The Future of Crypto Custody: On-Chain Asset Verification and Proof of Reserves in the Wake of Texas Legislation

Introduction

On June 9, 2023, Texas Governor Abbott signed into law a groundbreaking bill that is set to reshape the landscape of cryptocurrency custody. The Texas Proof of Reserves Bill, officially known as HB 1666, mandates cryptocurrency exchanges licensed by the state’s Department of Banking to adopt robust measures ensuring they maintain sufficient reserves to cover customer liabilities. In this Medium post, we delve into the significance of on-chain asset verification and Proof of Reserves through a Qualified Custodian, exploring the implications of this pioneering legislation.

Understanding the Texas Proof of Reserves Bill

Proof of Reserves is a process wherein a cryptocurrency exchange demonstrates its ability to cover customer liabilities by holding adequate digital assets. The Texas bill, championed by State Rep. Giovanni Capriglione, significantly refines the definition of Proof of Reserves and introduces stringent requirements for digital asset service providers. Let’s break down the key amendments to Section 160 of the Texas Finance Code:

Applicability and Scope

• The law applies to “Digital Asset Service Providers,” including crypto exchanges, custodians, lenders, and similar platforms with 500 or more customers in Texas and over $10 million in total customer funds.
• Exclusions: Banks and public companies are exempted, focusing the bill on areas where consumer risk is perceived to be higher.

Prohibition on Commingling

• Service providers are explicitly prohibited from commingling customer funds with any operational capital, proprietary accounts, digital assets, fiat currency, or other non-customer funds.

Full Reserves Requirement

• Providers must hold reserves sufficient to immediately cover all possible customer withdrawals.

Quarterly Transparency and Audit Firm Involvement

• Service providers must create a plan for quarterly transparency, allowing customers to view their outstanding liabilities and digital assets held in reserve custody.
• Auditors are mandated to review and attest to the information provided to customers.

Annual Filing Requirement

• Digital asset providers must file an annual report with the Department of Banking, including evidence of outstanding customer liabilities and attestation by an auditor.

Attestation Reports and Compliance Conditions

• Management must file attestation reports, and auditors must adhere to standards set by the American Institute of Certified Public Accountants (AICPA).
• Non-compliance may result in revocation of the license to operate in the state.

From Model to Mandate

The evolution of Proof of Reserves as a regulatory minimum gained momentum after the market upheavals of 2022. Lawmakers in Texas, recognizing the need for consumer protection, enacted HB 1666 to restore confidence in the blockchain economy. The nearly unanimous support for the bill reflects a belief in its potential to establish a robust compliance regime and enhance transparency for consumers.

Compliance Timeline and Strategies

Implementation Deadline:

• Compliance begins in September, demonstrating Texas lawmakers’ commitment to immediate consumer protection.

How Companies Can Comply:

• Engage regulatory counsel, communicate with the Texas Department of Banking, and seek assistance from qualified CPA firms.
• Develop internal plans covering trade operations, engineering, custody operations, and accounting to ensure compliance with Proof of Reserves reporting.

Attestation Plan:

• Engage with a qualified CPA firm for year-end attest reporting.
• Align teams with a year-end snapshot date and implement necessary systems or tools.

In-Scope Assets/Liabilities and Coverage Plan:

• Clarify reporting requirements for all customer liabilities and assets on the platform.
• Address complexities associated with supporting a wide range of tokens on various blockchain networks.

Cryptographic Proof of Liabilities Planning:

• Explore various approaches and tools for cryptographic proof to meet the annual reporting requirement.

Segregation Planning:

• Implement processes to segregate customer and company funds, ensuring compliance with the prohibition on commingling.

Planning to Demonstrate Collateral Treatment:

• Establish policies and procedures to evidence compliance with the prohibition on using customer funds as collateral.

Conclusion

With the signing of HB 1666 into law, Texas has taken a significant step toward fostering a safer and more transparent cryptocurrency ecosystem.

While certain aspects of the bill remain subject to interpretation, early communication with the Department of Banking and collaboration within the industry will be crucial for effective compliance. The proactive adoption of on-chain asset verification and Proof of Reserves through a Qualified Custodian represents a forward-looking approach that may well become the gold standard for crypto custody worldwide. As the Texas Department of Banking refines the compliance requirements, industry participants and service providers must actively contribute to the development of best practices and continue advocating for a secure and trustworthy blockchain economy.