What’s Next for Proof of Reserves: Auditing Crypto in the Long Run

Proof of reserves has become imperative for fintech businesses looking to retain trust, as customers need assurance that their funds are properly managed and accounted for.

While digital assets offer a high degree of transparency, their inherent auditability has largely been overlooked. To compound matters, in late 2022, some of the firms that had managed to become the leading providers of proof of reserves reports for crypto companies announced that they would discontinue their crypto auditing operations following the disastrous insolvency cases of recent months.

As the company to pioneer а real-time attestation of custodial assets, Nexo is disappointed that a number of auditors are choosing to wind down their digital asset audit practices for all crypto clients, but we are convinced this will only be a temporary phenomenon.

These firms cater to some of the biggest players in the industry (including Kraken and Binance). Naturally, their decision to reorganize or slowly withdraw from the crypto market leaves a huge gap in the sector, which has implications for the tremendous progress that companies like Nexo had made when it comes to ensuring transparency and accountability in the industry. But the market need for such products, coupled with digital assets’ auditability, is a telltale sign that the firms will be back, and sooner than we think.

To find the best path forward for the future of Proof of Reserves (PoR) in crypto, perhaps it's worth considering what the best practices are and push to reinstate them in reserves audits' next iteration.

Nexo’s Industry Benchmark

Back in 2021, we engaged PCAOB-certified auditor Armanino LLP, one of the 20 largest accounting firms in the US, to perform an industry-first real-time attestation. Armanino has since become a leading provider of proof of reserves reports.

After several months of hard work, Nexo was the very first crypto lender to shed light on its reserves and demonstrate 1:1 backing through a third-party, 24/7 reserves attestation, showing the company’s custodial assets always exceed liabilities.

Nexo’s procedure per se not only marked the first time that a crypto platform had gone real-time in providing this level of transparency; it also required deep integration between the auditor and Nexo to show that assets surpass liabilities by more than 100% at all times.

We established a transparency benchmark by showing that our clients’ assets are properly managed and accounted for. We additionally nurtured customer trust, thus setting a prime example for others in the industry to follow.

But by the time more industry players committed to PoR attestations en masse in late 2022, auditors and accounting firms had initiated a significant shift in their risk tolerance, resulting in a widespread decision to – at least temporarily – backtrack on providing crypto solutions. According to Armanino LLP chief operating officer Chris Carlberg, “market conditions” had changed.

The worldwide decision of auditors to reconsider crypto services will also affect Nexo's ongoing real-time reserves attestation. This will occur in two phases: Nexo’s downloadable independent accountant's reports will be available in PDF format until January 31, 2023. In addition, the real-time, online reserves attestation will be fully operational for the foreseeable future. TrustExplorer is the world’s first application that provides independent accountant reports in real time and has become the industry standard for transparency.

Don’t Trust, Verify

Although our industry is changing, the commitment we had when we pioneered such a report in 2021, runs deeper than ever. To keep demonstrating utmost transparency in the way we manage client assets is on top of our list of priorities for the next week, month, year, and decade – in short, it is a never-ending endeavor.

Nexo has been working for some time now on finding suitable and sustainable alternatives that will even surpass the previous benchmark we set for transparency in the blockchain space. We are committed to ensuring the continuity of “Don’t trust, verify” when it comes to showing everyone that customer funds at Nexo are backed 1:1.

Among the options we are exploring is to continue working with the team of experienced professionals who currently produce our reserves attestation reports and who have been carrying out financial statement audits and other attest work with crypto companies, such as Kraken, since 2014, thus building the necessary infrastructure for a blockchain audit in the first place.

These professionals are in the process of separating from Armanino and setting up a new entity, with the separation due to be completed by the end of February, 2023.

Commenting on the recent events, Armanino COO Carlberg said:

“There continues to be a pretty big gap in understanding between what an audit or a proof of reserve offering provides to the recipients of those reports. Hopefully that gap of understanding changes over time, but it’s a pretty big gap today,” he added.

Finding a suitable solution that includes full liabilities disclosure, is done with auditor oversight, and addresses the dynamicity inherent in the blockchain finance space is no small feat. Finding it a second time around is even more challenging, but we will not rest on our laurels until we find a worthy alternative.

Among the options we are currently exploring are audits by traditional accounting firms, alternatives focused on digital assets assurance – a notable example is blockchain security auditor Hacken, third party-assisted options by business intelligence providers, internal solutions, and/or some combination of the above.

Why Nexo Needs Third-Party Verification (Unlike Exchanges)

Traditional centralized exchanges have their own internal order books and match all of their clients' orders to buy and sell. They, therefore, must keep all their assets on-chain.

Unlike these exchanges, Nexo generates value for its clients and thus needs to manage the entrusted assets actively. For example, our trading platforms, i.e. Nexo Prime and Nexo Pro, don’t rely on in-house matching engines and order books, but aggregate liquidity from various venues via smart order routing. In addition to trading services, Nexo’s revenue generators include crypto-backed loans and staking, among others. What do these activities have in common? They require Nexo to hold on and move balances across a number of exchanges and DeFi protocols as part of our standard operations.

By holding balances across different exchanges and protocols, Nexo is able to generate alpha for its clients and its own treasury in market-neutral ways.

Many exchanges are now publicly disclosing addresses in an attempt for Proof of Reserves. The shortfall is it only shows one side of the equation: the assets, omitting whether those assets exceed liabilities.

To continue to provide the full suite of Nexo services, Nexo has assets both on-chain and off-chain for the above-described reasons. We, therefore, unlike exchanges, need an independent auditor to monitor all those assets and draw the necessary conclusions.

Going Forward

We believe that the cryptocurrency space is capable of providing a level of assurance and accountability that surpasses the traditional financial services industry by a wide margin. Any company that is trying to operate a sustainable business still has to prepare for an audit. There’s a level of dedication that’s required – we all have to put time, people, and resources into producing auditable information despite technical and all sorts of other challenges.

Surely, the future belongs to those players who are willing to go the extra mile for their customers. We would like to use this opportunity to remind everyone that Nexo is the only centralized finance platform to unequivocally show that the company’s assets always exceed its liabilities, and we have been doing so continuously since mid-2021. Since we pioneered the first real-time attestation in crypto lending, Nexo’s platform has grown to responsibly serve five million people. Nexo’s proactive stance on regulation and years of following the traditional licensing procedures around the globe is testimony to the company's resolve and ability to adapt to changing circumstances and to best protect and serve its clients’ interests.

Going forward, despite the supply vacuum for crypto auditing solutions that affects the entire digital asset space, we will keep raising the bar for other providers for the betterment of the industry.