and material expressions associated with the production, use, and management of resources’. Economic agents can be individuals, businesses, organizations, or governments. Economic transactions occur when two groups or parties agree to the value or price of the transacted good or service, commonly expressed in a certain currency.
It is common to refer to activities related to a blockchain as on-chain and off-chain. A blockchain’s on-chain activities clearly delineate a social domain and thus boundary of an economy. Such cyberspace economies have particular practices (mining, staking), discourses (finality, security, immutability, sovereignty), and material expressions associated with the production (states, protocols, runtimes, smart contracts), use (state changes, transactions), and management (policy, governance) of resources.
1.2. Cyberspace economies
With Bitcoin, cyberspace economies started as relatively simple economies with only limited classes of economic agents.
- The protocol serves as a central bank and regulator of the economy
The blockchain protocol has a dual-function to serve as a central bank, enforcing monetary policy and to serve as a regulator, enforcing the rules of the cyberspace economy in the broadest sense.
- Accounts are simple economic agents
Accounts are the simplest of economic agents in a cyberspace economy. Accounts are externally enactable native economic agents capable of owning the economy’s native assets and transacting with those assets within the cyberspace economy.
- Miners are specialized economic agents
Miners are specialized accounts. Miners benefit as economic agents by producing the cyberspace’s native assets.
In the context of economies and their constituent economic agents, a significant number of technological innovations have been made in the blockchain industry over the past 10 years. More sophisticated and more specialized economic agents have emerged within cyberspace economies. Furthermore, cyberspace economies increasingly show characteristics of open-economies rather than the closed-economies they have been so far.
1.3. Specialized economic agents
Innovations in economic agents’ ability to specialize have so far gone through three distinct eras which we coin as the Protocol Era, the Smart Contract Era and the Interoperability Era.
- Protocol Era (2008–2013)
The protocol era peaked with Bitcoin as the dominant cyberspace economy with its relatively simple economic agents. In this era there were significant barriers to introduce new classes of economic agents (Script). Additionally in this era there were significant barriers to changing the rules of the economy (forks). These drawbacks were a major driver for the emergence of alternative cyberspace economies, with altered protocols and new classes of economic agents.
- Smart Contract Era (2014–2019)
The smart contract era peaked with Ethereum as a dominant cyberspace economy. This era provided solutions to drawbacks of the protocol era by lowering the barriers to introduce new classes of economic agents and by enabling the creation of sub-economies within the larger cyberspace economy. The Ethereum Virtual Machine (EVM) and its programmable smart contracts spawned an explosion of new specialized economic agents (smart contracts) and sub-economies (tokens). More importantly, this era brought so-called intraoperability: i.e. interoperability between these sub-economies but still within the boundaries of the larger cyberspace economy. Limits to the capacity of smart contract platforms (cost, throughput) were a major driver for the emergence of alternative smart contract blockchains, again with altered protocols and again with new economic agents.
- Interoperability Era (>2020)
Most blockchains so far have been (and will remain) in a complete state of autarky. Autarky is the characteristic of self-sufficiency; the term is usually applied to political states or their economic systems. Autarky exists whenever an entity can survive or continue its activities without external assistance or international trade. If a self-sufficient economy also refuses to conduct any trade with the outside world then economists may term it a closed economy.
There are clear signs of major innovations in the blockchain industry that allow cyberspace economies to become more open economies. An open economy is a type of economy where the domestic community and foreign communities have trade in products (goods and services).
The main benefit of open-economies is foreign trade (importing and exporting). In the context of blockchains, this implies a blockchain’s ability to sell goods or services to another blockchain and to buy goods and services from another blockchain.
A number of projects are making significant progress towards more open cyberspace economies through working on blockchain interoperability. We at WEB3SCAN believe that Polkadot holds the best cards to dominate the interoperability era by fostering specialized cyberspace economies and by fostering the broadest foreign trade mechanisms imaginable between these specialized cyberspace economies.
1.4. Specialized economies
The value proposition of specialized economic agents within cyberspace economies was established in the smart contract era. However, the degree of specialization of its economic agents of this era’s cyberspace economies is inherently bound by the rules of the respective cyberspace economies themselves. In this regard, Polkadot advances its design from Ethereum 2.0 by implementing interoperability as a heterogeneous multi-chain rather than as a homogeneous multi-chain.
Ethereum 2.0 beacon chain will create a sharded multi-chain of many Ethereum Virtual Machines (EVMs) in ‘Execution Environments’. This will no doubt provide a scaling solution for cost and throughput. However, each of the autonomous shard-chains of the Ethereum 2.0 multi-chain will inherently be bound by the performance constraints of the identical EVM’s gas-systems of the individual shards. It should be acknowledged that an EVM is but one class of cyberspace economies and the Ethereum 2.0 multi-chain will, therefore, be a homogeneous multi-chain.
