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The fall in FTX has heightened the need for greater transparency among cryptocurrency exchanges. Several centralized exchanges have released evidence of their reserves to regain public confidence. However, publishing proof of reserves may not be enough to allow customers to fully trust the exchange. Here we discuss the issue of proving reserves.
proof of reserve Exchange proof that all customer deposits are safe and fully backed by on-chain assets. This proves that the exchange will be independent if the bank is attached. Exchanges are primarily custodians and are not expected to use customer assets for purposes other than custody. Proof of reserves is a great way to demonstrate this. For these reasons, Binance, Bitfinex, OKXKraken, Gate.io, and others all publish reserves.
Coinbase is one of the major exchanges that still needs to publish proof of reserves. Coinbase’s decision is premised on the fact that it is a public company that maintains more transparency than other exchanges. We have our financials reviewed by an external auditor on a quarterly basis and are required to file audited annual financial statements with the Securities and Exchange Commission. Exchanges must also include customer funds as liabilities and assets on their balance sheets.
Other unlisted exchanges are not bound by the same standards as Coinbase. Proof of reserves based on Merkle trees is therefore the best way to demonstrate solvency. Nonetheless, there are still legitimate concerns about the audit process to provide reliable evidence of reserves. Problems include:
Blockchain technology is relatively new and still evolving. While it may borrow some concepts from traditional finance, the accounting process is different. Therefore, reviewing the financial records of these exchanges requires additional expertise among auditors. Most auditors operate according to traditional financial rules and standards and should be fully aware of the inherent risks associated with cryptocurrencies.
Confidence in reports from these auditors is declining as more expertise is required among auditors. This has been a problem for Mazars, an accounting firm that has audited the reserve proofs of several cryptocurrency exchanges, including Binance. It has stopped working with all crypto entities, claiming it lacks confidence in its reports and media scrutiny.
There is a history of cryptocurrency exchanges collapsing even after auditors vouched for their financial health. In 2019, months after Grant’s Thornton audit and positive ratings, New Zealand-based exchange Cryptopia collapsed. In addition, FTX’s collapse also occurred despite the audit process of Armanino LLP.
Traditional auditors have faced problems due to their lack of understanding of digital assets. However, major accounting firms are very reluctant to cooperate with cryptocurrency exchanges. This is due to reputational risk if the exchange fails. KPMG, Deloitte, Ernst & Young and PWC are the big four accounting firms that are generally reluctant to do business with most cryptocurrency companies. Therefore, crypto exchanges either use unreliable auditors or rely on internal audits as a last resort.
Another big problem with proving reserves is the reliance on humans. Auditors are independent, but must rely on the exchange’s information. If an exchange provides inaccurate data and auditors do not exercise due diligence, audited proof of reserves becomes meaningless as they cannot disclose their true financial position.
The Need for Cryptographic Audit Standards
Proof of reserves is flawed, but it is the best way to prove that a cryptocurrency exchange is in good standing. Therefore, we need to address the issue of current cryptographic auditing standards. Ideally, crypto companies and traditional auditors should invest in education and training to improve their expertise.
