The Breakdown - Okay Proof of Reserves, But for Real This Time?

Episode Date: November 20, 2022

This episode is sponsored by Nexo.io, Circle and Kraken.   On this edition of “Long Reads Sunday,” NLW reads Nic Carter’s newest “Let’s Actually Commit to Proofs of Reserve This Time, Okay?” - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - Kraken, the secure, trusted digital asset exchange, is our sponsor for today’s show. Kraken makes it easy to instantly buy 185+ cryptocurrencies with fast, flexible funding options. You’re covered by industry-leading security and award-winning Client Engagement, available 24/7. Sign up and trade today at kraken.com. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is "Back To The End" by Strength To Last. Image credit: C.J. Burton/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, circle, and crack it, and produced and distributed by CoinDes. What's going on, guys? It is Sunday, November 20th, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conference, conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.L.Y slash breakdown pod. All right, friends, well, last week I read an old Nick Carter piece about

proof of reserves. It was from 2020 and it came after the Quadriga case. It was called something to the effect of how we prevent the next Quadriga, which spoiler alert, we did not. Completely appropriately, Nick is back with a follow-up called, let's actually commit to proof of reserves this time, okay? In the week that has transpired since I read that post, not only has the need for proof of reserves made itself known even more clearly, but the debate has gotten a lot more sophisticated. People are discussing what type of proof of reserves is acceptable. Can it be occasional auditing? Does it have to be constant on-chain analysis? And I think it's great to see that sort of engagement. But let's see what the latest update from Nick is, and we'll go from

there. I'm not going to mince words. The fraud-driven collapse of FTX and Alameda research is, in my estimation, the worst single event in the crypto industry since its inception. Even though as a share of overall crypto market cap, the impact may have been less in relative terms than Mount Gox was. The fallout will be more significant. For one, no one really thought of Gox as a particularly credible institution. It wasn't institutional in any way. Mark Carpels, who was the CEO of Mount Gox didn't go on a charm offensive in Washington to win favor from politicians. Mount Gox didn't air Super Bowl ads. Celebrities didn't line up to endorse the platform. And crucially, the number of users worldwide were much fewer. FTCs, by contrast, served millions of

users worldwide. It catered to numerous funds, institutions, and startups. It was aggressive in promoting itself to mainstream users. Its enigmatic CEO, Sam Bankin-F, known as SPF, practically lived in Washington, charming members of Congress and financial regulators. The exchange was widely considered one of the most trusted and credible institutions in the industry. The apparent fraud and collapse was therefore particularly catastrophic because it happened so quickly and took almost everyone by surprise. Few silver linings. The fallout will linger for years. Silver linings are few. I will admit to having breathed the sigh of relief at SBF's discrediting. His agenda was fundamentally hostile to decentralized finance. His interest seemed to extend only to obtaining a

regulatory baptism for his firm and no one else. He was an unrepresentative and non-aligned ambassador in Washington, and I'm glad he will be no longer representing us in policy conversations. The other considerable bright spot to emerge from this mess is the renewed industry interest in proof of reserves. The more serious among us have been contemplating how we can win back trust among end users and regulators. Some in Washington will naturally call for exchanges to be more heavily regulated under the guise of consumer protection. Some crypto-natives are redoubling their efforts on defy and dexes, considering centralized finance to be a lost cause, and Bitcoin maxis are bleeding to no one in particular about how all centralized institutions are frauds. None of these three

approaches make sense to me. Bitcoin preachers will never convince everyone to adopt a rigorous self-custodial setup. There are no indications whatsoever of their imminent, glorious hyper-Bitcoin-eized, non-intermediated future. Centralized custodians, lenders, and exchanges have existed for over a decade and will continue to be useful and necessary. This is not out of step with a core Bitcoin ethos either. Software developer Hal Finney famously advocated for a free banking approach to Bitcoin. The pro-regulatory crowd would throw the baby out with the bathwater. A crypto industry that replicates the legacy banking sector would achieve little. It's critical we do everything to preserve the interoperability of the crypto sector and eliminate barriers to entry and regulatory capture.

