Attention: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!
Blake Oliver: [00:00:02] Hello everyone, and welcome back to earmark. I'm Blake Oliver joined for a second time by Noah Buxton, a prominent figure in cryptocurrency and digital assets accounting. He is the co-founder and CEO of the network firm LLP, bringing over 15 years of experience in tax, audit, legal and regulatory compliance matters. Noah, welcome back to the show.
Noah Buxton: [00:00:24] Thanks for having me back and for the very kind intro.
Blake Oliver: [00:00:27] You very kindly indulged me talking about Bitcoin for an entire hour in our last interview together. And that was a lot of fun. But Bitcoin is just one type of digital asset, and today I'm eager to explore the whole space with you. And I understand that like that is your specialty at the network firm.
Noah Buxton: [00:00:51] That's right. Yeah. We're 100% focused on digital assets. I think we're the first firm to put ourselves out there in that way, you know, 100% focused on this industry. Today, I think we're the largest, and I think there's a number of other, uh, a number of other firms, at least one in the US and a couple globally.
Blake Oliver: [00:01:10] So digital assets started out with crypto, with Bitcoin. That was what everybody thought of when we thought of digital assets. But it's way bigger than that, right?
Noah Buxton: [00:01:20] I think so, yes. You know it's bigger than that in sort of the number of tokens you can count for sure. Right. You could look at coin market cap or some of these other aggregator sites. And you can see, yes, Bitcoin is still the number one asset by market cap. Uh, there's hundreds or thousands maybe even created every day. Definitely tens created every day. And so there's there's many, um, many thousands now technically of cryptos, right. Running on many different blockchains.
Blake Oliver: [00:01:50] So but it goes beyond crypto. It's not just these digital currencies that we're talking about anymore when it comes to digital assets?
Noah Buxton: [00:01:59] I think so, yeah, exactly. By count, there's a lot right by opportunity of what this technology can do. I think there's a lot more. And sometimes that's under the surface. You know, I think our last conversation I agree I had a lot of fun. I did not I didn't flex my bitcoin debate muscle before. I wasn't quite ready for that. But I think it was a great conversation. Um, you know, there's a lot under the hood basically. Right. So at first blush, this this market, this industry can seem, uh, hard to understand. You know, it can seem scammy even. Right. I think, you know, some of the top headlines that you see, you know, the clickbait headlines are typically about the problems in the industry. Uh, under the hood, the technology facilitates, uh, a lot more than that. So, yeah, we'll get into it hopefully today, you know, things like tokenization of real world assets, uh, things like stablecoins. I think these are somewhat inevitable innovations. They're the way we interact, transact and store value is inevitably going to change. How is that going to happen? I think largely through public blockchain networks.
Blake Oliver: [00:03:11] So when we talk about tokenization of real world assets, give me an example. What are we talking about?
Noah Buxton: [00:03:17] Sure. So originally theorized as this idea that you could hey, tokenize real estate. And people say, wait a minute, how are you going to tokenize a deed to real estate? Well, it's not actually about tokenizing the deed itself. It's actually about putting using the token, as I like to think of it, as a wrapper, candy wrapper, or however you want to visualize that wrapper for a real world asset. So in real estate, right. A real estate investor isn't investing in the deed, right? They're investing in a partnership. They're investing in a legal structure that owns the underlying real estate and the associated rights of that real estate and and the obligations as well. And so, you know, the tokenization of real world assets generally is this idea that you can wrap a real world asset, you can represent it on chain. Um, and so it gets complicated, right. So let's just think about a spectrum real quick. You know, I would put stablecoins or tokenized dollars crypto dollars as some people have called them. I'd kind of put that on the the real world asset bucket just for simplicity.
