Self-regulated crypto exchanges need to prove their solvency using stress tests for capital adequacy, not a proof of reserves.
Shortly after the FTX collapse Binance prompted a sector-wide call for “Proof of Reserves” audits of centralized crypto exchanges, to prove their solvency and calm investor’s fears. Nevertheless, several billions of dollars have been withdrawn from Binance during the last few days.
Unlike normal exchanges but in common with most other ‘self-regulated’ exchanges, Binance acts as a custodian as well as a trading platform. A Proof of Reserves audit is designed to show that, at one particular snapshot in time, such a 'custodian' exchange has enough money to cover customer withdrawals.
However, solvency – i.e. having sufficient funds not to go bankrupt -- is a completely different issue which has little to do with Proof of Reserves, as this blog will explain.
Mazar’s Group, a South African accounting group, agreed to undertake the Proof of Reserve audits for Binance, Crypto.com, KuCoin and other crypto custodians. But on Friday 16 December they suspended them citing concerns about the way their reports were being understood by the public.
Because of this, crypto investors are getting very scared indeed now. Could it be that this suspension of Proof of Reserves reports somehow somehow lifted the lid on a crypto Pandora’s box? If so, what can we see inside the box?
To answer these questions, one has first to understand that self-regulated exchanges like Binance perform multiple functions. As well as trading platform and custodian of customer’s money, they are stablecoin brokers (especially for tether and their own coin BUSD) and they act as their own ‘clearing house’. I suspect it might be these last two activities that are coming into focus now.
The stablecoin brokerage conundrum that I wrote about in a blog from the end of 2021, called The Tether-Binance Axis and the Great Crypto Crash of 2022 remains a focus of mine and watch out for another blog about this soon. Today’s blog is about the clearing house activities. Let me explain what these are.
More than two-thirds of all crypto trading is just about making a bet, on something called a ‘derivative product’.[1] On derivatives, for every winner there is a loser of the same amount. When the bet ends, someone needs to transfer money from the losers to the winners. This ‘clearing and settlement’ is a delicate process which could easily de-stabilize markets if not performed correctly. For this reason, in normal financial markets, clearing and settlement is performed in very highly regulated clearing houses.[2]
But Binance performs this activity itself without any independent oversight, as do all the other ‘self-regulated’ crypto derivatives exchanges. Therefore, to prove that an exchange which operates as its own clearing house is solvent, it is necessary to use techniques that have been tried and tested by a generation of properly certified risk managers.[3] That is, the auditor will need to perform a stress-test for capital adequacy.
This type of stress test requires the operations that underpin the clearing and settlement activities to be subjected to ‘what if’ scenarios of the worst possible type. Often, they are taken from historical data. For instance, what would happen if the price of all the derivatives products on Binance fell by 25%? If that happened today, plenty of losing customers would have their account entirely liquidated, other winning customers might have their leveraged profits suddenly reduced by a factor of 10 or more, and the prices of derivatives might just continue to fall more and more in the panic.
Or maybe not. We just don’t know unless such a stress test is performed. The Bank of England regularly performs stress tests for capital adequacy on independent clearing houses (called central counterparties, CCP) for traditional exchanges [5]. This standard practice for normal markets is what the ‘self-regulated’ crypto exchanges need, to prove their solvency not just their ability to cover customer withdrawals.
Carol Alexander, 16 December 2022
[1] See Crypto Compare’s Exchange Review https://data.cryptocompare.com/research
[2] See, for example, https://www.theice.com/clear-europe
[3] See my 4-volume textbook on this subject, ‘Markets Risk Analysis’ – details on the books page of this website
[4] These include trade matching, liquidation engine, insurance fund, automatic deleverage and a whole host of other novel procedures that are unique to crypto exchanges and have not been approved by certified risk managers.
[5] https://www.bankofengland.co.uk/stress-testing/2022/ccp-supervisory-stress-test-results-2021-22