The debate over whether cryptocurrencies need tighter regulation in South Africa, has been a controversial topic for some years now. Looking at certain factors in the cryptocurrency industry today, there surely is a strong case to be made for intervention by regulators. There have been too many instances of virtual asset service providers (VASP) not complying with the Companies Act, and cases of cryptocurrency investors being massively defrauded are being reported nearly every day – both issues that can be mitigated by the monitoring of applicable laws and regulations.
However, more stringent regulation is not the only way to bring positive change to the industry. Better reporting practices can also help to better protect stakeholders.
Proof of reserves has become an important point of discussion among VASPs and crypto investors alike. The need for these reports was first brought about with the introduction of stablecoins, such as Tether (USDT), where investors wanted reassurance that the stable coins in their possession were in fact collateralised by the US dollar (and that the USD balance held by the issuer existed). Almost all VASPs, including cryptocurrency exchanges and investment platforms, work on the same principal: customer assets are held in a fiduciary capacity and therefore should have a corresponding liability on the platform’s balance sheet of funds owed to its customers.
These proof of reserve reports are usually issued by audit firms such as Mazars, who have the required expertise and experience in cryptocurrencies. These reports are issued as an agreed-upon procedure engagement and can be issued monthly or quarterly, depending on the VASP and their customers’ needs.
The proof of reserve may include several procedures, but essentially focuses on two specific areas – the customers’ assets under the custody of the VASP and the corresponding liability of funds owed to its customers.
The objectives of the report is to ensure that the VASP’s customer liability balance is complete, correctly valued and collateralised by customer funds controlled by, and situated in the VASP’s custodian solutions, wallet or public key addresses without compromising any confidential or sensitive information.
These proof of reserve reports, as well as the VASP’s ability to produce these reports on a regular basis, is a fundamental advantage to stakeholders. They do not have to wait for the auditor’s opinion on the financial statements (which they may not be able to access), and these reports can be produced one month after a company’s incorporation. More regular reporting on customer funds and corresponding liabilities will limit potential misappropriation by criminals.
The vast majority of VASPs are required by law to be audited, based on the fact that customers’ assets are being held in a fiduciary capacity. In addition to the directors ensuring their company’s business is conducted in a manner above reproach, they also need to appoint an auditor to conduct the statutory audit.
If we look at South Africa’s largest cryptocurrency fraud cases over the last year against the backdrop of the Companies Act and the timeframe over which these frauds occurred, it becomes clear why we need these regular proof of reserve reports. When a company is incorporated in South Africa, it has 12 to 15 months to operate before it reaches its financial year-end and another six months subsequent to financial year-end before it is required to submit audited financial statements. This gives criminals 18 to 21 months to lure and defraud customers before being declared non-compliant.
Once a company reaches the status of being non-compliant with a lack of monitoring, there is also the chance of further fraud being committed over a period of more than 21 months before another tipping point is reached.
The primary focus, facilitated by the implementation of these proof of reserve reports, should be for the crypto industry and its stakeholders to prevent and to limit fraud, irrespective of whether the industry is regulated or not. Internationally we have seen an increase in a demand for these proof of reserve reports by customers and investors. Hopefully this trend of social responsibility towards investors and customers will be followed in South Africa, and add to the credibility of the industry as well as ensuring a safer investment environment.
Wiehann Olivier is digital asset lead and Partner at Mazars.