Proof of Reserves: Show me the money or it didn’t happen

If we’re going to claim to be an improvement on traditional finance, we’d better start playing the part. It’s clear how Bitcoin fixes rampant monetary discretion. It’s also clear how Bitcoin changes your relationship with money—both financially because you’re more inclined to save an appreciable asset—and physically because you can do new things like keep GDP of a small island nation on a USB. There is one thing, however, that is slowly gaining acceptance and must be accepted if we are to truly improve upon the mistakes of the past, and that is Proof of Reserves.

Bitcoin has unique auditing properties built into the system itself. Bitcoin allows any third party to audit the entire money supply down to the smallest unit. A third party can do this for free without special privileges or permissions. It is difficult to overstate how novel and consequential this property of the Bitcoin protocol is and the implications of the guarantees it provides. For context, the total global dollar supply is an estimate and not an exact number, due to a variety of factors, including the existence of physical and digital cash, as well as currency circulation abroad. The total number of existing gold is also an estimate for quite different reasons, mainly the lack of certainty regarding the volume of gold extracted from various mines around the world, gold existing in private hands, hoards and gold deposits, new mining. , recycling and unreported sources. There is no global, trustless source of truth for any money or commodity other than Bitcoin. And that should be Bitcoin’s driving force moving forward.

Proof of Reserves (PoR) has been an important part of the industry since its inception. The infamous collapse of Mt. Gox in 2014 set the stage for much-needed transparency. The exchange was hacked, 850,000 BTC (~$47,617,204,000 at the time of this article) was stolen, and their customers were unaware. Funds were depleted within a few years before the actual collapse. A PoR system would have mitigated further fund losses as their clients would have seen the exchange’s reserves depleting at an alarming rate. If this sounds more like a recent memory than an ancient piece of Bitcoin history, it’s because the same argument applies to FTX and the same basic thing happened to FTX. If customers and the market at large had seen the exchanges BTC reserves depleting in real time (or the fact that FTX had no Bitcoin), the systemic risk would have been dramatically mitigated.

So what do you think would happen if the single custodian that owns 90% of the Bitcoin price backing these ETFs was hacked and/or acted maliciously? If the public is not notified of the exchange, millions of people would hold billions of paper Bitcoins. The more we connect to traditional finance, the more cross-risk there is between traditional financial markets and crypto markets. There are two options at this point as we continue to mature as an asset class – apply old security and risk management tools to this new technology, or apply new, better performing standards that are risk adjusted to it ensures that we do not see a systemic collapse if a particular class of financial products suffers a shock.

It can be argued that having auditors is enough, that we already have these tools in place and as regulated financial products, this is essentially already ‘taken care of’. This statement, in itself, is valid because imposing audit controls to mitigate risk is actually the best thing we have been able to do so far in financial products. But any meaningful investigation into the role of auditors yields alarming results: PwC vs. BDO v Colonial Bank (2017), Grant Thornton vs. PwC (Parmalat Scandal, 2003), BDO vs. Ernst & Young (Banco Espírito Santo, 2014). ), KPMG vs. Deloitte (Steinhoff Scandal, 2017), and this is only 20 years ago. FTX and Enron both had auditors. We use auditors because we don’t trust the individuals running the organization, and all we’ve been able to do so far is defer trust to another set of people, outside the organization. But the inherent risk of trusting people and organizations has never been fixed until now. Enron’s biblical collapse was due to a clear conflict of interest between them and their auditor – namely that Arthur Andersen was also providing lucrative consulting services to Enron in addition to their auditing function, and by extension, helping them cook their books.

Bitcoin is different, behaves and lives differently. It behaves differently because the cryptographic guarantees it presents are something incomparable to traditional assets. Just as anyone can audit the entire money supply in the system with trustless collateral, so anyone can audit the personal holdings of an individual, corporation or ETF holding Bitcoin in a completely risk-free manner. It is an important note that it is not risk-mitigated, but risk-free. Someone who cryptographically proves to any other counterparty that they own Bitcoin for, say, a loan can do so without any doubt as to whether that person is the actual owner of the BTC. This can happen repeatedly with little overhead and can be continuously monitored in real time. There are no titles, there is no external auditor, there is no review of the books that needs to happen. This data can be ingested without question.

So what does this mean for ETF products? At this point, it should be clear that because ETF products are such an essential pillar of our modern financial system, and because Bitcoin introduces unique risk paradigms that old auditing standards inadequately support, that new risk infrastructure must be applied to these products. The solution is simple, and it’s the same solution that made its way through the ice we’re all sitting on trying to get some air. Require spot Bitcoin ETF products to implement and comply with Proof of Reserves regimes. They should give their investors peace of mind that the underlying asset backing these ETFs exists, that they are in solid custodial configurations and are not being remortgaged. The ETF issuer’s failure to do so, or refusal to do so, speaks to the issuer’s priorities – namely that they either do not understand the nature of this particular financial product, or that they are more comfortable operating with opacity than transparency. Failure to implement this as an industry-wide standard is simply a ticking time bomb.

Hoseki was created for this very purpose, to build the plumbing that makes Bitcoin financialization a reality, starting with PoR. Hoseki helps individuals prove their reserves to counterparties through Hoseki Connect and through Hoseki Verified provides services to private and public companies and ETF issuers so they can publicly verify their Bitcoin holdings, building better brands, redefining trust and diminishing risk for a healthier and more robust environment. financial ecosystem. Contact us at [email protected] to integrate your organization with Hoseki.

This is a guest post by Sam Abbassi. The opinions expressed are entirely our own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.