Crypto Accounting Is Changing – How Proof Of Reserves Could Improve Crypto Reporting

How can crypto custodians, crypto trading exchanges, and (ultimately) crypto banking institutions prove to external parties that reserves are indeed what they say they are? This is a pivotal question that continues to come to the surface, with a potential solution recently put forward; Proof of Reserves (PoR).

In order for any trading platform or exchange to function as advertised the trading operations certainly must perform correctly, but there is an additional expectation that investors, regulators, and policymakers will certainly bring to the table. Specifically, and in order to maintain the trust of those external participants, as well as avoiding some of the potential issues that had previously arisen with several crypto organizations, clear and consistent guidelines simply makes good business sense.

Clearly the cryptoasset space has developed far beyond the concepts outlined in the bitcoin blockchain whitepaper, and as the ecosystem continues to grow the need for auditability is also increasing. This might strike some as a bit of a paradox, especially since the idea of blockchain is that it creates an immutable and transparent ledger; this is absolutely true. What complicates this conversation, however, is the rise of centralized organizations where a sizeable percentage of – especially retail – crypto trading and transactions occur.

Proprietary databases, off-chain transactions, omnibus wallets, and the inscrutability of these records are well known and acknowledged potential issues, especially as the ecosystem continues to grow in both product variety and market size. While it is true the audits are performed in order to maintain money transmitter (and other) licenses, the concept behind proof of reserves is to take this process one step further. In other words, one of the aspects behind PoR is to expand the depth and scope of audit tasks that can be performed.

Let’s take a look at a few of the considerations that accounting and audit professionals might want to keep in mind as concepts such as PoR become increasingly part of the crypto policy conversation.

Different types of reserves. Much like how assets, liabilities, and external risks need to be assessed differently depending on the specific type of organization in question, the types of reserves that will need to be assessed will also vary. For example, are the reserves in question tied to a specific stablecoin or other type of crypto product, or are the reserves being verified for a crypto exchange?

Stablecoins, in and of themselves, are not a new topic or idea, but are an example of just how important and complicated the auditability of reserves can become. When newer products and services are added to the mix, such as decentralized finance (DeFi), the development of different reserve proofing and audit tools will be necessary. This includes, but are not limited to, liquidity pools, staking and other related activities.

Counterparty risk. One the issues that exists for every financial institution, whether it is crypto based or not, is the idea of counterparty risk. To put it simply every asset is potentially a liability on the books of some other organization, and this risk can be exacerbated in the crypto sector. For example, and directly due to the lack of crypto-specific accounting standards running up against the rapidly differentiating cryptoasset landscape, there can be instances where the same cryptoasset can be reported on the books of more than one organization.

Such a situation is obviously incorrect and unsustainable, but might not even be the result of any malicious intent. That said, intended or not, this potential double reporting of certain cryptoassets could quickly lead to a mispricing of risk, and potentially systemic issues in unresolved in the long run.

Controls. As verification tools and techniques such as PoR potentially become more widely adopted and utilized, there is going to be a need for updated or new control techniques to be implemented as well. For example, if a third party service provider such as an auditor or accounting professional is seeking to verify the results of a PoR process – or even potentially conduct such processes in the future – there have to be controls around which individuals and firms have access to the source data.

This is not dissimilar to the process by which assets are audited and verified at incumbent financial institutions, but is complicated by the unique attributes connected to cryptoassets. Not every cryptoasset is going to be as easily verifiable as the price of bitcoin, for instance, and the process by which this centrally managed data is examined needs to be managed carefully.

Reporting. Ultimately the goal of any verification process, be it PoR or some other iteration on this same theme, is to improve the quality and transparency around the cryptoasset data that is published to the external marketplace. This is again where the importance of involving the accounting profession seems logical; accountants and auditors already play a pivotal role in how a large array of information is reported to the marketplace.

The idea of a proving reserves, despite the superficial similarities to other audit and attestation processes already being used, is a new concept developed specifically to address some of the issues around centrally managed crypto trading exchanges. To that end, as well as working on the inevitable bumps in the road, the results of the PoR type of engagements will need to be translated in a way that is usable for the non-expert audience.

No matter what ultimately comes out of the Proof of Reserves conversation, and even if this specific idea takes on new characteristics over time, the fact remains that this idea is addressing a legitimate market need. Centralization has come to the cryptoasset space, with stablecoins, central bank digital currencies, and financial institutions beginning to offer full suites of crypto related products and services. With the centralization, however, come new potential complications that will need to be clarified moving forward. At the end of the day, the marketplace demands transparent and consistent information; just what accountants and auditors are positioned to assist with delivering.

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