Noah Buxton: [00:04:21] You could say it's a dollar a real world app. Put it on the spectrum for now and say that's sort of the easy case, right? Have a dollar in the bank and the issuer can create a token that represents $1. Um, the then you get a little bit more complex. Well, what about a commodity. Right. Like what about gold? Can you know, gold is, you know, valuable commodity, but it's very illiquid. It's very it's not very portable. Right. It's largely sitting in vaults. Right. Okay. Could you tokenize that and create markets that are more liquid and tradable on gold? Yes. A little harder than dollars, but you can do it. Far on the spectrum is real estate, which is because the token has to reasonably represent the rights and obligations that come with that partnership. Right. Uh, you could tokenize sort of a partnership interest, but there's a lot of complexity that comes with that tax reporting and compliance. Um, you know, securities regulations, transfer restrictions and all of those, uh, similar things that come with that. So.
Blake Oliver: [00:05:23] Got it. So when we talk about tokenizing, whether it's a a coin, like a crypto coin that stands on its own or it is something that is backed by the US dollar or another fiat currency, or it's a physical asset in the real world or a commodity. It's all represented by ownership on the blockchain. What is the benefit of putting something on a blockchain, of tokenizing it over the the way we do things now. Like why do you see tokenization of real world assets being a big thing in the future?
Noah Buxton: [00:06:02] Um, I think the there's a number of factors. So liquidity is one of them. That's kind of a loosely used term. But what does that mean? It means that the investor has the ability to put capital into an investment, can reap the rewards hopefully, of that investment, but also isn't stuck in it for a very long time necessarily. Right. Doesn't have a lot of the barriers to exit. So real estate here is a good example. Again, it's one that there's a lot of work to be done on the tokenization of it. But it's it's a it's an asset class. If you think about, um, uh, industrial real estate specifically or commercial real estate. Excuse me. Right. So multifamily housing and triple net lease and office etc.. Right. Um, these are often owned by REITs is one example of a structure that owns this type of real estate, you know, private partnerships and funds that own this real estate. And so investors come in to a deal. Right. And there's potentially lock up in that deal. Uh, there if you want to get out you know, sometimes there's theoretical liquidity, right. But how does the investor actually get out? They have to find either another investor in the same fund that wants to buy them out. Right. Which isn't always easy. Or they have to take that sort of share that partnership, share that they have out to market.
Noah Buxton: [00:07:19] Right. So if a middleman, they have a broker, right. They've got legal fees for transferring. They've got M&A sort of deal assessment due diligence. Right. On on the real estate itself. And so all of these things prevent liquidity and they prevent the free movement of capital in. We're talking about real estate right. But this could really apply to multiple different sectors. And so if you tokenize something um, you have, you know, a theoretically a much freer transfer of that. Um, so a number of companies have started this, I think t0 was the first one. Right. But they essentially create a walled garden. So it's not a full public blockchain use case of this, more of a walled garden. You come in as a, as an investor with a right. Um, I forget what the what these checks are called. Right. Sort of the qualified investor. Right. Ben qualified. You can sort of be within the walled garden, and now you have access to any of the tokenized investments that are within that platform. So, you know, the promise is sort of buy class A real estate in California in the morning and, you know, sell it for class A in Florida in the evening. That kind of idea.
Blake Oliver: [00:08:26] Got it. So, uh, when the REIT buys a property, I guess if it's set up, like to tokenize these ownership stakes, if I'm, if I'm understanding it correctly, they could like, issue a thousand shares via tokens on the blockchain. I could buy one of those. And then because it's on a blockchain, because it's a token. There's a marketplace online where I could then buy and sell. I could sell my interest without having to go through this complicated legal process that it normally takes to to do that.
Noah Buxton: [00:09:03] Exactly. So reduced friction, reduced middlemen and fees, increased transparency as well, I think is a really interesting factor for the accounting world. You know, property again, I keep coming back to that example because it presents a complex one. Right. But in property it's very expensive.
Blake Oliver: [00:09:21] Right now to do that. Right. It's like there's a lot of inefficiency.
