Following the FTX collapse, confidence in crypto exchanges has fallen across the industry. While market leader Binance is trying to improve the transparency of its reserves, some accounting and financial experts see red flags raised. The limitations of "proof-of-reserves."
The world's largest cryptocurrency exchange is trying to reassure its customers about the safety of its holdings. Binance has recently committed to transparency in order to increase confidence in its financial situation. The move is aimed at preventing another FTX case. However, accounting and financial experts at the Wall Street Journal say there is still a long way to go before enough meaningful information is disclosed. Proof-of-reserves is meaningless without verification of liabilities.
USD 60 billion in reserves
Binance launched a proof-of-reserves website about two weeks ago to reassure its users following the collapse of FTX. These provide insights into the exchange's crypto holdings. As always, however, there are some limitations to these proof-of-reserves exercises - after all, only Binance's bitcoin inventory is disclosed.
For the remaining holdings, Binance uses a "Merkle Tree" to capture all individual user accounts and generate a cryptographic seal. This Merkle Tree includes user balances across multiple Binance products - spot, funding, margin, futures, earn, and options. The exchange has also published all the wallets that hold customer assets.
With an Agreed Upon Procedure (AUP) from the auditing firm Mazars, Binance wanted to consolidate this position. According to the report, the operator of the world's largest crypto exchange has enough Bitcoin to cover the balances of all users on the exchange.
No trust from financial experts
As one former member of the Financial Accounting Standards Board (FASB) opined, the Mazars report does not inspire confidence among sophisticated investors. The audit lacked information about the company's own finances and did not evaluate internal controls. In addition, he said, it is not known how Binance's systems liquidate assets to cover margin loans.
Mazars found that Binance was approximately 97% collateralized. They did not take into account the out-of-scope assets pledged by customers as collateral for in-scope assets lent under the margin and loan offering. This resulted in negative balances in the customer liability report. If the in-scope assets lent to customers via margin and loans are included, Binance was 101% collateralized. The out-of-scope assets were separately overcollateralized, the audit firm noted.
Another misleading "PoR" AUP (not an audit) released today. Apparently, there is no consistent process used across exchanges. Again, the process strays far from the original spec.🤦♂️
1. "interchangeable" assets
2. negative balances included
3. no signing
4. aggregation by "class" https://t.co/FGQ3Mn9kyo— Jesse Powell (@jespow) December 10, 2022
However, the "Liability Report" does not distinguish between the two unknown BTC derivatives, which in themselves form a dependency with their low liquidity. Furthermore, negative account balances are listed, as according to Binance and Mazars there is an overcollateralization somewhere. If the shortfall is indeed only 4%, the company is still a rock in the current storm. Without independent verification of liabilities, however, a definitive conclusion remains difficult. This led not least to the withdrawal of around USD 5 billion in customer funds.
