Crypto DeFined Recap: Proof of Reserves and Public Trust
The implosion of FTX is putting a spotlight on proof of reserves and why they matter -- especially right now.
The additional scrutiny has major players scrambling. Since FTX went belly up in mid-November, Binance, Crypto.com and KuCoin have brought in accountants to verify that they have adequate assets if customers decide to withdraw their funds. These reviews are limited in scope, however, which is not sitting well with some critics. That the same accounting firm -- Mazars Group -- conducted the reviews for all three firms has also drawn scrutiny. With public backlash growing, Mazars said last week it was suspending all its work for crypto companies.
On Dec. 15, accounting experts Dr. Sean Stein Smith and Gil Hildebrand joined Crypto DeFined to talk about public wariness of proof of reserves. Smith is an assistant professor of business and economics at Lehman College in Bronx, N.Y.; Hildebrand is the chief executive of Gilded Finance, which provides crypto accounting software.
Five takeaways from the interview (edited for clarity):
— There’s no standard way of verifying proof of reserves. “If you ask 20 people to define exactly what a proof of reserves engagement is, how it should be done, and the output to be produced, I guarantee you, you'll have 20 different answers,” Smith said.When accountants verify proof of reserves, as Smith and Hildebrand note, they’re not conducting audits of the sort that you find in the regulated world -- because the crypto exchanges determine what assets can be reviewed and, perhaps most importantly, how they’re reviewed. As a result, these unregulated reviews are limited in their usefulness.
Another problem: “Most of these proof of reserve (engagements) have only focused on the asset side, but for every asset, there's a liability, and that's a major issue as well,” Smith pointed out.
— Watch out for assets being lumped together interchangeably. The proof of reserves report released by Binance in December combined bitcoin and wrapped bitcoin on various blockchains to reach the conclusion that the exchange is 101% collateralized.
Over at Crypto.com, meanwhile, tokens and assets held on different blockchains were assessed together to reach the same conclusion: that it had adequate reserves, according to Crypto.com’s proof of reserves report.
Smith takes issue with both approaches: “It makes no logical sense to me to have assets counted as the exact same thing if they aren’t,” he said. “It would be almost as if … I’m classifying pickup trucks, cars and 18-wheelers as autos.”
If exchanges can't easily check to confirm that they have adequate reserves on hand for each distinct asset, Smith said it could mean that the internal "processes and controls. . . are not able to keep pace with how the company itself is operating.”
Another potential red flag: classifying assets as interchangeable. According to Hildebrand, that could expose the exchange to an "unknown risk of things that could blow up.” The exchange, for example, may believe it has enough bitcoin to cover liabilities, but it may not, in reality, not have enough for withdrawals if some assets are in a bitcoin equivalent on another blockchain.
— Offshore exchanges are likely to get more scrutiny. Hildebrand believes that exchanges like FTX that have offshore operations have long played “regulatory arbitrage” by locating in jurisdictions with light regulation.
Why this matters: Crypto-friendly jurisdictions make it easier to avoid financial scrutiny. Exchanges have argued, generally, that offshore spots with fewer rules make it easier to offer new products and services.
According to Hildebrand, crypto investors are increasingly aware of the offshore issue. In the future, he predicts, crypto exchanges will need to stop with the regulatory gaming and focus, instead, on building customer trust.
— Proof of reserves should be verified using wallet signing. Crypto exchanges set their own rules on how they want accountants to verify assets, but investors need to pay attention to whether the exchange actually signs the digital wallet, Hildebrand warns.
Why this matters: If the exchange owns the wallet, "they should have some ability to sign transactions and move funds out of that wallet,” he said. The signing of digital wallets is a relatively straightforward process, Hildebrand notes, though it may require multiple signers and steps.
And if the exchange didn’t sign its digital wallets as part of the process of verifying assets? In that instance, Hildebrand says, the question to ask is: "Why not? Were they rushing to get this proof of reserves out more quickly? Was someone on vacation, and they didn’t have time to sign it?" The latter case would still raise a red flag, he says, because it speaks to how well the exchange’s operations are being managed.
— Crypto implosions are recasting the regulatory debate. Hildebrand said he is a "true believer" in crypto, but the last six months have changed his mind a bit on regulation of the space. "I do believe in things like self custody. I do believe in having the ability to transact without intermediaries. However, if you look at who got in trouble this year — Three Arrows Capital, FTX and others — none of those are based in the U.S. You have to ask yourself: Okay, what’s going on here?”
The moral of this crypto story: This year's meltdown has shown that "mistakes happen," Hildebrand says, and because of that "we can (now) start to define some specific rules” and regulations.
Watch the replay here.