The Polkadot relay chain design, on the other hand, has a higher level of abstraction and allows interoperability between more classes of cyberspace economies. It is thus a heterogeneous multi-chain. Simply put, rather than facing the lock-in Ethereum 2.0’s Execution Environments introduce, Polkadot parachains and parathreads will be able to build their own state machine in their chain’s Wasm Runtime, optimized to their use case.
The smart contract era spawned many software development kits (SDKs) to foster the design of cyberspace economic agents. The interoperability era will spawn SDKs to foster the design of cyberspace economies as a whole. Substrate is a prime example of an advanced SDK that truly opens up the design space for cyberspace economy architects.
If the smart contract era explored the value proposition of specialization of economic agents within cyberspace economies, the interoperability era will explore the value proposition of specialization of cyberspace economies as a whole.
1.5. Foreign trade
The value proposition of domestic trade of cyberspace economies was established in the smart contract era. Each of the sub-economies that exist within any EVM-instance is perhaps characterized by their respective sub-economy’s token. The smart contract era showed that sub-economies can specialize and benefit by trading with other sub-economies within the larger cyberspace economy. A prime example is the DAI stable coin sub-economy and its role in its larger cyberspace economy.
Such token-economies however are only scratching the surface of the design space that economic trade in cyberspace economies may have. Many examples of value propositions exist within the Ethereum cyberspace economy that go beyond the utility of a mere token. Examples that spring to mind are DEXs, DAOs, NFTs, or any other smart contract-based economic agents that gain traction without a necessity for a primary role of the sub-economy’s (fungible) token in itself.
Interoperability leads to the emergence of foreign trade between cyberspace economies. If the smart contract era explored the value proposition of domestic trade of economic agents within cyberspace economies, the interoperability era will explore the value proposition of foreign trade between economic agents in different cyberspace economies.
One of the areas where Polkadot presents a clear advantage in design over existing systems is Polkadot’s ability to express foreign trade as arbitrary messages between cyberspace economies. While competing systems’ messaging is constrained to token-swaps as foreign trade mechanism, the Polkadot relay chain can send arbitrary messages, trust-free, between chains. Interchain messaging provides the most utility with the lowest friction when you want to have one chain autonomously affect a change of state on another chain. Arbitrary messaging is a prime example of a mechanism that truly opens up the design space for foreign trade between cyberspace economies.
1.6. Economic analysis
Microeconomic analysis and macroeconomic analysis are well-established fields that provide research and practices for thinking about behavior and financial performance of geographically bound economies (macroeconomics) and their constituent economic agents (microeconomics).
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by governments to assist in the development and evaluation of economic policy.
Microeconomics is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. One goal of microeconomics is to analyze market mechanisms that establish relative prices among goods and services and allocate limited resources among alternative uses. Microeconomics shows conditions under which free markets lead to desirable allocations.
This article explores one such microeconomic analysis method, called: ‘financial accounting’. We introduce the notion of ‘Cyberspace Accountancy’ as a new way to think about the financial performance of cyberspace economies and their native economic agents. By applying financial accounting practices on blockchains, their combined multi-chain data is made accessible and understandable for a wide and potentially new audience, beyond the tech-savvy.
Future work may include other microeconomic analysis methods and macroeconomic analysis methods to further our thinking about aspects of cyberspace economies such as aggregate economic activity, issues of growth, inflation, monetary policy and more.
Accounting or accountancy is the measurement, processing, and communication of financial and non-financial information about economic entities such as businesses and corporations. The terms accounting and financial reporting are often used as synonyms. Accounting can be divided into several fields including financial accounting, management accounting, external auditing, tax accounting and cost accounting. The remainder of this article will focus on the sub-field financial accounting.
2.1. Financial Accounting
Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision-making purposes.
2.2. Financial statements
Financial statements generally have three distinct components:
- Statement of financial position (balance sheet)
The balance sheet is a financial statement showing a firm’s assets, liabilities and equity (capital) at a set point in time, usually the end of the fiscal year reported on the accompanying income statement. The total assets always equal the total combined liabilities and equity. This statement best demonstrates the basic accounting equation: Assets = Liabilities + Equity. The statement can be used to help show the status of a company.
- Statement of profit and loss
The statement of profit or income statement represents the changes in the value of a company’s accounts over a set period and may compare the changes to changes in the same accounts over the previous period. All changes are summarized on the ‘bottom line’ as net income or ‘net loss’ when income is less than zero.
