Proof of reserves is not enough: the relevance of ETPs in ensuring transparency and investor protection

Transparency and accountability are key to helping the crypto industry gain further traction among retail and institutional investors, especially after the high-profile collapse of FTX in 2022.

Proof of Reserves (PoR) has emerged as a way of reassuring customers that an exchange holds sufficient assets to meet its liabilities. However, it isn’t a panacea because it only provides a snapshot of assets and doesn’t always reveal liabilities.

This article highlights the limitations of PoR and explains why ETPs offer investors a more reliable way to access crypto.

Understanding Proof of Reserves

PoR is a way for crypto exchanges to prove they’re solvent, meaning they have sufficient assets to meet their liabilities, such as withdrawals and trades.

An exchange can verify PoR with an attestation or an audit carried out by an independent third party like an accounting firm. An attestation verifies that documents or data provided to demonstrate PoR are reliable, whereas an audit is more comprehensive as it involves a thorough analysis of financial records to confirm their accuracy.

PoR has become a hot topic in the crypto industry following the collapse of FTX, the exchange founded and run by Sam Bankman-Fried.

To recap, after Alameda Research, a quant trading firm and FTX’s sister company, experienced several losses, FTX propped it up with around $4 billion secured by assets including FTT, its native token. Allegedly, a portion of the tokens belonged to customers. When reported by crypto media site CoinDesk, this move caused concerns about Alameda’s financial well-being and the possible impact on FTX. Rival exchange Binance sold its FTT holdings, causing the token’s price to collapse and a run on FTX, with customers attempting to withdraw $6 billion. After an aborted takeover bid by Binance, FTX declared bankruptcy on 11th November, owing an estimated $8 billion to one million creditors.

While PoR is a good starting point for increased transparency, it isn’t a failsafe solution:

• PoR only provides a snapshot of reserves. Investors can’t tell whether an exchange borrowed assets right before an attestation or audit took place, just to repay them straight afterwards, and if it has undisclosed off-chain liabilities.

• A lack of industry standard has led to inconsistency regarding what an attestation should include. Each exchange makes that decision with its auditor, leading to doubts about the reliability of the information provided.

• Establishing PoR means nothing if the reserves doesn’t match the liabilities. If this is the case, the exchange is exposed to the volatility of the assets in the reserve.  In the FTX example above, the loan to Alameda led to a mismatch between its assets and liabilities. 

Even if an exchange’s PoR overcomes the flaws listed above, it must secure its infrastructure against cyberattacks. One of the latest exchanges to fall victim to hackers was Bitrue, which lost $23 million when a wallet holding 5% of its reserves was hacked in April.

The Rise of Exchange-Traded Products

Exchange-traded products (ETPs) offer an alternative for investors seeking to add crypto to their portfolios.

ETPs are financial products that provide exposure to an underlying index or asset by mirroring its performance. They trade on the stock market like shares, so they’re easily accessible and investors can hold them in a portfolio alongside traditional asset classes.

Crypto ETPs aren’t new to the markets, despite the excitement surrounding BlackRock’s recent application to the US Securities and Exchange Commission. CoinShares launched the world’s first crypto ETP in 2015, while Fidelity listed one in Frankfurt in 2022.

Part of these products are Physical ETPs, which means they purchase and hold the underlying assets. CoinShares stores its crypto backing the products with Komainu, a digital custodian regulated by the Jersey Financial Services Commission. Komainu is a joint venture between Japanese investment bank Nomura, leading crypto hardware developer Ledger and CoinShares. Its digital vault delivers a world-class custodial solution by combining encryption and authentication software with custom hardware, storing tokens in a secure data centre protected by a hardware security module.

Transparency and Regulation in ETPs

Crypto regulation is constantly evolving, and some jurisdictions, such as the EU, are more advanced than others. The Markets in Crypto Assets (MiCA) regulation came into force in June 2023 and aims to provide investor protection, by increasing transparency and putting in place a comprehensive framework for issuers and service providers including compliance with the anti-money laundering rules. This regulatory clarity is expected to drive demand for crypto from European retail and institutional investors alike.

In addition to MiCA, ETPs are covered by legacy financial regulations (such as the MiFID Directive and Prospectus Regulations) designed to enhance transparency and investor protection.

ETPs are also subject to the reporting requirements enforced by listing venues. For example, the SIX Swiss Exchange is one of the venues where CoinShares lists its products. SIX requires providers to submit annual and, in some cases, interim financial reports. These reports must meet accounting standards such as International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).

Incidentally, to offer investors additional reassurance, CoinShares partnered with registered Certified Public Accountant The Network Firm to provide PoR for its physical ETPs. The Network Firm’s LedgerLens solution leverages blockchain technology to verify that the crypto held in CoinShares’ reserve matches its liabilities. This information is shared on a daily basis via downloadable attestation reports, ensuring that the products are always at least 100% backed.

Finally, ETP providers must appoint a trustee or a collateral agent to protect the interests of investors. The trustee ensures that the ETP’s assets are properly safeguarded and the product is managed according to the objectives outlined in its Prospectus. The Law Debenture Trust Corporation PLC serves as a trustee for the CoinShares Physical ETPs.

What happens in case of default?

To demonstrate what happens to an investor’s assets when an exchange or ETP issuer defaults, here are two hypothetical scenarios.

Crypto exchange default

Customers receive a percentage of what’s left after bankruptcy proceedings conclude. Put simply, the value of the remaining assets is divided among every creditor. In some cases, the exchange may have enough assets to cover its liabilities, in which case investors are reimbursed. In others, all that’s left may be the ‘goodwill value’ of the exchange’s intangible assets, such as its intellectual property or brand, and native tokens. Of course, those tokens may end up practically worthless.

Ultimately, the less closely an exchange is supervised, the greater the uncertainty about how much customers can recover. It's also worth remembering that crypto exchanges aren’t covered by deposit guarantees, government-backed schemes which reimburse depositors up to a certain amount when banks fail.

ETP Issuer default

As described above, Komainu holds the underlying assets for CoinShares ETPs. Should CoinShares Digital Securities Limited cease trading, The Law Debenture Trust Corporation (the trustee) would take control of the assets and process an ‘unsubordinated claim’ which distributes funds to investors (less the costs incurred by the process). By the very design of ETPs, the issuer (in our case CoinShares Digital Securities Limited) never has the power to tap into funds.

Conclusion

PoR is a way for crypto exchanges to show customers that they hold sufficient assets to meet their liabilities. They can either use an attestation or an audit to demonstrate PoR.

ETPs offer investors an alternative way to access crypto. While regulations are constantly evolving, some jurisdictions have introduced dedicated legislation. Crypto ETPs are also subject to the same rules governing traditional assets listed on mainstream exchanges.

If an ETP issuer goes out of business, investors should recover their funds in full because they're stored by a custodian and the issuer’s trustee ensures all holders are treated equally. Conversely, customers are less likely to recover funds from an insolvent exchange.

Learn more about CoinShares crypto ETPs.