Are Exchanges Falling Short on Proof of Reserves Efforts?

Blockworks December 18, 2022
Updated 2022/12/18 at 12:44 AM
8 Min Read
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Various so-called proof-of-reserves reports by crypto exchanges following the collapse of FTX are misleading, industry participants said, as assuring the solvency of a centralized crypto firm may only ever go so far.

“The challenge is that you will probably never get to 100% confidence or 100% coverage just because crypto works in very different ways than the fiat system does,” Neal Singh, senior product manager at Merkle Science, said during a webinar Thursday.

Staking, collateralized loans, uncollateralized loans and funds moving to and from different entities within a specific exchange present unique challenges, he added.

“So when you’re looking at it as an auditor, it becomes extremely complicated and extremely difficult to track those funds and to make sure that those funds are being used for legitimate business purposes,” Singh said.

Armanino, the auditing firm for crypto companies such as FTX US and Kraken, is set to exit the crypto space, Forbes reported Thursday.

Audit firm Mazars, who previously conducted reports for and Binance, is also reportedly leaving the segment. The firm told CNBC it had paused activity relating to its crypto proof-of-reserves reports “due to concerns regarding the way these reports are understood by the public.”

Spokespeople for Armanino and Mazars did not immediately return requests for comment.

Kraken calls for a higher standard

In a Dec. 12 blog post, crypto exchange Kraken said certain crypto platforms and exchanges have attempted to pass off “diluted and misleading methodologies” as a proof-of-reserves audit.

“Amid the chaos of the past month, the industry has failed to explain what proof of reserves audits should truly entail and convoluted the process in order to cash in on the hype,” the Kraken blog states.

Proof-of-reserves audits need to be a combination of proof of assets and proof of liabilities, Thomas Perfumo, Kraken’s head of strategy, told Blockworks.

“Because what are you reserving against if you don’t disclose, or basically prove, that you have the assets to cover liabilities,” he said.

The lack of proving liabilities is common right now, the Kraken executive added. Excluding negative balances in the accounting — so as not to “artificially” decrease the amount of deposits you actually owe to your clients — is another key to proving solvency, Perfumo said.

“There’s definitely different levels here, but it all comes down to proving your assets that you control wallets, proving your liabilities and also accounting for the liabilities correctly through a methodology and working with the supervision of an auditor.”

Kraken had a proof-of-reserves audit done by Armanino in February — years after implementing its first one in March 2014. Armanino conducted another audit for Kraken in August, as the exchange expanded its coverage beyond bitcoin and ether to include tether (USDT), USD Coin (USDC), ripple (XRP), cardano (ADA) and polkadot (DOT).

Perfumo said the company plans to include additional assets in its future proof-of-reserves audits and publish such disclosures multiple times per year.

A representative did not immediately comment on how Kraken would proceed with such audits now that Armanino has reportedly halted its work in the sector.

A work in progress

Exchanges such as Binance, OKX and Bybit have released proof-of-reserves reports or tools in recent weeks and have acknowledged they are exploring more transparency efforts.

Kraken CEO Jesse Powell and others called out Binance’s report — conducted by Mazars — for not being comprehensive enough.

A Binance spokesperson told Blockworks Friday it would go forward with proving its assets exist — under its control — on the blockchain, and are seeking to provide “additional transparency” in the coming months.

OKX launched its proof-of-reserves page late last month, showing that all client assets are fully backed and providing a self-verify feature.

OKX Managing Director Lennix Lai told Blockworks that the firm aims to implement real-time wallet custody monitoring for institutional clients. It is also exploring zero-knowledge succinct non-interactive argument of knowledge (ZK-SNARKs), which could provide users with proof of their total net positive US dollar balance.

“We understand that there are some limitations to existing proof-of-reserves approaches, which is why we are exploring the implementation of additional technologies to further enhance transparency, such as zero-knowledge proof,” Lai said.

Though a Bybit spokesperson declined to comment on Kraken’s blog post, it said ​​the firm wants to see better ways of organizing and automating data that reflect holdings and liabilities more comprehensively and make traceability more legible.

“Bybit is deepening our understanding of technical solutions to address industry-wide accountability issues,” the representative said. “Some of the initiatives we are working on internally include exploring transparent wallets and optimizing decentralized custodian solutions with full accessibility.”

Where does proof of reserves go from here?

Sergey Nazarov, co-founder of Chainlink, said that DeFi protocols have for years offered cryptographic proof around the collateral backing assets such as stablecoins and wrapped tokens.

“I fully expect that the second-by-second-updates-created proof of reserves will be the new minimum for all centralized exchanges, and that this new minimum will eventually migrate into the traditional financial system as well,” he told Blockworks in an email.

Singh said during the webinar Thursday that real transparency will take time and require ongoing audits.

“Crypto transfers extremely quickly, so I could take a snapshot today and tomorrow be completely insolvent,” he said.

But a Binance spokesperson said the “Big Four” accounting firms — known to be Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers — are “currently unwilling” to conduct a proof-of-reserves audit for a private crypto company. The crypto exchange continues to seek for a firm to work with.

Spokespeople for the four companies did not immediately return requests for comment.

Aaron Jacob, head of enterprise resource planning for TaxBit, said in an email that the importance of robust accounting solutions for the digital asset space has never been higher.

“The FTX collapse, and now watching their former auditors pull out of their crypto practices, highlights the lack of confidence that has existed for historical crypto accounting practices,” Jacob said. “Now is the time for the accounting profession — enabled by world-class technology — to rise to the occasion and help restore lost trust.”

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