On The Brink with Castle Island - Jeremy Welch (Kraken) on Contemporary Proofs of Reserve (EP.283)

Episode Date: February 7, 2022

In this episode, Kraken chief product officer Jeremy Welch joins the show to cover Kraken's newly announced Proof of Reserve procedure. In this episode:  Why bring back PoR? What distinguishes today's proof of reserve from the procedure Kraken undertook back in 2015 Why haven't exchanges done PoR historically? What Kraken's PoR actually proves to depositors The role of Armanino in Kraken's PoR What happens when a depositor verifies their PoR How Kraken protects user privacy in PoR The trustlessness of the PoR procedure What regulators can gain from a PoR How Kraken clients can benefit from PoR How Jeremy expects other exchanges to react Sponsor notes:  Compass Mining is the world's first and largest online marketplace for bitcoin mining hardware, hosting, and ASIC reselling. Start mining your own bitcoin by visiting compassmining.io See more on Kraken's PoR here

Brought down by bad mortgage investments, Lehman, which has 25,000 employees, will be liquidated. The federal government loans American International Group, AIG, $85 billion. This is a different kind of market, and the Fed is asleep. The federal government is stepping it to stabilize Fannie Mae and Freddie Mac, the two mortgage giants that have been threatened by the housing crisis. The Bank of England has pumped 75 billion pounds more to Britain's ailing economy with a new round of Conjectureeasy. You print a couple trillion dollars, and all of a sudden, people start to worry. So out of this worry, we have something called a Bitcoin. I'm sitting here today with Jeremy Welsh,

chief product officer at Cracken. Very exciting. Cracken has just announced that they are undertaking a new proof of reserve procedure for Bitcoin and Ethereum. This is such a proud moment. You know, this show I think is the podcast that has covered the ice. idea of proof or reserve the most, maybe, of any sort of crypto podcast? Yeah, you're one of the leaders here, Nick, kind of thought leaders around proof

reserves, period. So we're very excited about this. Jeremy, welcome to show. Thank you for coming on. Thanks for having me on, Nick. So there's a bit of history here. Cracken did a proof of reserve back in 2015, the sort of heyday of proof reserves in the wake of Gocks.

So what, and then, you know, then the idea just sort of fell off the map. the crypto space until I guess there was a bit of a resurgence recently. What was sort of the motivating factor to bring it back? Yeah. So, you know, Cracken was the pioneer around this, around Proof of Reserves. And did this, this was many years ago. So this was back. It's crazy to think about how far we've come.

This is back in 2014. And Cracken's 10 years old, 10 years old. you know, Bitcoin's over a decade old. Cracken is now over a decade old. And that's another thing. It's just super hard to believe about how fast this space has moved and how fast adoption has moved. But at the time, whenever this was done too, a lot of people, I mean, a lot of people in the crypto space, I think, understood the importance and understood that he was even possible.

I think was a, it was kind of a groundbreaking idea. But a lot of people that were deep in crypto thought it was great, thought it was cool. a lot of people outside of crypto had no understanding. But I think that now that we're in a world where crypto is much more relevant, and it's in so many conversations and FTs are everywhere, it has a different way and a different meaning. And so you're asking kind of why to your motivating factor and why to bring this back and it comes down to the fact that the same root points is when we did it the first time. You know, crypto, Bitcoin enables you to do certain things that you could never do before in the traditional financial system.

And one of those is to validate actions because we have the blockchain and because the way that Bitcoin and other cryptocurrencies are architected, we can cryptographically prove. that something happened or that something's owned. And that is just as valid as it was back then. It's important today. And in fact, it's probably more important today just at the scale that we're getting to. So it's something we've wanted to do for a while to get back to doing proof of reserves.

And in the last year, we think we finally hit on a little bit more scalable way to do it. And so we're bringing it back. So I know you weren't at Cracken in 2015. when I think the first procedure was undertaken, but to your knowledge, what would be the distinctions between this new one and the older one-off event? Yeah, so first off, we are working with Arminino, so just in terms of how it was done. This is using an independent third party accounting firm.

the prior when was done, I believe, by an individual. But in this case, this is done by a third-party accounting firm. And even the fact that we have accounting firms that are actively doing this as a function is just something totally different in the world we are today and a great marker. But I think that one of the other big things is that clients can log into their account and directly validate that their balances are included in this. And more importantly, they can even go to Arminino's website. And they can also plug in the account ID or it's a, it's a, it's not the exact account

ID, but the identifier that they can get from their cracking account. They can go plug in on the Arminino side and they can see the validation from Arminino's site as well. So the degree of, you know, client interactivity in this one is higher. And the way that we are doing it, now the underlying process is still very similar in the attestation. But definitely a new level of scale in terms of the provider we're working with as well as the client interaction. Gotcha. Yeah, it is remarkable that there are sort of.

crypto native accounting firms. And those Arminino guys have been on the show. A couple times, I think the last episode we did with them was called like the Renaissance of Proof of Reserve or something. So sort of quite relevant. That said, though, Prove Reserve. I mean, Bitmex has sort of brought it back to a certain degree. We'll see if they do that on an ongoing basis. There's kind of smattering of other exchanges and lenders actually that are doing PORs or things similar. So there's been a slight resurgence, but certainly not broad-based exceptions. So what kind of, in your view, explains the reluctance of exchanges to do these kinds of procedures, but just simply proving that they're, you know, solvent and whole?

