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How to Improve Transparency and Public Trust in Crypto Markets

Proof-of-reserves and off-chain transaction reporting are key to improving trust in trading platforms following the scandals of the last 18 months, say Bruce Tupper and Tyler Williams.

By Bruce Tupper, Tyler Williams|Edited by Benjamin Schiller
Updated Jun 14, 2024, 6:50 p.m. Published Mar 25, 2024, 5:59 p.m.
(Agence Olloweb/Unsplash)

Revelations last year involving fraud, money laundering, lies and deception by FTX, Binance and others have shaken the public’s trust in the digital assets industry – especially its trading platforms. Transparency and a strong commitment to investor protection are vital to earning back that trust.

Bruce Tupper is the president and founder of CoinRegTech, which provides compliance services to the digital asset market. Tyler Williams is the head of regulatory and legislative affairs and regulatory counsel for Galaxy, a financial services and investment management innovator in the digital asset and blockchain technology sectors.

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We believe two proposals – Proof of Reserves Reporting and Off-Chain Transaction Reporting – are prudent requirements for trading platforms to implement. Both proposals would immediately improve transparency to protect customer funds. More is necessary, but let’s not let the perfect be the enemy of the good.

It is past time for the U.S. Congress to move forward with comprehensive digital asset legislation. Two recent bills are noteworthy. First, S. 3087, The PROOF Act, introduced by Senators Thom Tillis (R-NC) and John Hickenlooper (D-CO) in October 2023, would require trading platforms to cryptographically prove monthly that they can honor all customer deposits held in custody.

Second, H.R. 5966, the Off-Chain Digital Commodity Transaction Reporting Act, introduced by Rep. Don Beyer (D-VA), also in October 2023, would improve transparency and customer protection by requiring trading platforms to report all digital commodity transactions (such as Bitcoin and Ether) to a trade repository licensed by the Commodity Futures Trading Commission (CFTC). This reporting requirement is comparable to what applies to swaps transactions today.

These legislative efforts are novel in using blockchain technology’s noteworthy public transparency and auditability functionality. Blockchains track debits and credits to accounts on a ledger, just like an ordinary accounting system, but in a real-time, transparent, and immutable fashion. The existence of any asset that resides on a public blockchain, whether a tokenized security or a digital commodity, is verifiable by customers and regulators. This is not the case for off-chain transactions, which don’t commit digital asset transactions to the appropriate blockchain. Instead, records of off-chain transactions are stored in the trading platform’s internal systems and not recorded on the blockchain. As a result, customers rely on the internal recordkeeping of unregistered trading platforms to track their record of ownership.

Now, trading platforms and lawmakers are coalescing around a simple idea: What if trading platforms that act as custodians could indisputably prove control over customer assets? This is known as a Proof of Reserve (PoR). This evolving concept has existed in the digital asset markets for about a decade. PoR involves a trading platform acting as a custodian to attest to their customer assets by committing all these assets to a public ledge (on-chain). By publishing these datasets, customers and regulators could verify assets, and assure trading platforms are sound.

Legislative initiatives have focused on mandating trading platforms to segregate client assets from the operational funds of trading platforms. The goal is to provide customers and regulators with assurances in the case of a trading platform liquidation or bankruptcy while protecting customer assets. Some trading platforms have voluntarily adopted monthly PoR attestations. PoR should be part of any comprehensive legislative solution adopted by the US Congress, which is precisely what Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) recognized when they reintroduced the Lummis-Gillibrand Responsible Financial Innovation Act, S. 2281, which included a specific provision that would require crypto intermediaries to maintain PoR and undergo annual verifications. If blockchain technology were broadly implemented across our financial services industry, markets and financial services would be more transparent and less costly.

The other “must have” is Rep. Beyer’s proposal (HR 5966) requiring trading platforms to report off-chain and on-chain transactions to a CFTC trade repository, similar to how the agency already collects and oversees swaps markets. While on-chain transactions are already recorded on their respective blockchains, this bill would standardize and gather that data, along with off-chain transactions, to offer customers transparency and confidence in trading platforms and the digital asset market generally. The Beyer bill would permit a registered trade repository to share transaction data with the CFTC and the Securities and Exchange Commission. The reporting requirement would also assist regulators in monitoring the trading platforms and other market participants.

Some lawmakers in Washington have taken a very negative view of these transparency proposals. In some cases, lawmakers have sought to stymie the digital asset industry by blocking access to accounting services. In a Januaryletter to the Public Company Accounting Oversight Board (PCAOB), lawmakers attacked PoR and called it a “sham audit.” The PCAOB duly released an advisory letter warning investors about PoR attestations. As a result, audit firms have pulled back from engagements, and the PCAOB’s stance is the opposite of what a reasonable accounting regulator should do.

The major criticisms of PoR have largely been addressed in S. 3087 the Proof Act. PoR is not contemplated as a substitute for standard audits, but rather to complement standard audit practices. Traditional audit assurance is necessary, but it is no substitute for high-frequency and publicly verifiable proof that customer funds are present with the trading platform that is also acting as a custodian.

Trading platforms shouldn’t be held to a different standard from traditional custodians and registered exchanges. Frequent PoR attestations could provide more transparency than traditional custodians currently offer. The reporting of both on-chain and off-chain digital asset transactions to a CFTC-registered trade repository – a kind of “trust, but verify” approach – offers an additional layer of federal oversight and protection for customers.

The digital asset industry is putting forward good faith and reasonable approaches in the form of PoR and Off-Chain Transaction Reporting. More may be necessary. We ask simply that Washington politicians and regulators work with us. The Digital Asset industry is turning a page and working hard to gain back the trust lost by customers and policymakers.

With the advancement of the PoR and Off-Chain bills in connection with comprehensive digital asset legislation, trading platforms and blockchain technology will have the opportunity to flourish and underpin a new era of American-led financial innovation and exceptionalism. This is a worthy goal and one that Washington D.C. should support.

Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.

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