Noah Buxton: [00:09:25] Yeah. You've got the valuation of this underlying real estate. Right. And then you've got sort of the management of it. You've got sort of it's three nets. You know, it's um, it's taxes, it's maintenance, it's insurance. And then you've got its income stream if it's, you know, income producing real estate, how are all these things validated? Well, think about a REIT, right. They've got thousands of properties. Let's say they're shopping malls and office buildings and the like. They're all managed slightly separately. Maybe they all use a different, slightly different bookkeeping methodology. There's a lot of accounting sort of that's messy under the scenes. I think one of the it's a bit future looking, but is the idea that you can you could standardize that process. You could think of an issuer who goes and buys real estate and standardizes the process of validating the income stream and as well as the outflows. Um, and then I think, you know, the valuation piece potentially comes more from the tradability of certain properties or like kind properties. So you're looking to comps essentially, which are trades on chain and trades in liquid marketplaces as opposed to comps today, which are how do we value the shopping mall? You know, I don't know. We got to look for one over here that sold recently. You're based on, you know, sort of very, uh, illiquid sales, you know, sort of so. Right.
Blake Oliver: [00:10:39] So if people can trade their shares, if you will. I mean, that's not really we don't want to use that term necessarily, because then we're talking like it starts to sound like, uh, Stock and there's a lot of, you know, issues. Go ahead.
Noah Buxton: [00:10:53] No, I think that's okay. Actually. So like, yes, the crypto industry wants to say that crypto tokens like Bitcoin and Ethereum and sort of go down the chain are not securities, right? They're not within SEC jurisdiction. Right. That's kind of been the case. The industry has made things that are a digital wrapper for something that is definitely a security, right. Like an investment or real estate partnership is definitely a security offering that as a Reg D offering. Right. So I don't think we're trying to avoid that. Putting a digital wrapper around it doesn't change the underlying character of it. Uh, there could be some incremental change in rules that could be really beneficial, like these transfer restrictions, for instance. That is something that's onerous, right? Transfer agent rules for knowing the identity necessarily of participants in the trade. You know, pretty difficult. While I'd like to see that sort of go away, I can also see the other side, which is wait a second. You can't have sort of no identity verification in these types of trades.
Blake Oliver: [00:11:49] And real estate is a great example. Because of the cost and complexity associated with like buying it, selling it and tokenization could definitely streamline that. I see that, but it's not limited to real estate. It could be almost any asset, intellectual property even, right. Like an artist could sell their catalog of songs and they could tokenize that intellectual property theoretically, and fans could buy into it. And then if you set up the the blockchain algorithm in the right way, they could actually get paid royalties. This could all be automated.
Noah Buxton: [00:12:32] Yeah, theoretically. And there's been some real world examples of folks trying this. I think Spencer Dinwiddie was one of the first pro basketball player to tokenize his contract, essentially.
Blake Oliver: [00:12:43] So how did that work?
Noah Buxton: [00:12:45] Uh, not I, I didn't I didn't read up on this before, so I don't want to miss anything. But I would say not that well, basically didn't didn't work out that well. Um, and that was a case where, wait a second, he was raising money essentially. Right. Taking fan investment, so to speak. Right. And committing to some portion of proceeds from his his contract. So he was kind of selling a future basically right on his, on his career, uh, basically a securities offering. So I think that sort of fizzled. Uh, you got more successful examples. Um, there's an artist. I think it's it's Blau. He's a digital music artist, uh, EDM, you know, electronic music. And he's taken a very crypto forward approach and direct fan engagement approach. And he's he's made NFTs out of his songs. Um, he's been able to distribute royalties from those songs. Uh, you know, directly to, to token holders here again, there's a whole, like, thorny nest of tax reporting issues, right? I mean, paying dividends, paying royalties. Excuse me. Is a is a tax reportable event? Right. I think it's is it the 600 rule and above. Right. Might have varied, but I think it's 600 bucks in royalties. Triggers a tax reporting event. Right. Which is a 1099 obligation. How do you do that to token holders who have no name? They just have a wallet. That's why you have.
Blake Oliver: [00:14:04] To have the walled garden. You have to have some additional data that you collect. You can't just let these things loose.
