Proof of Solvency

It all keeps circling back to custodial accounts. It is not necessary to deposit your bitcoins to use them, but for some reason, people keep doing it. Assuming you’re using a custodial account, or providing them, you’re probably feeling a little rattled right now. Today, Vircurex announced they are insolvent and they are freezing client accounts tomorrow, following on the heels of the Mt. Gox collapse.

Gox me once, shame on you. Gox me twice, shame on me.

Mt. Gox had a design flaw that made it possible to alter identification tags on transactions before they were adopted by the blockchain. Accounts would not be debited for transfers made on their behalf. This was known since 2011, and exploited since then, reducing their holdings of bitcoin (assets) below the claims held by account holders (liabilities).

Vicurex, on the other hand, was the victim of hackers who were able to circumvent their server security to access bitcoins. However, the result is the same, they no longer held enough bitcoins to satisfy customer accounts.

Bitcoin exchanges are not fractional reserve institutions, and they are expected to have 100% liquidity. Liquid assets – liabilities = some positive number. That’s solvency in the world of bitcoin. The question arises: is Coinbase solvent?

Purportedly, Andreas Antonopolous inspected the bitcoin held by Coinbase last month when he visited their offices, and confirmed that they were solvent (in a cryptographically signed blog post, no less).

One guy, who seems very nice and respectable, cannot audit an entire deposit institution. Traditionally, the assets and liabilities of deposit institutions are audited by accounting firms. Bitcoin, as usual, creates an opportunity for innovation.  The amount of bitcoin held by an exchange is always publicly available. The issue is determining their liabilities, or value of the client accounts – without violating client privacy. It has become a popular topic of conversation amongst exchange developers.

One viable solution to the liability proof problem has been published on Github by Olivier Lalonde. This is a major opportunity for exchanges to regain user trust and to retain control over the marketplace. The future of custodial accounts depends on the development of this kind of tool.

edit: Key members of the bitcoin community (well, one exchange + some people from the bitcoin foundation) are trying to develop self regulation for exchanges, called DATA.