Elevating a handful of centralized exchanges and raising barriers to entry for competitors, as SPF sought to do, would make it far easier for regulators to capture the entire industry by tightly managing a few choke points. And lastly, the Defi and Dex's only crowd misses the mark. Pure Defi isn't without reproach. Terra Luna could, for instance, be called Defi. Hacks and rugpoles are plentiful. And of course, DeFi users need to hold their assets in sales.

self-custody, which, while being the premise of Defi, is a non-starter for the vast majority of people. The fact is, while the average users should have the ability to withdraw funds and transact with them outside of an intermediated system, most users won't choose to do that. We can admit the reality that many users will always prefer intermediation while pushing to improve the quality of these intermediaries. Time for Proofs of Reserve. That's where Proof of Reserve comes in. Proofs of Reserve harmonized the innate transparency of blockchains with the convenience of centralized custodians. The procedure generally refers to a demonstration undertaken by exchanges, proving that they possess client assets to match outstanding

liabilities. There was a minor wave of proof-of-reserve enthusiasm post-Gox, which immediately fizzled out, and a slight renaissance starting summer 2021 with Bitmex proof of reserves and liabilities, followed by Cracken's efforts this past February. Things didn't move very fast thereafter, despite my ardent lobbying. Reform must wait for a crisis, it appears. Post-FTX, a new enthusiasm for proofs of reserve has emerged. A number of exchanges at a minimum Binance, Gate.io, Kucoin, Polonex, Bidget, Bitget, Huobi, OKX, Deribit, and Bybit, have indicated their attention to publish proofs of reserve. A few such as Crypto.com, Bitfinex, and Binance have taken the intermediate step of releasing wallet addresses as a crude

proof of assets, but this is incomplete without corresponding liabilities. The asset side is trivial. It can involve publishing wallet addresses or signing a transaction. The tricky part is matching the assets with the outstanding liabilities. To achieve that, an exchange adds up all user balances, anonymizes them, and publishes the data in mercilized format. From there, depositors can verify that they are included in the liability set. If enough do this, they can have strong confidence that the exchange isn't cheating by omitting liabilities. And if the process happens under the eye of an auditor, users can gain additional assurance that no liabilities are being excluded. Cynics and Bitcoin Maxis

tend to protest that proofs of reserve aren't perfectly trustless. Of course, they aren't. Nothing is, but critics would sacrifice the perfect at the altar of the good. There also has been a brouhaha in recent days about major exchanges engaging in asset snapshots with purportedly borrowed funds, and many are using this to write off proofs of reserve entirely. Some of these accusations were later shown to be unfounded. Writing off proofs of reserve because some weak implementations weren't credible is the equivalent of ordering Little Caesars and assuming all Italian food is garbage. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on Nexo Pro. The new spot and futures trading platform uses aggregated liquidity of over

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A stronger system. A point-in-time asset snapshot without the supervision of an auditor or a cash flow analysis proves very little. The proofs of reserve I and others talk about involves ongoing, frequent attestations, ideally supervised by an auditor. In its more complete form, it provides very strong assurances. Recalcitrant exchanges have few excuses left. Compared with the first rush for Proofs of Reserve in 2014-2015, there are far more resources available today.

The 2021 Practitioner's Guide to Proofs of Reserve, published by myself and a few other collaborators by the Digital Chamber, offers a full picture. The Bitmex Proofs of Reserve open-source code and a guide to replicating the procedure is available, and to the critics who bemoan the lack of accounting firms with expertise in facilitating the process that is no longer true. Top 20 audit firm Arminino has been undertaking these engagements for years and it isn't the only one. During a bull market, I can understand why exchanges wouldn't bother competing based on credibility, but in a time of consolidation, retaining user trust is absolutely vital.

This procedure allows exchanges to be far more transparent than their Tradfite counterparts that cannot independently verify user assets held. Regulators, I expect, will come to demand it. Already, proofs of reserve receive a mention in Wyoming's SPDI or special purposes. depository institution rules, and I imagine it will appear in more legislation soon. Now, with so many exchanges, including market leader Binance, embracing the procedure, the few not participating will raise eyebrows. When pressed, Coinbase's Emily Choi protested that the exchange is already audited and that this should be a sufficient substitute,

but if Coinbase cares about the integrity of the industry, it will undertake the procedure anyway. I would much rather depositors have the option to choose between a variety of public and non-public exchanges, all doing POR, rather than being limited to a handful of public exchanges doing quarterly disclosures through the SEC. Let's be clear, a proof of reserve wouldn't have stopped FTX, Quadriga, or Mount Gawks. All three were insolvent for long periods of time because of either fraud or hacks. But in a world where proofs of reserve become the norm, their refusal or inability to perform a proof of reserve would have stuck out like a sore thumb and alerted users that something was likely awry. So proofs of reserve at the industry scale works via negativa. It's most telling

if you don't do it. In the next few months and years, as proofs of reserve become more common throughout the industry, I hope and expect that we will apply the same scrutiny to the remaining holdouts. All right. Well, first of all, thank you, Nick, for another great, thoughtful piece. Always love having the chance to read them on the show. Now, I want to dig into a few different details here in sort of my commentary follow-up. The first is the question of how much our emphasis should be on making centralized finance infrastructure like exchanges better, versus redoubling our efforts around areas like self-custody and decentralized versions of those centralized infrastructure.