Yeah. So it's hard to speculate on the exact reason or it's hard to, to put a finger, I would say, on the exact reason. Maybe it's easier to speculate. But I think that one part of this comes down to whether it's even important from a values perspective, cultural perspective for some of these other companies. We were at a maturation space, a maturation of the entire ecosystem in the entire space, but a phase where you have a.

a lot of people coming into cryptocurrencies and into Bitcoin that were not here from the beginning and not here for the core reasons that Satoshi started off with, right? And so in some ways, I think that some companies, they just don't care. They're here to make a buck. They're here to scale into some new technology and provide a product for customers, but they don't, there are definitely companies out there that just don't care about the underlying, um, long-term goals of Satoshi and other cryptocurrency, you know, providers and creators. So I think that's what. I think that it's just a cultural difference.

Yeah. I think probably the other one is that is that these companies are busy with the rapid scale that we've gone through in the in the last few years. Everybody has priority. Everybody's shipping new products. And the, there's just a lot to do. And so I think that it maybe hasn't been a priority, even for some of the ones that have, that may have the cultural piece there. But I think the third, I think that probably a third bucket or a third kind of entire bucket here is that, you know, some of them may not have the capability to do it.

Or they may not, you know, they may not want to do it because they might be afraid of the results. I don't know. I mean, that's a, that's a, again, all these are speculations as the categories of things. But, but, you know, we have seen other exchanges that, you know, have gone under and have had major solvency problems in the past. And so it is, it is important for crypto firms to be doing this, you know, going forward. And that's why we're doing it. You know, we've seen a lot of legacy financial institutions that have also had had major problems over the years. And so going forward, our hope at least is that more crypto companies definitely do this, but this also raises the bar even for more legacy or traditional financial firms,

knowing that this is possible on crypto, you know, should continue raising the bar for them as well. So for those that are new to the concept, can you walk us through sort of what this actually entails and then what it kind of proves to depositors and the general public? Yeah, so ultimately, you know, all of the funds that we're talking about are on the blockchain. There are a lot of people have heard this term, the blockchain, all of the cryptocurrency funds that are in Bitcoin or in Ethereum or in these other polka dot. I mean, you take your cryptocurrency and there's a blockchain. and all the transactions are bundled up there. All the funds that are created are represented.

And it's different by each system, but are represented somehow, whether it's an accounts-based system or UTXO-based system. There's multiple ways it's represented. But ultimately, all those funds are somewhere tracked in different types of accounts on the blockchain. And because you have these transactions that are happening and the transactions have, you know, you're, you're ultimately signing between any one of these transactions. You can also sign a proof that you have access to, you know, a particular account that has funds on it on the blockchain. And what that enables you to do now is create a, you know, a cryptographic proof of, of the assets that you have in your engagement or your or your possession.

And you can do it in a way that's that's very scaled too. So what's happening with these proof of reserves checks or this proof of reserves audit is we're working with a third party to come through and check and understand, you know, what assets we have in possession and make sure that that lines up closely. to, you know, that lines up closely to what we are claiming to have for customers. This episode is brought to you by Compass Mining. Compass Mining is the world's first and largest online marketplace for Bitcoin Mining hardware hosting and ASIC reselling. Bitcoin mining is only getting bigger and so is Compass Mining. Compass is adding 280 megawatts worth of hosting capacity next

year with more to come. That's over six times Compass's current hosting capacity, meaning more people can mine Bitcoin. With Compass, anyone can mine Bitcoin. Start mining your own Bitcoin by visiting compass mining.io today. So there's the sort of the balances on the blockchain side, and that's eminently cryptographically provable. And then there's the liability side. And you know, you want to add up all of the balances that users have a claim on on the exchange. Exactly right. And the role of Arminido in this is to assist with summing up the liabilities in proving that you're not omitting any.

