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Exchanges & custodians: Build trust with Proof of Reserves and reconciliation controls with The Network Firm

Exchanges & custodians: Build trust with Proof of Reserves and reconciliation controls with The Network Firm

Our recent webinar, Exchanges and Custodians: Build Trust with Proof of Reserves (PoR) and reconciliation controls featured industry experts Jeff Rundlet, Head of Accounting Strategy, Cryptio, Jeremy Nau, Co-Founder & COO, The Network Firm and Clayton Lowery, Co-Founder & CSO, The Network Firm – offering deep insights into the importance, challenges, and future direction of Proof of Reserves (PoR) in cryptocurrency exchanges and custodians.

In this blog, we summarise the key insights shared, including:

  • The evolution of PoR, highlighting its inception by Bitcoin developers as a means to assure asset backing amidst growing transparency demands.
  • The skepticism surrounding PoR, emphasizing its distinctiveness from financial statement audits and its role in enhancing trust and regulatory compliance.
  • Looking at the technological advancements facilitating PoR implementations and the varying regulatory landscapes across jurisdictions like Texas, which have started to formally recognize and legislate PoR practices.
  • How PoR is shaping user confidence and the importance of developing standardized practices to navigate the complexities of digital asset management.


The necessity of Proof of Reserves (PoR)

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Jeremy opened the conversation by emphasizing the foundational role of PoR, stating,

"Proof of Reserves is not a financial statement audit. It's not a panacea for solving every problem out there. But prior to 2023, Proof of Reserves was often seen as a net benefit for most parties."

This sets the stage for understanding PoR's value beyond traditional financial audits, highlighting its emergence as a vital tool in the crypto ecosystem for ensuring transparency and trust. Although there is still a lot of innovation that needs to be done when it comes to PoR, Jeremy underlines that crypto accounting advancements in the future will make it better.

“Proof of Reserves today isn't perfect, but we shouldn't let that be the enemy of good. We shouldn't let that stifle innovation in the accounting industry that desperately needs innovation, and it shouldn't help hinder us from providing transparency to the public. So I think that's why we're here today. We're here to explore the detractions, the pros, and what Proof of Reserves could be in the future.”

Evolution and understanding of Proof of Reserves

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Delving into the origins and evolution of PoR, Jeremy provided a historical perspective.

"Proof of Reserves initially was ideated by a couple of Bitcoin developers, Peter Todd and Greg Maxwell...It wasn't meant to just be a proof of assets...but also wasn't meant to be a full financial statement audit."

Coinbase was one of the first exchanges to do a PoR with Andreas Antonopoulos. Who at the time was just able to confirm control of the assets by Coinbase. It was only in 2020 when CPAs started getting involved with PoR, which was a major step forward for the industry in terms of correct methodologies.

This reflection on PoR's beginnings underscores its targeted approach toward verifying digital asset holdings against liabilities, differentiating it from broader financial audits.

Clayton added that there is still no standardized method for PoR, everything is a little “all over the map right now”. However, he explained that in PoR you don’t typically look at other liabilities that aren’t customers.

“In Proof of Reserves, you don't typically look at other liabilities that aren't customers. That could call into question the solvency of the exchange from other debt they've taken on financial statement audit. It's really complementary to that. It should be part of it, but neither solve each part of that equation for making sure that the customer's assets are there in full.”

Expanding the scope of Proof of Reserves beyond exchanges and custodians

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In this section, Jeff and Clayton delved into the broad applicability of PoR, discussing its relevance not just for cryptocurrency exchanges but for a wider array of entities within the digital asset ecosystem.

Clayton explains PoR’s broadening perspective, illustrating its application across different asset types and entities.

"It goes beyond exchanges. It was certainly initially just exchanges, but that was before stablecoins even really existed. And the concept of tokenizing assets really existed, and certainly any traditional financial instruments existed."

This highlights the evolution of PoR from a niche requirement for crypto exchanges to a more widely applicable procedure for various digital and tokenized assets, including those backed by fiat or gold.

Clayton further explains the nuances of applying PoR across different asset holders, stating:

"It's the crypto in custody, certainly for ETP issuers and exchanges. But then on the tokenized asset side, it's fiat, gold, whatever is kind of backing those tokenized IOUs."

This indicates the diverse applications of PoR, from verifying cryptocurrency holdings to ensuring the backing of tokenized assets, demonstrating the procedure's versatility in addressing transparency and trust across the financial spectrum.

Navigating the complex landscape of self-attestation in Proof of Reserves

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The speakers discussed the evolution, challenges, and credibility concerns associated with self-attestation practices. Jeff noted the shift in the industry towards self-attestation and raised questions about its reliability and the hesitancy among firms to engage with it.

"The industry has changed. We're seeing some self-attestation and CPA-assisted Proof of Reserves. I think another thing to highlight here is that a lot of firms won't even touch this (self-attestation)," explained Jeff. 

This introduction prompts a deeper exploration of the motivations behind self-attestation and the concerns surrounding its effectiveness. Clayton provides a historical perspective, acknowledging the initial necessity of self-attestation and its evolution.

"Self-attestation was first theorized before probably 99% of CPAs had even heard of Bitcoin. And so back then, it was certainly up to the exchanges and the users.”

He also mentions the varied approaches taken by companies, from CPA assistance to technology-driven solutions like Merkel trees and zk proofs, highlighting the industry's diverse strategies in addressing transparency and trust issues.