The honest answer is that right now it's going to take all of it, all at once, and that anyone who only wants to talk about one side of this or the other probably has an axe to grind. It is very, very clear that the core bedrock fundamental principles of self-custody that have always been an aspect of crypto, going back to the very beginning of Bitcoin, are a mentality that more people should be introduced to, and ideally a user experience that should be better for others. Now, self-custody can become a fetish, and I think that's some of what Nick is reacting to here. There are huge parts of the world who trust themselves less to remember security phrases and to hold on to hardware wallets than they trust a centralized service to just do it for them.

Even in a world where we get 10, 20, 30, 40%, 50% more people comfortable with the tools of self-custody, there will still be some who opt out. So in some ways, it's not really in either or. When it comes to self-custody, the question becomes, with a combination of education, discussion, and better user experiences, what percentage of the future total market for Bitcoin and crypto assets can be engaging with the self-custodial paradigm, or at least partially self-custodial paradigm where they can move between self-custody solutions sometimes and then decentralized or centralized services when they need them. That to me feels like the right way to think about

that side of the objective. It's not to pretend that there won't be centralized services that exist because, of course, there will. It's to ask, how do we make it so that more people are less entirely reliant upon them? But that does inevitably spit us back to the other side of this equation, which is how those centralized services function. I do think it's worth in the case of FTCS specifically, Reiterating Nick's point, the Proofs of Reserve would not have changed this situation exactly, in that the issue was massive large-scale fraud that was intentionally concealed, not only from the industry but from all but a few of Sam's co-founders and closest consigliaries. But to Nick's point, in a world of normalized industry standard sorts of disclosure regimes

like Proofs of Reserve, it might have been the type of red flag that actually had people willing to ask tougher questions than we got. As I mentioned on Monday's show, one of the things that I've spent a lot of time thinking about over the last couple weeks is what if this had gone on even longer? As painful as the unwinding of FTX has been, obviously personally for me, but for the entire industry, for everyone who is directly and indirectly impacted by that fraud and the fallout from it, it seems to me undeniably true that it was better that it happened the day that it happened versus on any subsequent day. In other words, every single day it went on, it would have been worse. To the extent proofs of reserve or any similar type of normalized, self-imposed, or externally

imposed disclosures give us the ability to root out that sort of bad actor earlier, I think that's probably a good thing. Now, I will also say that I'm glad that we're finally having the conversation about what the difference between a bullshit whitewashing sort of proof of reserve of attestation is versus something that we actually accept. I think especially in this moment where we're particularly fired up, not leaving it at just, hey, we did our proof of reserve, we're good now, right? And instead, designing the regime that this industry finds acceptable in terms of process, in terms of third-party involvement and verification, in terms of frequency, in terms of what data we expect, and more, is super, super important. If you listen to last week's

show, you know there was nothing about the approach to proofs of reserves, really, because we weren't even close to in that state of discussion. Now, the fact that we're talking about what type of firm is or isn't acceptable, how the data needs to be processed, and more, that means we're in a much better place, but I think we need to keep running it down. I appreciate folks like Nick who have been beating this drum for a long time, and I'm very excited that so many others are now thinking about this. In short, proofs of reserve, in whatever version we decide is the appropriate version, feel very much to me to be directly in line with the founding principles of this entire space. They are a mechanism whereby communities, networks of individuals,

ensure that power does not pool with any sort of centralized entity in such an egregious way that it can produce the type of catastrophe we've been living through all year. Now, with all of that said, I want to say again that tomorrow we begin grateful for Bitcoin. I'm so excited for this series. I think you guys are going to have a great time with it. We've got awesome guests, great conversations, and at least for a week, very, very little FTX chat. For now, I want to say thanks again to my sponsors, nexus.com.i.O., Circle and Cracken. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.