Proof of reserves: an essential advancement for Bitcoin-secured financial instruments

Since its early days, Proof of Reserves (PoR) has played a crucial role in the industry. The notorious downfall of Mt. Gox in 2014 highlighted the urgent need for transparency. The exchange suffered a hack, with 850,000 BTC (~47,617,204,000 USD at the time of this writing) stolen while their clients remained oblivious. The depletion of funds unfolded over several years before the exchange’s eventual collapse. A PoR framework could have alleviated further financial losses as customers would have noticed the alarming decline of the exchange’s reserves. If this scenario sounds more contemporary than historical, it’s because a similar situation unfolded with FTX, where the same core issues occurred. Had customers and the broader market been alerted to the ongoing depletion of the exchange’s BTC reserves in real-time (or the fact that FTX possessed zero Bitcoin), many systemic risks would have been significantly reduced.

In Australia, similar problems have been observed with conventional audit methods. The downfall of HIH Insurance in 2001, recognized as Australia’s most considerable corporate failure at the time, was partially attributed to insufficient auditing practices. The auditors failed to accurately evaluate the company’s financial situation, resulting in a loss exceeding billion and catastrophic consequences for policyholders and investors. This serves as a stark reminder that even within highly regulated environments, conventional audit techniques can falter in providing transparency and accountability.

Conventional audit methodologies, although historically effective for traditional financial systems, are fundamentally mismatched for the distinctive characteristics of Bitcoin and other digital assets. The primary concern lies in the fact that traditional audits depend on trust in third-party auditors, who are themselves susceptible to human error, conflicting interests, and in certain instances, outright deception. The Enron collapse in 2001 exemplifies how traditional audit mechanisms can fail dramatically. Despite being audited by Arthur Andersen, one of the foremost accounting firms of that era, Enron managed to distort its financial records, leading to one of the most significant corporate bankruptcies ever. The auditors, expected to function as an independent check, were compromised by their dual role as consultants, creating a conflict of interest that ultimately led to the crisis.

And this only covers the past 20 years. Both FTX and Enron utilized auditors. We hire auditors due to our distrust of the individuals managing the organization, and thus far, we’ve redirected trust to another group of people outside the organization. However, the intrinsic risk of relying on individuals and organizations has never been alleviated until now. Enron’s catastrophic collapse stemmed from a clear conflict of interest between them and their auditor—specifically, that Arthur Andersen also provided lucrative consulting services to Enron alongside its auditing role, which ultimately aided them in manipulating their financial results.

One might argue that having auditors suffices and that we already possess these tools, with regulated financial products being “adequately managed.” This assertion has merit, as establishing audit controls to mitigate risk represents the best we’ve managed to achieve concerning financial products. Nevertheless, any serious examination of auditor functions reveals troubling findings:

  • PwC vs. BDO in the Colonial Bank Case (2017)
  • Grant Thornton vs. PwC (Parmalat Scandal, 2003)
  • BDO vs. Ernst & Young (Banco Espírito Santo, 2014)
  • KPMG vs. Deloitte (Steinhoff Scandal, 2017)

For Bitcoin-backed financial products, the stakes are even greater. Bitcoin operates within a decentralized, trustless system where transparency is not merely an attribute but a foundational principle. Traditional auditing methods, which rely on intermittent assessments and human oversight, are ill-equipped to manage the instantaneous, cryptographic nature of Bitcoin. Auditors can only provide a snapshot of a company’s financial health at a particular moment, allowing room for manipulation and fraud in the interim. This is particularly concerning in relation to Bitcoin ETFs, where the foundational asset is digital and can be relocated or rehypothecated without the investors’ or regulators’ awareness.

Proof of Reserves (PoR) presents a resolution to these challenges by utilizing the inherent transparency of the Bitcoin blockchain. Unlike traditional audits that depend on trust in external auditors, PoR facilitates real-time, cryptographic validation of an institution’s Bitcoin reserves. This removes the necessity for trust in auditors and gives investors greater confidence that the foundational assets backing their investments genuinely exist. In a PoR framework, anyone can independently verify an organization’s reserves without needing special permissions or access to internal documents. This represents a revolutionary shift for Bitcoin-backed financial products, as it introduces a level of transparency and accountability that is simply unattainable through standard audit methods.

