Post-Binance Reality: Is Proof of Reserves Idea Compromised?

In light of Binance’s charges, the question persists: can we trust crypto exchanges solely based on their PoR audits?

PoR audit robot sitting on a pile of gold bars working on its laptop.
Created by Gabor Kovacs from DailyCoin

“Digital assets markets are new, but the risks and concerns within digital asset markets are not unique. Same risk. Same regulation,” stated the US CFTC Commissioner Kristin Johnson this week after charging Binance $4.3 billion for economic sanction and anti-money laundering violations.

On top of the hefty settlement, the world’s biggest crypto exchange is also facing the scrutiny of additional auditings, which may reveal things Binance would not want anybody to see, like the origins of its funds or the actual value of its reserves.

Soon after the FTX collapse last November, Binance became one of the key advocates for transparency, championing Proof of Reserve (PoR) audits as a means of restoring customer trust in the crypto industry.

Yet, in light of today’s legal charges, we are once again faced with a weighty question: Can we trust the entire invisible puzzle by relying on a single clear piece provided by a PoR audit?

PoR Audit Paves Paths into Legislation

Although the idea of a PoR audit has been in the air for a long time, it was only as recently as October that it first reached the US Federal Senate. Senators John Hickenlooper (D) and Thomas Tillis (R) introduced a bipartisan bill that required digital exchanges to comply with basic accounting standards.

The document, labeled a PROOF Act, seeks to oblige crypto exchanges to prevent the unethical mixing of customer funds. It also mandates a monthly PoR report from an independent third-party accountancy firm.

If the law is approved and takes effect, it will be the first of its kind in the United States at the federal level. A similar legislative act was adopted earlier in Texas, the state with the second-largest gross domestic product (GDP) in the U.S.

Unanimously passed legislation mandates that Texas-licensed crypto exchanges maintain sufficient on-chain reserves to fulfill their customers’ obligations since September 1. It also prohibits commingling customer funds with operational funds and requires regular auditing.

“The focus of our work was to get to a bill that delivered consumer protections while recognizing the importance of having participation from the industry,” Steve Kinard, Texas Blockchain Council Director and former candidate for State House, told DailyCoin.

A crypto advocacy association contributed to drafting the Texas Proof of Reserves bill, which was later unanimously passed in state legislature. The Texas Blockchain Council financially supports the lawmakers, ensuring that the blockchain community is represented in government at all levels.

According to Kinard, the advisory committee comprised an accountancy expert, among other industry experts. As shown on the open sources, Jeremy Nau, co-founder and partner of The Network Firm, is also a proud TBC member. His brand new accounting firm is basically formed from the same crypto auditing team that separated from Armanino LLP in early 2023.

Armanino, a former accountant of now-bankrupt FTX, issued a positive financial health assessment for the exchange a year before Sam Bankman-Fried’s crypto empire collapsed. 

Proof of Reserves Scope Remains Narrow

So far, the only existing Texas “Proof of Reserves” bill focuses on ensuring “that exchanges do not deceive their customers by representing that they are storing non-existent third-party bitcoins,” says Steve Kinard.

The PROOF Act, if passed, will probably be the same. The scope of the Proof of Reserves audit is limited to a very specific verification of the existence of the reserve assets.

Compared with traditional financial audits, this is a fragmented audit that does not look at the bigger picture of a cryptocurrency exchange’s financial health. It does not provide any information related to other liabilities or risks that the exchange faces, including sanctioned transfers, transactions related to money laundering, or financial fraud.

“Further disclosures around sources of funds or investors would be outside the scope of proof of reserves, though it is something that could be revisited in future legislatures in a separate bill.”

Considering that the Proof of Reserves legislation alone first appeared a decade after the emergence of digital currencies, the wait for a more comprehensive obligation for crypto exchanges to comply with financial auditing rules may take some time. In fact, the sponsor of the law, Senator Thom Tillis, noted that a comprehensive regulatory framework for crypto firms is “not likely to occur.”

There is an ongoing debate among U.S. politicians as to why cryptocurrencies should or should not be easily integrated into the financial system and, above all, should become subject to anti-money laundering rules so that sanctioned or criminal entities cannot use their services.

Auditors Lack Regulatory Framework

One of the key reasons why the creation of clearer audit standards may take time is that the legislative framework governing crypto assets is inconsistent across jurisdictions worldwide.

