Accounting firms aim to replace ‘dangerous’ Proof of Reserves approach used by crypto giants

When crypto powerhouses FTX, Celsius, and Voyager crashed last year industry leaders understood they had a serious problem: How would investors ever trust them again?

Their answer: Publish Proof of Reserve “attestations’ to show just how much crypto firms have in their wallets to back up their deposits.

Yet now this approach, dubbed PoR, is being branded “dangerous and inadequate” by accounting firms Nephos Group and KYAX.

“What does Proof of Reserves actually prove?” Joe David, founder and CEO at Nephos Group, told DL News. “That at one snapshot point in the month you held assets in a wallet.”

False reassurance

David said PoR as it stands now is counterproductive. “Proof of Reserves is actually dangerous in that it presents to the market a false reassurance of solvency, when it proves nothing of the sort,” he said.

Nephos and KYAX have teamed up to propose a new methodology to help crypto firms prove they are solvent, and help them provide customers with the same standards of transparency commonplace in traditional finance.

Their methodology, which they call KYA — or Know Your Assets — aims to help restore trust in an industry beaten down by a series of crypto crashes which collectively cost investors tens of billions.

“In crypto, there’s a big push towards making things trustless,” Matthew de la Fuente, the CEO of KYAX, told DL News. “But it’s made people not respect the need for trust.”

For De la Fuente, the subject hits close to home. He was crypto lender Celsius’ vice president of strategy and planning when the firm suddenly collapsed in June last year, bringing down with it $12 billion in assets under management.

According to Shoba Pillay, a former federal prosecutor assigned to investigate Celsius by a US bankruptcy court, the company’s financial mismanagement meant it had been “insolvent since inception.”

Proof of Reserves

In response to last year’s spate of crypto bankruptcies, crypto exchanges including Binance, OKX, Bitfinex, and Kraken started using Proof of Reserves to reassure customers they held adequate funds to back customer deposits.

Proof of Reserves involves taking a snapshot of a company’s wallet balances and from them creating a cryptographic proof. The company then hires an auditing firm to sign off on this proof. Customers can check the proof to see how much crypto an exchange had on its books at the time of the snapshot.

“When we say Proof of Reserves, we are specifically referring to those assets that we hold in custody for users,” said a Binance blog post explaining its Proof of Reserves attestations. “This means that we are showing evidence and proof that Binance has funds that cover all of our users’ assets 1:1.”

These snapshots are meant to show that a given company — usually a crypto exchange — is solvent. Ever since PoR emerged it has drawn fire.

“The biggest issue by far is that there’s no verification of total liabilities,” 0xngmi, a DefiLlama developer and creator of the website’s Proof of Reserves dashboard, told DL News. DefiLlama is DL News’ sister company.

“It’s impossible to check that the info on total liabilities is correct, which means that you can’t check that total deposits are greater than liabilities.”

‘The industry relying on this framework is an accident waiting to happen.’

—  Matthew de la Fuente, KYAX

0xngmi said gaps in the data provided by crypto exchanges as well as inconsistencies in their reporting pose additional challenges.

“Some exchanges, like Kraken, don’t report the addresses where they hold crypto, so for those cases it’s impossible to independently verify their total deposits,” he said.

Kraken did not immediately respond to DL News’ request for comment.

KYAX and Nephos say they know these pitfalls all too well.

De la Fuente called Proof of Reserves “dangerous and inadequate” and said it proves very little from an accounting or legal perspective.

“Consumers don’t seem to know that accountants, attestors and auditors often don’t sign off on the financial data itself. The industry relying on this framework is an accident waiting to happen,” he said.

Mazars, an auditing firm that worked with Binance, Kucoin, and Crypto.com, stopped providing Proof of Reserves reports last year, citing concerns over the way its reports were being understood by the public.

The firm said that its Proof of Reserves reports did “not constitute either an assurance or an audit opinion on subject matter.”

‘We want verified sign-offs in place on who can move funds and for what reasons.’

—  Matthew de la Fuente, KYAX

Instead of Proof of Reserves, David and De la Fuente’s KYA system seeks to provide a more holistic assessment of crypto businesses’ financial circumstances.

Rather than focusing exclusively on reserves, it integrates offchain risks, liabilities and governance, and brings them onchain through attestations. But this occurs only after an independent authority has signed off on them, which is similar to the audits of traditional companies.

Sufficient transparency

The idea is that KYA will become a proven and trusted methodology for ensuring crypto companies are following best practices and providing sufficient transparency to their customers.

“We want verified sign-offs in place on who can move funds and for what reasons,” De la Fuente said. “If there were an exchange with 100 employees and all of them had the ability to move customers’ funds, would you trust it?”

Still, creating a better system is only a start.

With a few exceptions, such as the European Union’s landmark MiCA bill, most jurisdictions have yet to introduce comprehensive regulations for crypto companies.

Additionally, many crypto firms choose to register in places with lax financial oversight, such as the Seychelles or the Cayman Islands.

With nothing to ensure that crypto firms put their finances in order and provide greater transparency and checks, it may be difficult to convince them to adopt the KYA methodology.

But this hasn’t fazed David and De la Fuente.

They said the response has been positive, and that they’ve worked with several crypto firms and exchanges on the KYA methodology, but didn’t name them. “They’re names you’ll have heard of,” David said.

Still, while the pair acknowledged the difficulty in building back trust in an industry plagued by malpractice, they expressed optimism about its future.

“The whole world is in scope for coming on chain,” De la Fuente said, “We want to be part of the process that attests that people, communities and companies can trust this movement and embrace the transition.”

Tim Craig is DL News’ Edinburgh-based DeFi correspondent. Reach out to him with tips at tim@dlnews.com.