Episode 3: Proof of reserves | The State of Digital Assets

Episode three of KPMG in Canada’s series on the state of crypto assets is all about proof of reserves. Adam Rodricks, National Lead, Digital Services welcomes back Kareem Sadek, Partner, Technology Risk Consulting; Kunal Bhasin, Senior Manager, Technology Risk Consulting; and Mitchell Nicholson, Senior Consultant, Technology Risk Consulting for a discussion on proof of reserve’s origin and how vital a proof of reserve is in today’s crypto space.

Episode Transcript

(00:00):
Hello everybody and welcome. I’m your host Adam Rodricks and today I am elated to welcome you to a special KPMG PodBytes series entitled ‘The State of Cryptoassets’. If you missed our first two episodes, I encourage you to check those out as well.

(00:16):
Today I’m joined today by my esteemed colleagues in Technology Risk Consulting, Mitch, Kareem and Kunal. Welcome everyone. Can we start off with some roundtable introductions – we’ll start off with you, Mitch. Please let everyone know what you do at the firm.
Thanks, Adam and it's a pleasure to be back. This is Mitchell Nicholson here. I've been with the firm for a few months. I'm trying to get involved with everything crypto here at KPMG.

(00:39):
Awesome. It's Kareem Sadek here. I’m a Partner with our Technology Risk Consulting practice and I co-lead our blockchain Risk Consulting practice across Canada with Kunal. It’s a pleasure being with you again, Adam.
Hi Adam, nice to be back again. My name is Kunal Bhasin. I'm a Senior Manager in our Risk Consulting practice and I co-lead our blockchain and crypto asset efforts alongside Kareem.

(01:08):
Fantastic. Once again from me to you, thank you so much. I've seen the Outlook calendars, I know how busy you gentlemen are, so the fact that you're here to share your insights with our KPMG Podbytes listeners means the world to me.
Kunal, up until this point, our series has looked at custody as it pertains to digital assets and virtual currency. Today, we're going to focus on proof of reserves. I've been trying to wrap my head around this for some time; could you please explain what proof of reserves are and how it applies to digital assets?

(01:39):
For sure, Adam. Proof of reserve is a concept that enables trust in the whole cryptoasset ecosystem. Companies want to be able to show their users and their clients that they have more assets than they have liabilities, that is, they have enough on chain crypto to cover their user liabilities.

(02:01):
If I dig a bit deeper into this, there are two sides for any crypto organizations that are providing services to its users. There's an asset side and a liability side; each side has its own ledger. So, if you think about it, Bitcoin or other permissionless networks like Ethereum are all public ledgers where assets are held and can be accessed using the private keys.

(02:29):
Now, companies also use an internal ledger or platform to manage or attract the amount of Bitcoin and crypto for themselves or their users. If there is deposit into the platform, that will show up on chain. However, if there is a transaction showing up on the trading platform that doesn't necessarily show up on chain, that's just tracking a company’s internal platform, which is generally a centralized database that's not shared or open to others.

(02:56):
So really, at the core of it, proof of reserve is about ensuring that the liabilities that are recorded on these centralized databases match the assets that are stored in the entities’ wallets on the block chain.
That's interesting. It almost acts as a safeguard for organizations like crypto exchanges. Kareem, I know we've talked extensively and yet somehow this has never come up. Does that mean that proof of reserves is a new concept; is it something that only crypto exchanges need to worry about?

(03:30):
It's not necessarily a new concept, but there have been some changes and let me try to clarify here. Quite a few exchanges did this back in in 2014, but then they stopped for some reason. Let me rephrase that. I think the reason it stopped is the customers or users haven't been asking for it or the regulation hasn't been there to justify it for a lot of these exchanges. Having said that, the trends back up in the right direction. We're seeing quite a few successful exchanges and custodians do the proof of reserves again.

(04:21):
You talk about exchanges, so they're just one type of entity that should do it. We also have stablecoin issuers that are issuing token or digital assets that are backed one-to-one with a denominated currency. What's happening is the customer or institutional expectation from such organizations is to be able to demonstrate that their assets on chain and in circulation are more than the liabilities.

(04:51):
If you think about it, cash backing, the stablecoins minted – that's essentially what it is. It really should be any firm that is custodying users’ cryptoassets. Exchanges and stablecoin issuers are the primary examples, but there are other things like lending firms, asset managers and ETF issuers, which is new here in Canada; they come to mind too.