Is that correct? Yeah. And the goal is also as a third party, an important point around just the, you know, the core steps of the process, right? So it's one thing for a company to come out and say, hello, everyone, you know, we're just telling you, we have all the funds here and without offering any proof. It's another thing for you to offer some cryptographic proof and also have a third party that is a part of that process that, who they themselves also have a reputation to protect and them also to be validating the steps that they've gone through. And, you know, as a part of

this, you know, with again the cryptographic proof. So what is happening under the hood when a crack in client or user is verifying, verifying the proof reserve from their account? Yeah. So we are, you know, with their account. So one thing I will say in this process is that we are actually, you know, with Arminino, it's important to us that, that we have. do anonymized things. And so, you know, we are the way that we shared information with them,

everything is anonymized in terms of actual information for clients. But there would be an anonymized record ID tied to the audit that the customer could then grab and can go validate in Arminino's copy of this entire attestation. So that record ID, is viewable by any customer. And then again, they can take that and step over to Arminino and also see that in their full copy of this, that it is valid as well. So they can see that their account is included in the summation of the liabilities.

And then the other information you give them is the size of the liability set in Bitcoin and Ether terms and then the size, you know, the number of assets held on. chain is that right yep that's exactly it gotcha and then so in terms of privacy like a third party wouldn't be able to triangulate someone's name or information to or any correct or any information really anything even uh account sizes right right and even if even if someone went went out and and you know shared a a public record ID that's not that's still not going to attach anything it would just, you would validate that it is included in this.

But, you know, for any of these record IDs, we, of course, would recommend that cracking clients keep these tightly protected. But, but again, just highlighting here that we've been very, very careful in terms of the process to make sure clients stay anonymous, but they can validate this and that, you know, in working with Armino, that they can validate the funds. but without, you know, exposing any customer information. And is the idea that if, you know, a sufficient number of clients do this, you can have a very strong level of confidence that you haven't sort of omitted any liabilities

and thus understated them? Is it kind of a herd immunity thing or is that kind of the model here? I think that ultimately it's it's you know I think this is kind of getting to what what proof of reserves is actually about which it is about it is about individual client confidence in one way and that over time you know if multiple clients are all checking and they can all see that their accounts are balanced but even even the process itself even just the the cost and the process to go through this this is itself a check on the company, right? And it's a check culturally. It's a check technically. And so just the very act of doing this, even if you have a small subsection of customers that validate it and are excited about it,

it still benefits so many more customers that may not check their exact balance and if they're exactly included. So the only information that's sort of like is publicly not. knowable at the conclusion of all this is just the aggregate size of the assets held on behalf of clients for Bitcoin and Etha Cracken. Is that right? Right. Right. Gotcha. And in terms of the trustlessness, are there any, like, I guess there's like some level of trust that your clients would have to place in Arminino as the entity that was like helping prepare the liability set, right? Yeah. And this is,

going to be true, you know, basically short of any individual client trying to come, trying to come do this process directly themselves. There is a level of trust in looking at the technical capability of a person or a firm or anyone else that's participating in this process. However, you know, the companies being two entirely different companies, both having very strong reputations that are that are now on the line around this, you know, that, that incentive structure is what's super important. And that's what, again, there is, there is an element of trust there, but that incentive structure is very strong that if something were wrong, or if there were some false representation that, you know, it would, it would destroy a lot of credibility

for both companies. So I think that that's what, you know, that's, that's one of the costs there. And that's, again, where, why I think that, that, that, that, that, that, that, that, that, that, that, that would maybe trust or would lean into, if they were to understand those incentives, or lean into why this is a valid vouching as an outside company. So in terms of sort of like the intended audience here, obviously the clients directly can participate in this, but is there also a lens in which this is directed at the general public and also regulators potentially?

Is this something that you expect to provide a signal to those entities? Yeah, it's for everyone. It's for everyone. I think that at a base level, it is for clients because it gives our clients confidence. One, that their funds are safe, that their funds are accounted for. Two, it gives those clients a confidence that Cracken is going above and beyond. for them in terms of safety and security. And three, it also gives them confidence that Cracken, you know,

from a cultural standpoint is the type of place that is that is going to continue doing these. And again, we were the pioneers around proof of reserves. So all of those things are very good, good for clients long term. But I think also if you look at the wider ecosystem of other, you know, crypto companies, it's beneficial for Crackin and for every other company that we're undertaking this and proving that it's possible and kind of utilizing the underlying tech, the original purpose that Satoshi laid this stuff out. We're bolstering the reason why you should be using cryptocurrencies instead of some other technology means, older technology means for financial

transactions. You know, it's also, if you look at the wider regulatory climate for regulators, for governments, even just for other companies that might be, say, like vendors or some other customer of some of these companies, it's very good because this is a, you know, we're again, raising the bar higher than what any kind of traditional financial firm has had to do. And it in terms of compliance and provability. And so that actually raises the bar across the board and is, again, a very good thing that I think builds confidence with, you know, regulators, other companies that might even do business with Cracken.