Noah Buxton: [00:14:12] Exactly. And frankly, like if you think about the walled garden, oftentimes you can really ask the question, well, wait a second, what's the point of tokenizing then? Because we have very good databases. If you're going to put everybody on a database ledger and give them permission to access to a website, essentially, why does it need to be tokenized? Right. So there's a really good critique of that. Um, you know, if we can if we can imagine, imagine a world where identity isn't necessarily managed on a centralized ledger, but we're talking about this idea of sovereign An identity, which is another thing that that blockchains theoretically enable is the idea would be you can be an anonymous wallet address for, let's say, all the crypto trading you do, right? On chain, you could go use a DeFi protocol and trade tokens, but if you want to go buy a regulated product, you have to use your self, your sovereign identity, right? You have to say, yes, this is my name and social and tax ID number, but you only expose that when you want to do the transaction. And the the walled garden doesn't store that information. It's only checking. Yeah. That's that's a person who's a qualified investor. They've been checked by another service. Right. They have sufficient net worth and background and income and all the things that are checked. I think we could get there, but both music royalties and identity. Very hard things to disrupt. So like over the past eight years, I think there's been a lot of really smart people that have tried to disrupt this space. And music is one where, um, I don't know, is it an oligarchy or how would you.
Blake Oliver: [00:15:44] Describe 2 or 3 companies that manage all the royalties payments you get with BMI? And I forget the other one of the big ones. Yeah.
Noah Buxton: [00:15:53] Yeah. So I wouldn't I wouldn't call them a cartel or whatever. But like jokingly we'd say, well, geez, how do you crack the cartel of music? Right? Yeah, it's pretty hard, right? I think because you've got basically a, like you said, a very few number of people that own the rights to the music, and then you've got a really limited set of distributors, I think is what they're called. Right. Your Spotify's Pandora's of the world. And those are pretty hard to disrupt too, because they have a very committed user base. Right. They've got the distribution. They've got the network effect pretty well locked in. Uh, how do you come as a startup business and completely disrupt both ownership and distribution? You know.
Blake Oliver: [00:16:32] Let's pause for a second. Um. Hey, Zach, I'm talking to my editor here. Zach, can you pause this? We're going to cut out this section. No, I think I heard your phone vibrate. Do you want to take that off the desk? Or, like I put it, turn it off.
Noah Buxton: [00:16:49] It was on personal. Do not disturb. Sorry. Yeah. Cool. Sorry about.
Blake Oliver: [00:16:53] That. You got the family blowing up your phone? I know how that is exactly. I know this is the beauty of not live streaming is we can do that. So, uh, 16 minute mark, uh, cut the. I can look.
Noah Buxton: [00:17:12] At my own video, but I look totally washed out.
Blake Oliver: [00:17:15] That's all.
Noah Buxton: [00:17:15] Good. Much light, but okay.
Blake Oliver: [00:17:17] It's nice. It's very like. It reminds me of the OpenAI, uh, videos. They like. They like that pastel. Kind of like. Look. It's good. Um, no, let's keep going. Okay, so, Zach, we're going to cut back in now. Um, so that is like the future. We've got real world assets tokenized. I'm really excited about that. I think there's a lot of opportunity, but we're not quite there yet, right? Most of the most of the digital asset activity is still cryptocurrencies. Not necessarily bitcoin all sorts of them. Right. So I'm curious to know Noah like what what is your firm doing. Uh what's what's what's your business about. Like as a CPA firm specializing in digital assets what services do you provide.