For Australian investors, the integration of PoR in Bitcoin ETFs would offer crucial reassurance. Australia is witnessing a growing interest in Bitcoin and digital assets, with an increasing demand for regulated investment options that provide exposure to this emerging asset class. However, the risks associated with traditional audit practices, as illustrated by previous corporate scandals, cannot be overlooked. By embracing PoR, Australian Bitcoin ETFs can establish a new benchmark for transparency and risk management, ensuring that investors remain shielded from the systemic risks that have afflicted traditional financial markets.

The argument for transparency: why conventional audit techniques are inadequate

Bitcoin is distinct; it operates and exists differently. Its behavior is unique because the cryptographic assurances it possesses are incomparable to traditional assets. Just as anyone can audit the entire money supply within the system with absolute trustless guarantees, so too can individuals audit the personal holdings of a person, corporation, or ETF that holds Bitcoin in a completely risk-free manner. It’s crucial to note that this isn’t merely risk-mitigated; it is entirely risk-free. An individual can cryptographically verify to any other party that they possess Bitcoin, say, for a loan, without any doubts regarding their actual ownership of the BTC. This process can occur repeatedly with minimal overhead and can be monitored continuously in real-time. There’s no need for titling, external auditors, or reviewing of records; the data can be accepted without question.

Furthermore, the global aspect of Bitcoin adds additional challenges that conventional audit methods are not structured to tackle. Bitcoin can reside across multiple jurisdictions, spanning various exchanges and wallets, complicating auditors’ efforts to confirm the total reserves of an organization. Compounding this issue is the irreversible nature of Bitcoin transactions, meaning that once assets are relocated, they cannot be retrieved. In instances of hacking or malicious activity, traditional audit methods would be too tardy to alert and avert financial losses, leaving investors vulnerable to substantial risks.

What implications does this hold for ETF products? By now, it should be evident that due to their critical role in our contemporary financial framework and because Bitcoin introduces exceptional risk dynamics inadequately served by older audit standards, there is a need for new risk infrastructure tailored to these products. The solution is straightforward: mandating that spot Bitcoin ETF products implement and comply with Proof of Reserves protocols. They ought to provide their investors with assurances that the underlying assets supporting these ETFs are real, securely held, and not being rehypothecated. Failing to do so, or any reluctance from the ETF issuer to adopt this practice, highlights the issuer’s priorities—suggesting either ignorance regarding the nature of this specific financial product or an inclination towards operating in opacity rather than transparency. Not establishing this as a standard throughout the industry poses a significant risk.

Source: bitcoinmagazine.com

Now, consider the implications if the sole custodian holding 90% of the spot Bitcoin backing these ETFs was compromised or acted with ill intent. Unless informed by the exchange, millions of individuals would be holding vast sums in paper Bitcoin. As we become further intertwined with traditional finance, the potential for cross-risk between conventional financial markets and cryptocurrency markets increases. At this juncture, we have two paths moving forward in our maturation as an asset class: either implement traditional security and risk management strategies to this new technology or adopt innovative, more effective standards that are risk-adjusted to prevent a systemic collapse in the event a certain category of financial products faces a shock.

To assert that we are an enhancement over conventional finance, we must embrace that role. It is evident how Bitcoin addresses excessive monetary discretion. It is also apparent how Bitcoin alters your financial interactions—both cognitively, as you are more motivated to retain an appreciating asset, and tangibly, as you can engage in innovative practices like storing the GDP of a minor island nation on a USB drive. However, there is one aspect that is gradually being recognized and must be acknowledged for us to genuinely rectify the errors of the past: Proof of Reserves (PoR).
Bitcoin possesses distinct audit capabilities integrated into its framework. It enables any external party to examine the total money supply down to the smallest denomination without incurring any costs or needing special permissions. The significance and innovative nature of this feature in the Bitcoin protocol cannot be overstated, along with the assurances it provides. For perspective, the total global dollar supply is merely an estimation and lacks precision due to numerous factors, such as the presence of both physical and digital cash, along with the circulation of currency abroad. Likewise, the overall quantity of gold is also an estimate, driven by different reasons, primarily uncertainty regarding the volume derived from various mines, the holdings in private possession, gold reserves, new mining operations, recycling, and undisclosed sources. Other than Bitcoin, there is no worldwide, trustless source of verifiable truth for any currency or commodity. This should propel Bitcoin as we progress.