A very big difficulty in learning in a new field is to find a set of efficient thinking framework and communication language. Web3 involves many issues related to token economy and finance. In related discussions, the balance sheet is a very useful tool. It can not only help you clarify your thinking and see the essence of things, but also improve the efficiency of communication. It can even help you discover new opportunities for innovation. I myself have benefited a lot from it. However, in practice, I feel that there are not many people in the industry who understand this tool and can actively use it to analyze problems, which is a pity, so I wrote an article to introduce and advocate it. In addition, this tool is also needed to be used frequently in the subsequent discussion articles on Web3, token economy and currency economy of this official account, so this article can also be regarded as a reference document and can be cited frequently in the future.
Balance Sheet Basics
The balance sheet is the basic tool of corporate accounting, and it is also the most basic of the “three major reports” or “four major reports”. In traditional business, junior managers are generally more concerned with the income statement, while bankers, investors and seasoned executives are more concerned with the balance sheet. When discussing the monetary economy, reading the balance sheets of the central bank and commercial banks is a basic skill and starting point. In fact, Web3 learners will gradually discover that the balance sheet used when discussing Web3 is more different from a corporate balance sheet and more similar to a balance sheet in macroeconomic accounting. The balance sheets used in DeFi research are quite similar to bank balance sheets. Therefore, I believe that reading and using balance sheets should be an essential skill for Web3 practitioners.
Back when I was studying monetary economics in 2017, I realized that this tool was very useful for discussing token economics. However, because I am not a professional in economics and accounting, I have never systematically studied accounting knowledge, so I only use the most basic balance sheet as a tool for analyzing the token economy. In fact, there is still a lot of valuable content in traditional accounting knowledge, including some estimation, assumption and adjustment skills, which are worth learning from the token economy. But my understanding of this knowledge is very superficial, and I need to continue to make up lessons according to actual needs. This is just to introduce some basic knowledge points within the scope of my understanding, the purpose is to lay a foundation for the following discussion.
A balance sheet reflects the state of a company’s assets, liabilities, and equity at a particular time. It looks like this:
Figure 1. Schematic diagram of the balance sheet of a traditional company
Looking at this graph, we can get a few key points about the balance sheet:
The balance sheet is divided into two parts: assets on the left, liabilities and equity on the right, separated by a vertical line in the middle, so it is also called a “T-shaped table”;
There is an identity: Assets = Liabilities + Equity. That is to say, the accumulated values on the left and right sides of the balance sheet should be exactly equal and balanced. This is the most important feature of a balance sheet, and why it is called a balance sheet in English;
Under normal circumstances, the equity of an enterprise should be positive. If the equity is negative, that is, assets < liabilities and the enterprise is insolvent, it will fall into a solvency crisis;
The asset side can be roughly divided into high-liquidity assets (cash and cash equivalents) and low-liquidity assets (short-term claims and long-term assets), generally arranged from top to bottom;
Liabilities are also divided into short-term debt and long-term debt, also listed from top to bottom. Enterprises should pay special attention to short-term debts and ensure that they have sufficient cash and cash equivalents to cover debts on the asset side, otherwise they will fall into a liquidity crisis;
Equity is the true net worth of a business, no doubt, according to point 2, Equity = Assets – Liabilities.
In fact, the basic knowledge of the balance sheet is so little that ordinary people can learn it in a few minutes. But in traditional finance, it takes a lot of time to learn some complex concepts, especially how to incorporate complex actual business into accounting rules, such as how to classify and estimate intangible assets (goodwill, intellectual property, etc.) on the asset side value and treatment, and distinguishing the conceptual difference between “owner’s equity” and “equity”, etc. These contents have little value in the short term for the research of Web3 digital assets. Instead, what should really be spent exploring is how different kinds of digital assets are represented on the balance sheet.
Digital assets mainly appear on the left end. Due to the variety of forms and the constant emergence of new categories, it is difficult to list them all. Based on the principle of lower and lower liquidity from top to bottom, we can arrange the current major digital assets as follows:
Figure 2. Arrangement of digital assets
Figure 2 might be what the balance sheet of a purely digital DAO might look like. Our subsequent discussion can use this as a starting point.
In addition, there are some extensible tools that are very important.
Incremental Balance Sheet
An extension tool commonly used in practice is the incremental balance sheet, which describes the impact of a transaction on the balance sheet. In the incremental balance table, we only list those items that are affected by the current transaction, and not those items that are not affected. This method not only highlights the problem, but also simplifies the drawing of diagrams, which can be used easily and is more convenient for communication.
As an example, a user sells his BTC worth $10,000 and exchanges it for $10,000 USDC. This transaction only affects the amount of BTC and USDC of the user, and does not affect other assets and liabilities. Therefore, it is expressed as an incremental balance sheet, and other items are not listed. It is only necessary to express the increase or decrease of BTC and USDC:
Figure 3. Incremental Balance Sheet for Sell BTC Transactions
As another example, suppose a user borrows 40,000 USDC and the equivalent of 20 ETH for market making when an ETH is worth $2,000. The incremental balance table shows as follows:
Figure 4. Access funds for market making
Assuming that after a period of time, he makes a market and earns 1,000 USDC and 0.5 ETH, but at the same time, the accumulated unpaid interest reaches 700 USDC and 0.3 ETH, and at the same time, the ETH price rises to $2,500, then the incremental balance table shows as follows:
Figure 5. Market making generates profits
It can be seen from the above examples that since the balance sheet is always balanced, the impact of a transaction is also balanced, and the quantitative change caused by a transaction in the balance sheet must also be balanced on the left and right, or the asset Either the increase or decrease on the liability side is offset, or both sides increase or decrease at the same time.
