If we claim to be an improvement on traditional finance, we’d better start playing that role. It’s clear how Bitcoin fixes the rampant cash hoarding. It’s also clear how Bitcoin changes your relationship with money — both financially, because you’re more likely to save assets that appreciate in value — and materially, because you can do new things like store the GDP of a small island nation on a USB stick. But there’s one thing that’s slowly gaining acceptance and needs to be accepted if we’re ever going to improve on the mistakes of the past: proof of reserves.
Bitcoin has unique auditing features 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 any special privileges or permissions. It is difficult to overstate how novel this feature is to the Bitcoin protocol and the implications for the guarantees it provides. In context, the total global supply of dollars is an estimate and by no means an exact number due to a variety of factors including the existence of physical and digital money, as well as the currency being traded abroad. The total amount of gold in existence is also an estimate due to entirely different reasons, particularly the lack of certainty when it comes to the amount of gold mined from different mines around the world, gold in private hands, gold hoards and caches, new mining, recycling, and unreported sources. There is no reliable global source of truth for any money or commodity other than Bitcoin. And this should be the driving force behind Bitcoin moving forward.
Proof of Reserves (PoR) has been a key part of the industry since almost its inception. The infamous Mt. Gox collapse in 2014 paved the way for much-needed transparency. The exchange was hacked, 850,000 BTC (roughly $47,617,204,000 USD at the time of writing) was stolen, and its customers were unaware of it. The funds were drained over the course of a few years before the actual collapse occurred. A PoR system would have mitigated the loss of even more funds as their customers would have watched the exchange’s reserves drain at an alarming rate. If this sounds more like a recent memory than an ancient part of Bitcoin history, that’s because the same argument applies to FTX, and the same fundamental thing happened to FTX. If customers, and the broader market, had seen the exchange’s BTC reserves drain in real time (or the fact that FTX had zero BTC), the systemic risk would have been significantly mitigated.
So what do you think would happen if the single custodian holding 90% of the spot bitcoin that backs these ETFs were hacked or acted maliciously? Unless the exchange notifies the public, billions of fiat bitcoins will be held by millions of people. The more we are tied to traditional finance, the greater the risk of cross-pollination between traditional financial markets and cryptocurrency 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 implement new, more performance-oriented, risk-adjusted standards to ensure that we don’t see a systemic collapse if a particular financial product class is hit.
It could be argued that having auditors is enough, that we already have these tools, and that as regulated financial products, this is already “taken care of”. This claim is in itself true because imposing audit controls to mitigate risk is actually the best we have been able to do so far with regard to financial products. But any meaningful investigation into the function of auditors yields worrying results: PwC vs BDO in the Colonial Bank Case (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 twenty years ago. FTX and Enron both had auditors. We use auditors because we don’t trust the people running the organization, and the best we have been able to do so far is transfer the trust to a different group of people outside the organization. But the risks inherent in trusting people and organizations have not yet been addressed. Enron’s collapse was due to a clear conflict of interest between it and its auditor—that is, Arthur Andersen was also providing lucrative consulting services to Enron in addition to its audit function, and thus helping it manipulate its financial records.
Bitcoin is different, it behaves and lives differently. It behaves differently because the cryptographic collateral it offers is incomparable to traditional assets. Just as anyone can audit the entire money supply in the system with trustless collateral, anyone can audit the personal holdings of an individual, company, or ETF holding Bitcoin in a completely risk-free manner. It is important to note that this method does not eliminate risk, but it is risk-free. Anyone who proves to any other party using cryptography that they own Bitcoin, for example, in exchange for a loan, can do so without any doubt as to whether that person is the actual owner of the Bitcoin. This can happen over and over again, with little overhead, and can be monitored continuously in real time. There is no ownership, no external auditor, and no auditing of any ledgers that must be done. This data can be ingested without question.
But what does this mean for ETFs? It should be clear at this point that ETFs are a cornerstone of our modern financial system, and because bitcoin imposes unique risk models that are not adequately served by the old auditing standards, a new risk infrastructure must be applied to these products. The solution is simple and is the same one that has been clawing its way through the ice we are all standing on trying to catch some air. It is to require bitcoin-based ETFs to implement and comply with proof-of-reserve systems. These products must give investors peace of mind that the underlying assets backing the funds exist, are in strong custody settings, and are not being collateralized. Failure to do so, or an unwillingness on the part of the issuer, signals the issuer’s priorities — either that they do not understand the nature of this particular financial product or that they are more comfortable operating in obscurity than transparency. Failure to implement this as an industry-wide standard is a ticking time bomb.
Hoseki was created for this very purpose, to build the infrastructure that makes Bitcoin financing a reality starting with PoR. Hoseki helps individuals prove their reserves to counterparties through Hoseki Connect and through Hoseki Verified, it provides services to private and public companies and ETF issuers so they can publicly verify their Bitcoin holdings, build better brands, and redefine trust and risk mitigation for a healthier and more robust financial ecosystem. Contact us at partners@hoseki.app to onboard your organization to Hoseki.
This is a blog post written by our guest Sam Abbasi. The opinions expressed here are entirely their own and do not necessarily reflect the views of BTC Inc or Bitcoin Magazine.
Comments are closed, but trackbacks and pingbacks are open.