Since crypto's meltdown in 2022, with the fall of market behemoths like FTX, the digital asset industry has come to rely on "proof of reserves" as the go-to attestation for trust and reliability from an internal accounting and market reassurance perspective.
As FTX was accused of misappropriating user funds, leading exchanges like Binance rushed to assure users their reserve claims could be trusted and many asset-based crypto firms followed suit. However, proof of reserves is not the panacea the industry portrays it to be. From an accounting perspective, the attestation is deeply inadequate and the industry's reliance on it has created a dangerous situation for the public, audit and accountancy firms in equal measure.
Understanding proof of reserves and its limitations
Proof of reserves, or PoR, refers to a verification approach confirming that a trading platform or cryptocurrency company genuinely possesses assets in custody that are equivalently matched one to one with the holdings it represents for its customers at a specific point in time. (This uses a technical cryptographic calculation to verify that assets exist without disclosure of the underlying asset details.)
Proponents argue that PoR is crucial in verifying the strength and stability of a crypto company. They claim the transparency afforded by the system gives investors the confidence to know their assets are securely stored with a solvent, stable entity.
The fact is PoR is a dangerous and problematic system that proves very little from an accounting, audit or legal perspective. When a company provides PoR, the potential liabilities, hazardous processes and lack of general safeguards that many crypto firms have are completely ignored or minimized. Similarly, it is merely a snapshot of an entity at a particular time and doesn't account for many financial structures, including automated repo transactions (such as those that took down Lehman Brothers). In digital assets, even a day is a long time. The industry relying on this framework is an accident waiting to happen.
Moreover, consumers don't seem to know that accountants, attesters and auditors often don't sign off on the financial data itself. In fact, it is this misrepresentation that accountants and accounting firms should be wary of. Many digital asset companies reportedly market their relationship with accounting firms providing PoR as auditors "signing off" on their books, despite the work not fitting this definition.
Recently, the SEC warned accounting firms working with crypto companies to be careful about how their PoR reports are being presented. Paul Munter, the SEC's chief accountant,
The path forward
For the digital asset industry, the path forward is clear. Instead of relying on PoR, the focus should shift to adopting a holistic and continuous approach to financial transparency, bringing off-chain liabilities and risks into the equation. This involves collaborating closely with seasoned accounting professionals, adapting traditional finance and accounting methodologies to digital assets' unique structure, educating users about the limitations of the current systems, and committing to comprehensive, ongoing and autonomous financial audit reporting.
These comprehensive audits should allow a firm to analyze a digital asset company's internal systems from top to bottom. The liabilities, governance, processes and data involved on the financial side of the firm should all fall into the remit of a full spectrum attestation.
Accountants and auditors, in turn, must be proactive in demarcating the boundaries of their associations with digital asset companies if relying on PoR. Clarifying the scope and nature of their work can preempt any misconceptions and protect their businesses were more upheaval to occur in this volatile industry.
The digital asset realm is teeming with potential. But realizing this potential requires an unwavering commitment to transparency, integrity and continual evolution. It's time to move beyond PoR and usher in an era of comprehensive, transparent financial auditing and attesting that truly safeguards professional standards and investor, market, consumer and community interests.