Most crypto exchanges are still largely unregulated from a conventional point of view, says Tina Balzli, the Partner leading the Fintech and Blockchain Practice at international law firm CMS Switzerland.

“The only thing which remains as a point of control is the ordinary type of audit, which, of course, is not as such, completely suitable to these types of operations and undertakings because they're made for more type-of-operational companies.”

As digital asset service providers are special companies, they require additional regulation and financial market laws. According to the lawyer, a fully-fledged financial market license could work as an additional layer of regulation.

A similar practice has been in place in Switzerland, which established a legal and regulatory framework and adjusted federal laws to integrate digital currencies back in 2021. 

Crypto-related firms operating in Switzerland have general rules under the license, which oblige them to comply with regulatory standards. For example, entities, even if they are crypto exchanges, can’t hold in custody any tokenized assets if they are operating without a banking license. 

However, obtaining such licenses is challenging and may take months due to high regulatory requirements for various factors, including liquidity coverage, provisions, corporate governance, ownership, and numerous other criteria.

Therefore, according to Tina Balzli, we are only talking about Proof of Reserves legislation because crypto industry players are not sufficiently regulated from a financial markets perspective.

“First, we need to have the legal requirements. And then, the auditor comes in and looks at whether these requirements have been complied with. The audit can only be as good as the rules.”

Audit Companies Are Ready

Meanwhile, as long as there is no legal regulation, crypto exchanges are not legally obliged to audit their reserves. They do it voluntarily, occasionally conducting PoR audits themselves or not disclosing who their independent auditors are.  

As per a previous DailyCoin investigation, only four of the ten largest crypto exchanges regularly conducted PoR audits this year. At least three of them admitted they’ve been running PoR verifications internally.

A fintech lawyer notes that such practice puts the consumer at very high risk, as he or she is only left to believe that the exchange is doing what it is supposed to be doing. Thus, the key question is whether this is enough for both the user and the jurisdiction in which the exchange operates. Investor protection within the market should be the primary concern, especially in a landscape where crypto exchanges are handling exponentially larger trading volumes.

Big4 audit companies – the biggest, most reputable international accountancy firms – are fully prepared to start working with cryptocurrency businesses. These firms have the required knowledge and experience. However, the auditors can only go as far as the necessary rules allow them to, notes CMS Switzerland Partner Tina Balzli.

In the European Union, the Markets of Crypto Assets (MiCA) regulation comes into force next June. It will cover a broader scope of digital asset regulation, including requirements to meet certain standards of internal company management and the avoidance of conflicts of interest.

According to Balzli, this could work as a good example of broader regulatory scrutiny, which, from the legal perspective, goes way beyond a too-narrow Proof of Reserves audit.  

The Bottom Line

Looking at the post-Binance reality, can we say that trust in crypto exchanges has been definitively shattered? 

The crypto market looks more stable than last November when Sam Bankman-Fried’s insolvent empire was exposed, hurting everybody around it. Bitcoin price was relatively unfazed following the dramatic announcement of the DOJ-Binance settlement, quickly reclaiming its former levels just days after the event. As usual, the crypto community remains divided between CZ supporters and critics

Everything looks as before, except that the world’s largest crypto exchange will, from now on, be heavily audited and will most probably step down from crypto Olympus. Transparency, not just the kind that the self-auditing exchange asked us to believe in, will likely increase in the near future.  Perhaps this is a good opportunity to start changing now?

Learn more about Proof of Reserves (PoR) audits:
Proof of Reserve Audits: Smoke, Mirrors, or Real Transparency?

Check out our latest investigation on the disappearance of the BKEX crypto exchange:
How to Make a Crypto Exchange Disappear? BKEX May Know a Trick

This article is for information purposes only and should not be considered trading or investment advice. Nothing herein shall be construed as financial, legal, or tax advice. Trading forex, cryptocurrencies, and CFDs pose a considerable risk of loss.

Author
Simona Ram

Simona Ram is a senior journalist at DailyCoin, based in Lithuania, who covers the forces and people shaping the Web3 industry and the areas where decentralized crypto assets meet the centralized world. She has experience in business communication within the financial sphere and has a degree in Foreign Languages, which helps her interact effectively with sources from diverse backgrounds. In her free time, Simona enjoys exploring new cultures.