Noah Buxton: [00:18:07] Yeah yeah. So first a caveat I think you're right. The majority is I guess it's fair to say the majority is really is crypto right. It's tokens and trading. There is a segment that is the real world assets which is again if you put dollar stablecoins on that list, that's a pretty significant market right now by by valuation, by market cap, and also by its daily trade volume. Um, and then there's a middle section of like commodities and gold tokens and things like that that are starting to be tokenized and, and used, but still pretty immature. Yeah. So what do we do? Good question. So, uh, some of our specialties, I would say, you know, are transparency. Like, the thing that we actually care about in this space is, is playing the role that CPAs have played for a very long time in markets is being a function of being a trusted function, right. Enabling transparency for investors, regulators, market participants. We think that's a very important role, right. It's a very weighty role. Uh, crypto has like in our last discussion we talked about. Right. There's some bad headlines about crypto. Uh, some of that is a lack of transparency, a lack of regulatory oversight, a lack of rules that has all led to investors getting harmed. And so, um, we call this generally this bucket of proof.
Noah Buxton: [00:19:29] Proof of reserves is what we call it. Um, and it's a nuanced topic. There's a lot to it. But essentially it's transparency for the crypto space. So whether it's, uh, you know, those stablecoins we mentioned, are there actually dollars and cash equivalents in a bank account backing this up? That's that's one question of proof reserves for an exchange. Let's say you've put some you've invested in some Bitcoin and you hold it at a centralized party. Uh, proof of reserves also answers the question okay. Does the custodian actually hold enough of everyone's bitcoin to meet all of the liabilities that it has on that ledger at a point in time? And then the third use case is the ETFs. Right. Like we've essentially tokenized the tokens. Right. We've we've put a securities wrapper around the token. Sort of the reverse of what we talked about before right. Put put a note around the tokens. And now they're traded on Nasdaq and the like. Um okay. Well how does the note holder know that those note obligations are sufficiently backed by crypto assets. Right. So how do we know GLD is actually backed by gold. How do we know that Bitcoin tracker notes are actually backed by physical Bitcoin held in custody. Right. So there's three big questions there in proof of reserves that we can answer. Yeah.
Blake Oliver: [00:20:42] And this is basically the fundamental role of of CPAs in history. It hasn't actually been that long. But ever since the securities laws were written in the 1930s, it's been CPAs who are responsible for auditing companies that are listed on stock exchanges, public companies and and validating. They have the assets they say they have, that they have the liabilities that they say they have, and that the, you know, identity equation of accounting adds up that assets minus liabilities, equal equity. And we don't have a lot of that in the digital asset space. A lot of these crypto companies are operating without any audits because they're not regulated. Or they say they're not. And there's been this, uh, argument essentially going back and forth between the SEC and the crypto industry About whether that should happen.
Noah Buxton: [00:21:39] Yeah. Yeah, exactly. I think the I think it it's true that there's a lack of transparency in the space broadly. I would say that the, the US market is really the way it's regulated is by money transmission laws right now. So if any of the exchanges you can see online or that you might have interacted with if you've tried to buy crypto, uh, are regulated on a state level, of course, there's the federal Bank Secrecy Act, which essentially says the states shall implement a system of um, of MTL laws, uh, money transmission licensing. And so these all of the states actually require financial statement audit as one checkbox for those licenses. And it's a patchwork of laws. There's a few different things. But so anybody who's doing like a custodial function or a trading function or the transmission of money payments platforms in crypto in the US is under MTL and is in the audit process is starting or has done for many years now. Um, the things on the periphery, like the token projects, you know, the layer one blockchains, the foundations, that's definitely a space where you're right, there's like that. It's really hard to serve that public function of of being a, you know, trusted provider of information because there's no standards. We're talking about, you know, potentially offshore entities. What are the accounting standards? What are the what are the best practices. Right.
Blake Oliver: [00:23:04] Um, right. So if you're in the US, if you're an exchange and you are taking money from us, people in the United States, you have to have an entity here that is audited. Yes. Okay. But most of these exchanges, a lot of the activity is offshore, right?
Noah Buxton: [00:23:24] Uh, well, usually the exchanges have a pretty complex corporate structure, right? The ones that I've worked with are definitely global entities. Uh, and so, yes, they have they have a US entity. Of course they a lot of times have a US parent. Um, but they have many. They have a whole corporate structure, right. That that extends to offshore entities. Um.
