Proof Of Reserves: Can The Industry Rely On 'Independent Audits' To Prove A Business' Solvency?

Binance, the world's largest centralized cryptocurrency exchange by trading volume, was the first to announce that it would share its proof-of-reserves as evidence of its solvency, in the wake of the FTX meltdown and exodus of investors from various centralized exchanges. But, the "independent audit" that Binance showed to the public is now under fire, leading many to question if the proof of reserves reflects the company's solvency.

When Binance released its proof of reserves (PoR) in November, which it claimed was its "next step" in its "commitment to transparency and fostering trust in the ecosystem," many were pleased. Bitfinex CTO Paolo Ardoino told International Business Times that they "welcome initiatives for exchanges to demonstrate proof of reserves and support greater transparency in the industry."

However, a few other crypto personalities immediately slammed the exchange's effort. Kraken CEO Jesse Powel, called Binance's act "pointless" and "either ignorance or intentional misrepresentation."

The crypto executive said what Binance showed was not PoR and that the "Merkle tree is just hand-wavey bullshit without an auditor to make sure you didn't include accounts with negative balances."

Binance later hired Mazars, a global audit, accounting and consulting firm that former U.S. President Donald Trump and his businesses used for years, but had cut ties in February. The firm performed a proof-of-reserves and proof-of-liabilities assessment and later said in an announcement that "Binance controlled in-scope assets in excess of 100% of their total platform liabilities."

According to the full-time lecturer of financial accounting at the Wharton School of the University of Pennsylvania, what Mazars did to Binance is not at all a financial audit.

"They did a comparison of balances per public key address from a list they got from management. They did not compare any balances in independent banks or custodians or depositories," lecturer McKenna said as quoted by Coindesk. "This is more worthless than even the Tether or USDC report," Mckenna, who is also an independent journalist at The Dig, added.

Proof of Reserves (PoR) is an independent audit process for crypto companies that ensures the on-chain holding of the business matches its liabilities. The auditor's role is to verify the on-chain funds of the cryptocurrency exchange platform against its liabilities to assess collateralization.

There were several issues industry watchers pointed out regarding the way these crypto audits were conducted.

In an article titled "Accounting's Big Lie — and How to Fix It" published in October, David Hilzenrath, the lead enterprise and investigative reporter at Project On Government Oversight noted that "the audit firms are not independent." He said, "The audit firms are chosen and paid by the companies they audit. Just as the company hires its auditor, the company has the power to fire its auditor."

And added that "the system incentivizes auditors to please their clients instead of protecting the public."

While Binance's effort to provide PoR is a major attempt to appease investors after the controversial collapse of FTX, still, there are concerns about proof of reserves. The report shows that it is not a live or real-time accounting of balances, but a single snapshot at a certain time.

The PoR only shows the on-chain assets of the custodian, or in this case, the exchange, but does not maintain a record of where the assets originated. Moreover, there are ways to game the report.

Experts in crypto auditing believe the most efficient way to eliminate the exchange's ability to cheat such audits is by using live on-chain monitoring proof of reserves tools, which do not rely on Merkle trees, but on ZK snarks technology instead.

"Every proper audit needs to be verified by an external party, which has proper expertise in the web3 and blockchain fields and is not interested in falsifying the results of the audit," Yevheniia Broshevan, Chief Business Development Officer (CBDO) of blockchain security auditing firm Hacken told International Business Times.

"Nothing stops exchanges from manipulations when they complete Proof of Reserves audits by themselves. The most credible PoR results can only be achieved in partnership with an industry-trusted auditor," the crypto executive added.

On November 22, Mazars took a snapshot of Binance's total liabilities and reserves to conduct a collateralization analysis.

Assets included spot, margin, futures, options, funding, loan, and earn accounts for Bitcoin and wrapped BTC, all held on the Bitcoin, Ethereum, BNB Chain, and Binance Smart Chain blockchains.