In practice, incremental balance sheets are much more commonly used than full balance sheets.
Joint Incremental Balance Sheet
Transactions occur between multiple entities, and in many cases, we also care about the impact of transactions on the balance sheets of other relevant entities. At this time, we put together the incremental balance sheets of two or more related entities, so that we can have a clearer understanding of the nature and impact of the transaction.
For example, in the example of Figure 3, if we juxtapose the incremental balance of the counterparty (such as an exchange) with this user, we can obtain the following joint incremental balance:
Figure 6. Joint Incremental Balance Sheet for Bitcoin Transactions
In practice, the corresponding variable items are often wired together to indicate “they are the same money”. For example, the above example can be wired as follows:
Figure 7. Joint Incremental Balance Table with Wires Added
In many cases, we do not care about the number of assets, but qualitatively study the changes in the relationship between the assets and liabilities of each subject involved in the transaction. In this case, the figures can be ignored. For example, suppose Zhang San mortgages some ETH to Compound, lends USDC, and then buys an NFT from Li Si. Assuming that we don’t care about the specific amount of this transaction, just qualitative analysis, then the joint incremental balance table is as follows:
Figure 8. Joint Incremental Balance Sheet for NFT Purchased by Mortgage Lending
The above table shows the ability of the joint incremental balance sheet to describe transactions, and it clearly describes the outflow of funds and the whereabouts of assets. If you add a connection, you can see it more clearly.
Figure 9. Joint incremental balance table with partial wiring added
In the union table, each increment must have a corresponding item. For example, an increase in an asset of one party must correspond to a decrease in the asset of the other party, or an increase in liability. This is the basic principle of using union tables.
The above is the basic content of the balance sheet. Of course, here are just some of the simplest examples. In fact, using the balance sheet can describe many complex scenarios and help us solve many complex problems.
Advantages of Balance Sheet Based Research Questions
Many people will question, buying and selling, or mortgage lending, these are very simple questions, why use the balance sheet to study? what are the benefits?
According to my long-term learning experience, there are at least three benefits.
First, to help us deepen our understanding of financial transactions and financial events. The balance sheet provides a magnifying glass for deep insight into financial behavior. The same thing, if you only roughly understand it as trading, you may only form a very superficial view. But if you draw the corresponding balance sheet, you can see the essence of things.
As an example, the MakerDAO community recently voted in favor of purchasing U.S. Treasury bonds with DAI. If this matter is only understood as a new use of stablecoins, it will dwarf the matter. When we look at the bond purchases on MakerDAO’s balance sheet, we come to a shocking conclusion.
Assuming that at this moment, after Maker’s users mortgaged excess assets (such as ETH), they generated DAI equivalent to $10,000 by borrowing, and the following is the balance sheet of MakerDAO before the bond purchase.
Figure 10. Hypothetical Maker balance sheet
Readers may wonder why the ETH pledged into Maker doesn’t appear on Maker’s balance sheet? Because the mortgage is not a transfer of ownership, but a contractual act to enhance the credit of the loan. After the mortgage, the ownership of ETH is not transferred to Maker and cannot be counted as Maker’s assets. Maker created $10,000 DAI based on the loan, not the ETH collateralized.
So, if Maker buys $5,000 of US Treasuries at this point, what kind of behavior is that? Here, Maker, as an algorithmic central bank, whether the 5,000 DAI it needs to purchase treasury bonds is taken out of the treasury or issued, is reflected in Maker’s balance sheet consistently:
Figure 11. Incremental Balance Sheet for Maker’s Purchases of US Treasuries
So what does such a simple incremental table reflect? As anyone familiar with central bank balance sheets can see at a glance, this effectively suggests that Maker is creating USD stablecoins based on U.S. Treasuries. That is to say, Maker is sharing the right to “create money based on U.S. Treasuries” that was only monopolized by the Federal Reserve in the past. This is certainly a far-reaching move.
It can be seen that using the balance sheet tool can help us gain a more in-depth view.
Second, it is easy to think and communicate. In this respect, the balance sheet is like the vertical operation we learned as children, helping us to become more organized, more standardized, and easier to exchange ideas with each other.
Third, help identify innovation opportunities and sort out business strategies. The asset insights provided by the balance sheet can sometimes help us identify gaps and potential opportunities in the market. Solv is one such example. As a platform that supports users to customize multi-dimensional assets, Solv has a clear long-term goal, but it is not easy to choose a business entry point. When we were doing strategic thinking, we produced the following industry-wide balance sheet, and saw the blank opportunities for low-liquidity assets (SAFT, locked tokens, real-world assets, etc.), so we decided to cut in from this field and obtain good effect.
Figure 12. The balance sheet that inspired Solv’s business strategy decisions
In conclusion, according to my practical experience, the balance sheet is a good tool for learning and researching Web3 digital assets, so I am happy to recommend it to everyone. My future articles will also actively use this tool to illustrate the problem.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/balance-sheet-in-web3/
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