(05:20):
Okay, got it. Kunal, I want to come back to you because Kareem mentioned that proof of reserves is a trend that we're seeing an uptick in again. Can you elaborate on the specific benefits an organization can expect by having a proof of reserve?
For sure. I just want to reiterate that blockchains are excellent accounting tools because the data is publicly accessible, it updates in real time, and the veracity of the data is also guaranteed as the miners or validators constantly secure the network.

(05:54):
The problem is that the liabilities data, which is the assets owed to the users of the exchange, custodian, or lender are not recorded on the blockchain. Hence, a proof of reserve involves an independent third party coming in and reviewing both the blockchain and the internal records to ensure that the entity has at least enough crypto assets to offset its liabilities. This is something that we are seeing an uptick in regulators getting the hang of this concept; they are looking to embed this as a requirement in their compliance processes.

(06:35):
So, Wyoming, as we all know in the cryptoasset ecosystem, has taken a huge lead on the regulatory front and proof of reserve is part of their regulatory process as well. As we see more and more regulatory clarity emerge and regulators further understand what the proof of reserve capabilities involve and the efforts involved as well, we will see a lot more organizations continue to do that.

(07:07):
Another reason is that it is a management best practice – it really serves as their internal audit function for good operational hygiene. Management themselves would want to know that they have what they think they have. It also supports them in obtaining insurance and better premiums for their insurance as well.

(07:29):
To add another benefit, it's really about user confidence and from the custodian’s point of view, gaining a competitive edge over their peers. In Canada, we had Quadriga, a large Canadian exchange, where many of its users ended up losing the majority of their assets held there. During the period leading up to its demise, the prices on Quadriga were actually about 10% higher than other exchanges. This really reflected a credit risk that, as clients had trouble withdrawing their assets from the platform, people demanded a higher premium in order to actually buy Bitcoin on that exchange. When we're thinking about a competitive advantage going forward, having the ability to prove that all client's assets are backed by funds that are stored within the custodian is essential to winning their confidence and emerging as the leading custodian in the industry.

(08:34):
Fascinating – thank you Mitch and Kunal. I think we have time for one last question and perhaps it's one that our listeners would have appreciated if I had asked earlier in our discussion. When it comes to proof of reserves, what is the end product that a client receives and what can they do with it?
The end product is an independent account and attestation report under the agreed upon procedure standard that's governed by AICPA or CPA Canada. This is not really a new standard – industries have been relying upon AUP reports, or agreed upon procedures reports, for quite some time now. What that shows is really that the organization for which we're doing the proof of reserve review or attestation is that they have more assets or equal in assets on chain as they have the liabilities on their internal books.

(09:30):
If I can jump in here, Adam - I started off at the top of the podcast explaining how this is happening and why is it that we're not seeing a lot of proof of reserves or adoption happening. And I'll end with the same thing; I think it comes back to us as consumers. So you're saying “What's the benefit that comes to the client”; for us to see more adoption and clients actually doing these proof of reserves, I think the onus is on us as consumers to ask for it. The more we ask for these things, the more we're going to see these exchanges, custodians or whatever it might be, doing these proof of reserves. Like Mitch mentioned, it is an advantage for them but it also gifts comfort back to the consumers around that.

(10:23):
So us being consumers, I'm going to call out on everybody, all cryptoasset lovers and believers out there to push for things like that, because we're going to see a lot more from the regulation standpoint. We're only going to see more and more when it comes to proof of reserves.
I love that Kareem and I totally echo everything that you just said. The traditional audit space, that once or twice a year audit, doesn't really give that level of comfort when it comes to the cryptoasset ecosystem. Proof of reserve reviews are by nature a best practice and more frequently done than your traditional attestation or audits. Because of the nature of cryptoassets, consumers would want to ensure that their liabilities are being accounted for when you're doing these proof of reserve attestations on a monthly or quarterly basis just to demonstrate that the exchange or the organization is maintaining that balance; it's not something that's coming onto their balance sheet just before an audit.

(11:34):
That sounds amazing. Unfortunately, we are out of time for today’s episode. I want to thank our three guests Kareem, Mitchell and Kunal for taking time out of their busy schedules to be with us in studio today. Join us next time on the KPMG in Canada’s PodBytes series on the current state of digital assets when we’ll welcome back Kunal and Mitch, and introduce Rebecca Ip, Partner in KPMG’s Financial Crimes practice, for a discussion on AML compliance and cryptoassets. Once again, I’m your host Adam Rodricks and thank you for listening. Bye everybody!