Blake Oliver: [00:23:46] So like an example for me is tether. Tether is a stablecoin that is that. And tether claims that it is backed 1 to 1 with US dollars. Right. So if I buy a $1 of tether, it is backed somewhere by a dollar of US currency. But tether has never been audited as I like. There have been they've done some audit like activities, but they've never gone through a full what we would call a, you know, financial statement audit like a public company here in the US. Is that right?
Noah Buxton: [00:24:29] Uh, that's my understanding. Um, that that may or may not be true. Right. Like, tether is a private company. It may well have had a financial statement audit for one or more years, and it's just not public information. So it's possible.
Blake Oliver: [00:24:42] I think they haven't published any audited financials.
Noah Buxton: [00:24:46] They've not published audited financials. There's a long history with tether. And there's some interesting things that have happened over the years with tether. Um, it's a bit of a black sheep in many ways. I would say, if you looked at across the stablecoin market, they're the largest player, but they also have a, you know, kind of a checkered past, frankly. Um, today, you know, my understanding of tether is they've done their best to clean themselves up, but they've also been pretty tactful in, I would say, not necessarily skirting regulation, but, um, being very defensive, being being very strong, you know, on their positioning. Um, today my understanding is that BDO Italia, uh, the Italian office of BDO uh, does an attest. So they do an attestation report on a monthly cadence covering the reserves. So they look at the total circulating supply of those tether tokens across multiple blockchains, and they look to the custodial accounts at financial institutions that hold cash and securities. They do that asset liability matching and they report on it.
Blake Oliver: [00:25:50] So so so that that it's a proof of reserves report. Is that what they're producing?
Noah Buxton: [00:25:57] Um, I would say that generally the yeah, it's like this is a technical thing. And, you know, people have been accused sort of of overstating the value of proof of reserves in the past. And I think that continues to happen. So I'm always very careful you don't get an elevator sort of quick answer from me on proof of reserves on any topic. But this is one to where I'd say, yeah, generally it's in that domain of proving reserves. Right. But how is it done? Well, it's a point in time attestation report, right? My understanding is it's issued under IFRS standards. So it's sort of the um, it would be the equivalent of an examination report here in the US and a 2005 report. But it's done under the IFRS standards.
Blake Oliver: [00:26:38] Okay. And what is happening in a proof of reserves engagement in general? I know they can all be different. Right. But like what is the idea.
Noah Buxton: [00:26:50] Yeah. Well let's let's pick let's stay on stablecoins for now. Right. Because that is really just the easiest version of this asset liability matching exercise. So we have a liability and or obligation you know is it a liability technically right. People will argue about that shorthand. It's a liability. It's an obligation of the issuer.
Blake Oliver: [00:27:10] Right. Tether. Tether says I can exchange my tether for U.S. dollars at this pegged value. That's the liability.
Noah Buxton: [00:27:19] One more caveat. This is actually a layered system. If you think about it as a sort of an onion. In the center of the onion is the issuer. This is tether, right? The next layer out on the onion is actually direct customers of the issuer. And these are largely exchanges actually. So for instance, if you wanted to go sign up with tether, you can't. Neither can I. Uh, both for those jurisdictional reasons, uh, licensing reasons, etc.. So that second layer again, is, is the big players where they go source and trade with tether. And the third layer out is retail essentially. Right. And that third layer is provided by the global exchanges of the world, the Binance and KuCoin and Huobi and etc.. Uh, so so we as retail get access to this dollar pegged promise by the fact that the exchange we're on has a sufficiently liquid book to where supply and demand doesn't push, you know, tether too far off of a dollar. So yeah sorry long answer.
Blake Oliver: [00:28:15] But so I guess dumb it down for me.
Noah Buxton: [00:28:18] Underlying promise a couple layers down. That's the promise is that. Yes. It's redeemable. Yeah. What is the.
Blake Oliver: [00:28:22] Proof of reserves proving.
