Proof of Reserve regulations are coming into effect across multiple jurisdictions across the globe, but why are regulators choosing Proof of Reserves as their tool of choice?
From Industry Elective to Regulatory Essential
Wyoming was the first jurisdiction to acknowledge Proof of Reserves as a regulatory tool in 2019, as part of its opt-in Enhanced Digital Custody Regime. However, in the aftermath of FTX, the urgency to verify that exchanges and custodians were genuinely safeguarding customer assets became more acute. Shortly thereafter in 2022-2023, Texas, Dubai, and Bermuda created the first compulsory Proof of Reserves requirements for applicable crypto companies.
Addressing Gaps in a Regulatory Regime
From regulating banks, asset managers, and other financial institutions, regulators are familiar and comfortable with the risk mitigation that BSA/AML regimes, capital requirements, financial statement audits and other risk management practices provide. While somewhat similar to “traditional” financial institutions, crypto institutions have one major difference, the assets in custody are fundamentally “bearer” assets. If the funds are misappropriated or lost, the funds are gone forever. There are no chargebacks, no support service agents to call, and no central banks to backstop.
This unique characteristic elevates the risk from a regulatory oversight perspective, and magnifies the need to demonstrate control of the crypto assets on a periodic basis.
Proof of Reserves has emerged as a favoured instrument among regulators for its unique ability to mitigate the significant risks associated with crypto companies, risks that other existing tools and oversight mechanisms fail to address effectively. Additionally, regulators can still largely use their existing oversight mechanisms (i.e. AML/BSA regimes, etc.) and simply insert Proof of Reserves as a supplement into their oversight “stack” to address the crypto-specific custodial risks.
The Regulatory Future of Proof of Reserves
Whether referenced by the term “Proof of Reserves,” or by euphemisms such as “Sufficiency of Redemption Assets,” or “Asset to Liability Reconciliations,” jurisdictions across the world have released public guidance or introduced legislation explicitly mentioning or alluding to Proof of Reserves-like requirements. Bellwether jurisdictions, such the United States, have even introduced proposed legislation at the Federal Level.
Given the distinct challenges inherent to the digital asset industry, regulators have recognized that Proof of Reserves uniquely addresses these challenges. With its adoption by regulatory bodies to date, Proof of Reserves is poised to become a cornerstone in regulatory toolkits worldwide.