Addressing the trustworthiness of self-attestations, Jeremy admits the lack of third-party oversight, and points out the potential for manipulation within self-attested reports.

"The ultimate problem with the self-attestations is that they can manipulate the customer liability balances. They can put a big negative balance to understate their liabilities or take out some bid customers that they could be colluding. So that's the key to why having a third party is important, is to check the completeness and accuracy of the customer liabilities because ultimately, that's how you would cheat, which would be understating your liabilities.”

Bridging financial audits and Proof of Reserves

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Jeff initiates the discussion by questioning the future integration of PoR with traditional financial statement audits, considering the significant confidence investors and customers place in the latter.

Jeremy explains the primary functions and intentions behind both audit types, suggesting their complementary potential. He clarifies that financial audits offer a holistic view of a company's financial health, whereas PoR focuses on the specific verification of digital asset holdings against liabilities. He points out a critical oversight in traditional audits concerning digital assets.

"Oftentimes in a financial statement audit, digital assets held on behalf of customers is held off the face of the balance sheet for many of these companies.”, indicating a gap PoR aims to fill.

Further, Jeremy addresses the visibility and frequency of reporting as key differentiators. He argues that PoR offers more immediate and accessible transparency to exchange users, a stark contrast to the lengthy process and restricted access of financial statement audits.

"But when you have this limited scope and you really focus on blockchain technology and APIs, nowadays you can pull information in now you can get transparency at thousands of times more frequently versus waiting till 90 days after or longer for the year-end.”

This emphasizes PoR's capability to provide real-time, transparent insights into digital asset reserves, which is particularly crucial in the fast-moving cryptocurrency space.

Oversight and integration with traditional auditing

Jeff and Jeremy discuss the importance of oversight for both traditional financial audits and PoR. They highlight the role of organizations like the AICPA in providing this oversight through peer review programs. Jeremy explains:

"The oversight piece for private companies typically falls on the AICPA's peer review program in the US...they look at a swath of our engagements over a three-year period and dive into them and essentially give us feedback.”

This ensures a level of quality and reliability in the auditing processes, whether for traditional financial statements or PoR.

The role of Proof of Reserves in compliance and reporting

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The discussion then moves to how PoR fits into the broader compliance and reporting framework for companies dealing with digital assets. Jeremy articulates the complementary nature of PoR alongside other compliance reports, stating:

"We view Proof of Reserves as a piece of that really is a scalpel to focus on that limited scope of that customer’s assets and customer liabilities.”

This emphasizes PoR's unique role in enhancing transparency and trust in the digital asset space.

Evolution and best practices in Proof of Reserves

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The conversation shifts to the evolution of PoR practices, particularly in the context of stablecoins and ETFs. Clayton points out:

"Stablecoins have done a really good job here...almost all of them, on a monthly basis, do an examination….and give out a lot of information on what’s backing the stablecoin.”

This reflects a maturation in the approach to PoR, moving beyond just cryptocurrency exchanges to include other digital asset entities such as ETFs.

“Bitwise came out with its tech solution, and then also 21Shares came out with one that puts their data on chain through an oracle network. And so we're seeing some cool experimentation on the ETF side," said Clayton. 

Benefits of completing a Proof of Reserve attestation

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One of the key benefits of PoR is highlight transparency for users, Clayton explained:

"Transparency for users over investors. I think that's pretty cool. And that's one thing that's really different from financial statement audits.”

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This user-centric transparency is contrasted with traditional financial audits, underscoring PoR's value in the digital asset ecosystem.

Another benefit is the wider and simpler distribution of reporting. Often these results are present on the UI, so it's more digestible than reading a SEC filing. It's also possible in some of these cases, especially on the tokenized asset side, to get very frequent transparency, down to less than a minute.

The need for education and standardization

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Jeremy and Clayton emphasize the need for better education and standardization in the field of crypto accounting and PoR. They suggest a focus on digital assets over enterprise blockchain use cases and the importance of setting baseline principles to encourage innovation without compromising reliability. Jeremy explained:

“A baseline principle is what’s needed, because if you create rules at every step of the process, that's when you hinder innovation. But if you create a baseline reporting framework that you need to cross at least this bar, I think that's a good place to start.”

Regulatory trends and the Texas Proof of Reserves Bill

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Lastly, the webinar touches on regulatory trends, especially the example set by Texas with its Proof of Reserves Bill. This legislation mandates quarterly self-attestations and annual CPA or auditor-assisted tests for exchanges. 

"Texas really took a lead here and did a great job...It protects almost everybody, like Texans in the wake of FTX that lost a lot of their money."

Clayton explained, illustrating how regulatory measures can bolster transparency and trust in the crypto space.

Embracing the future of Proof of Reserves in digital asset transparency and trust

The webinar underscores the evolving significance of Proof of Reserves (PoR) in enhancing transparency and trust within the cryptocurrency ecosystem. As PoR distinguishes itself from traditional financial audits by offering focused insights into digital asset holdings versus liabilities, it emerges as a critical tool for exchanges and custodians.

The discussion highlighted PoR's journey from its inception to becoming a vital part of the regulatory and compliance landscape, as seen in Texas' legislative advancements. Emphasizing user-centric transparency and the call for standardized practices. The webinar highlights PoR's integral part in bridging the gap between digital asset operations and the growing demands for clarity and trust from users and regulators alike, signaling a pivotal step towards a more transparent, regulated digital asset marketplace.

To watch the full webinar visit the Cryptio YouTube channel.

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