Why wasn’t a guide to reserves issued on some stock exchanges?

The fall of FTX has led to calls for increased transparency among cryptocurrency exchanges. Several centralized exchanges have issued Proof of Reserves to restore public confidence. However, it may take more than just publishing proof of reserves before customers can fully trust the exchanges. Here, we discuss the problems with Proof of Reserves.

What is Proof of Reserves?

Proof of reserves It is a certificate from the exchange that all customer deposits are safe and fully backed by on-chain assets. It proves that the exchange will become independent if the bank runs. Exchanges are basically custodians and are not supposed to use their clients’ assets for any purpose other than custody. Proof of reserves is an excellent way to show this. For these reasons, many exchanges, such as Binance and Bitfinex, OKXKraken, Gate.io, etc. have deployed all their reserves.

Which Exchanges Have Not Issued Proof of Reserves?

Coinbase is one of the major exchanges that still needs to publish proof of reserves. Coinbase’s decision is based on the fact that it is a public company which means it has a higher degree of transparency than other exchanges. It has a quarterly external auditor review of its financial statements and must provide the Securities and Exchange Commission with annual audited financial statements. The exchange must also include customer funds as liabilities and assets on its balance sheet.

Proof of reserves problems

Other exchanges that are not publicly traded do not adhere to the same standards as Coinbase. Therefore, Proof of Reserves based on Merkle tree is the best way to prove solvency. Despite this, valid concerns remain about the audit process to provide reliable evidence of reserves. Problems include:

lack of experience

Blockchain technology is relatively new and still evolving. While it may borrow some concepts from traditional finance, the accounting process differs. Therefore, there must be additional expertise among the auditors to audit the financial records of these exchanges. Most auditors operate under traditional financial rules and standards, and must be fully aware of the unique risks associated with cryptocurrencies.

The need for more experience among the reviewers reduced confidence in the reports from these reviewers. This has been an issue for Mazars, the accounting firm that has audited Proof of Reserves for several cryptocurrency exchanges, including Binance. It has ceased working with all crypto entities, citing lack of confidence in their reporting and media scrutiny.

There has been a history of cryptocurrency exchanges crashing even after auditors confirmed their financial health. In 2019, the New Zealand exchange Cryptopia crashed a few months after Grant Thornton audited and positively rated it. Moreover, the collapse of FTX also occurred despite the audits of Armanino LLP.

Lack of interest from leading audit firms

Traditional auditors have had problems with a lack of understanding of digital assets. However, there is a high degree of unwillingness on the part of leading accounting firms to cooperate with cryptocurrency exchanges. This is because of the reputational risk in the event of an exchange failure. The big four accounting firms — KPMG, Deloitte, Ernst & Young, and PWC — are usually reluctant to work with most crypto firms. Therefore, cryptocurrency exchanges use less reliable auditors or rely on internal audits as a last resort.

potential for human error

Another major problem with proving reserves is the dependence on humans. While auditors are independent, they must rely on exchange information. If the exchange provides inaccurate data and the auditor fails to exercise due diligence, the auditor’s evidence of reserves will be aimless because it will fail to disclose the actual financial position.

The need for cryptographic auditing standards

Despite the drawbacks of Proof of Reserves, it is still the best way for cryptocurrency exchanges to prove that they are doing well. Therefore, the problems of existing cryptographic auditing standards must be addressed. Ideally, crypto firms and traditional validators should invest in education and training to improve their expertise.