- Statement of cash flows
The statement of cash flows considers the inputs and outputs in concrete cash within a stated period. This component will remain off-scope in the remainder of this article.
2.3. Qualitative characteristics of financial statements
Financial accounting is the preparation of financial statements that can be consumed by the public and the relevant stakeholders. Financial information would be useful to users if such qualitative characteristics are present. When producing financial statements, the following qualitative characteristics apply:
Relevance is the capacity of financial information to influence the decision of its users. The ingredients of relevance are the predictive value and confirmatory value.
- Faithful representation
Faithful representation means that the actual effects of the transactions shall be properly accounted for and reported in the financial statements. The words and numbers must match what really happened in the transaction. The ingredients of faithful representation are completeness, neutrality and free from error.
Verifiability implies a consensus between the different knowledgeable and independent users of financial information. Such information must be supported by sufficient evidence to follow the principle of objectivity.
Comparability is the uniform application of accounting methods across entities in the same industry. The principle of consistency is under comparability. Consistency is the uniform application of accounting across points in time within an entity.
Understandability means that accounting reports should be expressed as clearly as possible and should be understood by those to whom the information is relevant.
Timeliness implies that financial information must be presented to the users before a decision is to be made.
3. Cyberspace Accountancy
This section explores what financial statements would show for economic agents in cyberspace economies.
Accounts are the simplest economic agent in cyberspace economies. Accounts are externally enactable native agents capable of executing transactions. In Polkadot, Kusama and most other Substrate-based blockchains, accounts have balances, can make balance transfers and can participate in staking activities.
3.2. Validators and nominators
Validators actively participate in the block production mechanism and contribute to the security of the cyberspace economy. Although validators can be enacted by individual accounts, more often a ‘validator’ comprises a more sophisticated construct including many ‘nominators’. Validators and nominators combined provide economic staking services in which good behavior is rewarded and bad behavior is punished. On Polkadot and Kusama, validators and nominators have a native reporting period measured in epochs and eras.
The treasury is a relatively simple economic agent that controls its assets by a governance (voting) mechanism. The treasury can be considered as a DAO. The DAO’s revenue consists of fees, staking rewards and spends its reserves on spending proposals and minor deflationary burns. On Polkadot and Kusama, the treasury has a native reporting period measured in spending periods.
3.4. Parachains and parathreads
Parachains and parathreads (and bridges) can be considered foreign economic agents in Polkadot and Kusama. These foreign economic agents are willing to pay for access to services the relay-chain has to offer, such as security and interoperability. Parachains pay through deposits, parathreads pay through fees (registration and usage). On Polkadot and Kusama, parachains have a native reporting period measured in auction slots and slot lease periods. Parathreads appear to have no such native reporting period.
3.5. Reserve bank
The reserve bank can be considered as the central bank of the cyberspace economy and its financial statements provide an overview of the assets and liabilities of the entire economy. The reserve bank has the singular task of controlling issuance of its native unit of account by burn-activities and mint-activities.
4. Polkascan and cyberspace economies
4.1. Polkascan as accountant
Polkascan aims to provide financial accounting services for the Polkadot and Kusama cyberspace economies. Polkascan will provide financial statements for key classes of economic agents in cyberspace ecosystems as outlined in this article.
Polkascan’s financial statements aim to comply with the qualitative characteristics outlined in section 2.3 by providing: faithful representations of relevant and timely financial statements, understandable ledger accounting schemas, relevant and comparable accounting periods.
Polkascan Accountancy is built on top of our ecosystem platform polkascan.io which provides verifiable data all the way down to the lowest possible level of granularity (accounts, blocks, transactions and events).
Polkascan intends to offer its accountancy services to the Polkadot and Kusama ecosystem and intends to submit funding proposals to both ecosystem’s treasuries in order to fund its operational cost.
4.2. Polkascan as a bureau of economic analysis
This article sets Polkascan’s multi-year strategy of providing valuable services to multi-chain ecosystems. Our accountancy services are the first of many services imaginable when framing blockchains as economies. We are driven by a belief that the fields of microeconomic analysis and macroeconomic analysis provide research and practices for thinking about behavior and financial performance of cyberspace economies. Polkascan will continue its research and will continue to apply practices to make multi-chain data accessible and understandable. Polkascan intends to further take on the role of the Bureau of Economic Analysis for Cyberspace Economies.
About Polkascan & WEB3SCAN
Polkascan contributes to the Polkadot ecosystem by providing block exploration and data analytic technologies. We will continue providing updates to our multi-chain data analytic platform: polkascan.io. The following public resources enable tracking of progress of the project: Medium, Twitter & GitHub.
WEB3SCAN — the organization behind the Polkascan project — offers professional services around blockchain data.
Published By Polkadot Network