And again, all of that, again, feeds back into being good for customers and for the wider ecosystem. Yeah, it's remarkable because it's not like banks have any way to prove directly to their depositors that they have. you know, liquidity or asset base that they claim to have. I mean, banks have a zero percent reserve ratio requirement in this country anyway. So the notion of them holding anything in reserve is antiquated almost, but even a custodian of gold bars, for instance, you know, gold custodian,

they have no way have proven to their depositors beyond, you know, traditional audits and mere trust that they actually have those, you know, it's sitting there in their vaults. And here is a way to at scale prove the literal on-chain cryptographic ownerships of these assets. So it's totally superior to existing technology. Is this something that you kind of expect might one day actually be incorporated into sort of regulatory model would be asking depository institutions to do these kinds of

undertaking? Yeah, we'll see. I mean, the fact that it is. possible. You know, it is, you know, we talked about earlier about reasons why others may not have done in the past or may not have done it at all. Other cryptocurrency companies and, you know, I think the first step here is making it a regular, a regular process. And but as a part of that, we're going to be educating a lot of people, a lot of customers, but also a lot of regulators. and it may get to the point to where it does become some kind of a requirement.

And I wouldn't be surprised about that, but I could also see it being nice to have that, you know, or looked on favorably. I mean, you go down a list of it may not even be something that although clients, I do think some clients will care. You could have insurers that might like to see a proof of reserves audit every once in a while. they may not even be something around like financial pieces, but it could be like an insurer around something with just the team that just by seeing that, they view it as it's a validation that this company is kind of going above and beyond. And, you know, the insurance companies look at your driving record, right, to give you better rates. So there's all kinds of reasons and ways that this might be used, even if it's not a pure requirement. But I think the important thing is

that the more we do it, the more we talk about it, the more we educate people, you know, will have these wider implications. So what are you expecting on a go forward basis here? How would you like to refine and improve the process? So for Cracken, first off, this is, you know, Bitcoin and Ethereum is, is, or, or balances that are a part of this first, uh, proof of reserves attestation. And then going forward, we plan to add more and more cryptocurrencies to the process and then also do it on a regular basis. So this is a, again, a first move.

We're hoping to do it at least a yearly, maybe a couple times a year. We'll just again, it's part of this is doing it in a scalable way, like any kind of product or engineering thing. And so we have been working already with that frame in mind and taking a scalable approach. But again, the two components to start with more cryptocurrencies and then at a kind of more frequent scale. But we'll see from there. I mean, eventually the stuff could become totally automated one day, but it is still quite a challenge and a lot of overhead right now. But it could get there one day. So what do you expect in terms of peer exchanges?

Do you think that the idea like finally now has? the traction that it deserves and will become the standard in the industry? To be seen, to be seen. I think that it could, I think that it has the potential to for sure. But it is, it is always surprising, I think sometimes the, it is always surprising sometimes how you get, you know, on a long-term basis, usually there's, usually things go down the biological path, but it's always surprising. Sometimes there can be a lag. And so maybe, maybe some customers will care up front and be excited. And for a lot of our, you know, core, core clients over the

years, the millions that we've built up, there are going to be a lot that care. There are going to be some that demand, you know, that other companies that they work with also do the same. But there will probably be a lot that don't and that don't fully understand it, but they'll be learning. So this first time that we do it, they'll be learning. But as we continue to do it more and more, you know, everyone will get more and more aware. And then, yeah, we do likely see a world to where more and more exchanges and other cryptocurrency companies have to do it because more and more of their customers are up to speed on it. Well, Jeremy, this has been, as you know, one of my passions and I've been pushing for it for a long time. And I think maybe picking on Cracken a little bit because Cracken was one of the, or maybe the first exchange to do it back in the day.

You guys have always been a leader in that respect. And so I'm so glad that, you know, we now have this reinstituted. So thank you and congrats. Yeah, of course. Thanks. Thanks for having me on. Thanks for joining us today. Of course.

Of course. It's going to be an interesting year too, I think. 2022. We're, you know, so much of the space has developed of the last few years. And we're now at a point to where I feel. feel like overall marketplace health is going to become an important topic. And I do think that this actually, proof of reserves, your underlying security, custody, transparency is going to be a part of that. But I think a lot more foundational things now that we have so many use cases and

increasing numbers of use cases of all these technologies, a lot of these foundational components of cryptocurrency ecosystem are going to matter more and more. So we're thrilled to be doing it. Again, we were the first to do it and we're thrilled to be getting back to that. But I think that the client benefits are what most excited us here. Awesome. Well, I appreciate the time with us today. Thanks again, Jeremy. Awesome.

Thanks.