Public blockchains have been touted as a cure-all by enthusiasts over the past decade. Promoters have promised faster securities settlement, decentralized social media, instant payments, cheaper money transfers, and everything in between. And indeed, those benefits may come in due course. But there is one area where blockchains are clearly ahead of their traditional counterparts today: accounting.
Blockchain tracks debits and credits to accounts in a ledger, just like a regular accounting system, but in real time, transparently, and immutably (once transfers are settled). The existence of any asset that resides on the blockchain – be it a security token or a digital commodity like Bitcoin – can be fully verified at any time by anyone with an internet connection. The entire Bitcoin supply, down to the smallest unit – one satoshi – can be checked in real time by anyone running a node. Furthermore, an entity can mathematically prove to any third party that it owns a digital asset via a cryptographic signature, without the need for any guarantor. This is not the case for traditional assets or commodities, which rely on a network of intermediaries to establish themselves. In practice, this means that financial assets end up concentrated in large custodians, like DTC with stocks, or gold with institutions like LBMA. The higher auditability cost of traditional assets tends to have a concentrated effect.
The remarkable property of digital asset auditing has enabled crypto platforms to build proof-of-concept tools that enable end-users to verify that their assets are actually held in reserve, and are not simply on someone else’s ledger, vulnerable to error or fraud. These tools are long overdue. For as long as cryptocurrency exchanges and custodians have been around, they let their users down with a series of stunning failures – one crisis after another from Mt. Gox to Bitfinex to Quadriga to FTX and most recently Prime Trust. Those of us who believe in the promise of digital assets are tired of this bleak situation and are starting to demand more transparency from the exchanges we all depend on.
As a result, exchanges and custody platforms today are united around a simple idea: what if these platforms could prove to users indisputably that they control the funds held for users? This is known in the industry as Proof of Reserve, or PoR. The concept has been around in the context of digital assets for nearly a decade, and has been constantly refined since then. Effectively, it includes a custody platform that provides signatures attesting to their unique ownership over certain on-chain digital assets, along with disclosure of client liabilities. By publishing these datasets, and giving end users—and even interested onlookers—the option of physically verifying that a particular liability corresponds to certain assets, customers can get strong assurances that the platform is sound.
Legislative initiatives at the state and federal levels have focused on requiring exchanges to segregate customer and operating capital, and to give customers guarantees in the event of the platform’s liquidation or bankruptcy. This is necessary, but it is only part of the solution. The Prime Trust, which recently revealed it lost $82 million in client assets and hid those losses for years, was a Nevada trust. The trust charter structure, strict from a legal perspective, did little to reveal the loss of assets. A monthly certificate – or even higher frequency -, as is standard with PoR, would have forced disclosure of the loss when it first occurred, because the Prime Trust was unable to provide valid signatures for users’ funds held. This was also the case with Mt.Gox, Quadrigra and FTX. All of these were drawn-out bankruptcies, which were covered up for months if not years. An exchange that participates in PoR certificates is not immune from losing customer funds or being hacked, but PoR discloses these losses as they occur, limiting further repercussions.
In the wake of FTX, PoR is now being voluntarily adopted across the industry. Many of the largest exchanges around the world, including Kraken, Binance, Bitmex, Derebit, Kucoin, and OKX, now frequently hold these certificates, covering tens of billions of dollars in client assets.
Lawmakers in the US and abroad are beginning to realize the importance of PoR. In March, the state of Texas passed standard HB1666, which requires businesses with licenses to send money to implement PoRs, starting in September. At the federal level, Sens. Cynthia Loomis (R-WY.) and Kirsten Gillibrand (D-N.Y.) are included in the mandatory proof of ownership form he reintroduced for the Responsible Financial Innovation Act and the PCAOB’s request to standardize the procedure.
Since 2021, Wyoming has indicated Proof of Reserve under the state’s digital asset custody framework. Dubai (see Reserve Assets) and Singapore (see Regulation 16C(11)) also indicated similar in-chain and off-chain adjustments in recent guidance. Canada has recommended since 2021 that exchanges participate in PoR as best practice. Bermuda, which distinguishes itself as a major crypto-focused regulator, has maintained an explicit proof-of-book reference in its digital asset custodial code of practice since 2019. PoR is neither new nor limited in its reach to a handful of enthusiasts. It has been around for years and has already been adopted by regulators all over the world.
This is not to say that PoR is without its detractors. Sens. Elizabeth Warren (D-Massachusetts) and Ron Wyden (D-raw) have engaged in a campaign of harassment directed at auditors who serve crypto firms. They aim to frustrate the crypto space by stripping it of CPA company services, which are essential for platforms operating under MTLs and similar regulatory regimes. In a recent letter to the PCAOB, they attacked PoR as a “fake audit.” The PCAOB has duly issued an advisory letter warning investors about PoR certificates. Scare audit firms away from a fit-for-purpose form of assurance is the exact opposite of what a reasonable accounting regulator should do. For its part, AICPA has objected to issuing any guidelines on PoR even though it is progressing on standards for certifying stablecoins. This uncertainty has left most CPA firms unwilling to oversee these procedures. We in industry are pushing for more sunlight, but some Washington lawmakers aim to leave us in the dark.
The standard criticisms of PoR have largely been addressed. PoR is not thought of as a replacement for standard types of audit but rather as a supplement. Recognizing this, the Texas legislation mixes traditional escrow with native crypto, asking for PoRs but also for CPAs to oversee them. Specialized CPA firms have emerged with expertise in overseeing these procedures. A traditional warranty is fine, but it’s no substitute for high-frequency proof to end users that guards have their money’s worth. And despite the risks of early client data leakage, innovations — such as no-knowledge proofs — allow PoRs to be accomplished safely.
We do not require cryptocurrency exchanges to be held to a different standard than traditional custodians. In fact, a recurring Proof of Reserve Certificate provides much greater transparency than what traditional custodians can offer. It is not a replacement for standard audits but a narrower complement – it enhances traditional audits. The two together provide a level of assurance that cannot be achieved otherwise. We simply ask that Washington stop undermining the industry’s efforts to clean itself up, recognize the validity of PoR, and facilitate its diffusion across the industry. Lawmakers should encourage accounting standards-setting bodies, such as the FASB or PCAOB, to certify industry efforts around PoR so that audit firms feel empowered to oversee them. And they should recognize the good work guardians are already doing to make themselves more transparent and accountable.
The cryptocurrency industry is working hard to restore confidence. If PoR becomes widespread and standardized, we will exceed the level of security that custodians can provide with traditional assets. This is a worthy goal that Washington should support.
Nick Carter is the founding partner of blockchain-focused investment firm Castle Island Ventures and co-founder of blockchain data firm Coin Metrics. The opinions expressed in Fortune.com articles. Comments are solely those of the authors and do not necessarily reflect the opinions or beliefs luck.