Noah Buxton: [00:28:25] So the proof of reserves is a is an attestation right. So if it's done under examination standards. Right. It's putting the auditor's opinion that management's report over custodial assets and liabilities is fairly stated in all material respects at the point in time. So typically the way these are architected is management's, excuse me, the auditor's opinion letter or independent accountant's report page, which says we've examined this right. Here's kind of the scope, here's our opinion. Here's any call outs, caveats, deviations. Um signed off by the firm. And then the second report, which is the subject matter of the test, um, can be a couple of things. One, it's disclosures. So it's typically a couple of line items that say total circulating supply of tokens, total assets in custody. So there's a sort of 1 to 1 matching. And then there's a bunch of assertions. And there should there should be as well management assertions. Right. And so those are things that the auditor tests as well. Right.
Blake Oliver: [00:29:21] So do you do these proof of reserves reports.
Noah Buxton: [00:29:24] We do. Yeah. Yeah.
Blake Oliver: [00:29:26] So how do you go Go for it. How do you do them? Like how does it like. How would you actually go about doing a proof of reserves for tether or any other stablecoin or any other digital asset? What do you look at?
Noah Buxton: [00:29:43] I mean, a lot of it's kind of like an inventory count type of exercise, right? So on. So let's talk about liabilities first on the public blockchain side. So can you have to ask first, can these blockchains serve as a sufficiently reliable source of audit evidence. Can they be sufficient appropriate audit evidence gained directly from a blockchain? Can you go to the blockchain and confirm right that there's a balance there? And yes, you.
Blake Oliver: [00:30:11] Can theoretically, if it's set up right, you should be able to do because the blockchain is public, you can download the whole history, the whole entire ledger for all time and analyze it.
Noah Buxton: [00:30:22] Right. Exactly. Which we call hosting a node or a full node would be downloading that full ledger. Okay. Um, yeah. And the AICPA even has this, uh, in recent standards, updates that blockchains can be a sufficient can provide sufficient, appropriate audit evidence. Um, so there's a couple of things the auditor wants to do behind the scenes to document. Okay. What blockchain am I looking at? Like is it sufficiently decentralized? Like, you know, is this balance relatively reliable? Um, but for the largest blockchains. Over the, you know, three, 4 or 5 things are held in a smart contract, essentially. So there's a smart contract that will, uh, record the circulating supply. There's the vending machine on chain. Right. And you can look to the vending machine and it knows the circulating supply of tokens. They may be held by many different participants in wallets. Right. Many different people globally. But that's the place you look, right. So now you get circulating supply. Um, on the asset.
Blake Oliver: [00:31:22] Side, that's the big number. That's the number you have to now confirm on the asset side that that equals or exceeds.
Noah Buxton: [00:31:29] Exactly right. And so it's it's an examination process the way we do it. Right. It's an examination engagement. So all of the typical audit tools apply. So you know, you you inquire, you understand their custody process. You understand the counterparties and custodians that they work with. You understand, you know, even internal controls, although you don't have to test internal controls to reach your opinion, you know, you do look for an understanding of internal controls. And then what do you do from there? You shoulder surf, you observe, you test directly by getting read only access and the like basically and document as such. But yeah essentially you're looking to banks right. So what's the cash account and what's the treasuries account. And you're summing up total.
Blake Oliver: [00:32:14] Summing up all the government bonds I've purchased with the US, dollars I've received, with the money I've received to sell this stablecoin, you're making sure that the money I've got in those money market funds, or in those bonds or in those cash deposits, all sums up to the total tokens outstanding, or the value of.
Noah Buxton: [00:32:33] That, as well as a number of other potential assertions that can be in these reports, like one important one is, okay, well, is that a company account? Is that some sort of a trust account? Is that held on behalf of, you know, is this specific account at the custodian held on behalf of token holders, for instance? So yeah, there's a number of other things that play in there. But that's the basic process. I mean look to the blockchain. Look to the custodians, bring the two together. So what.
Blake Oliver: [00:32:59] Are the limitations of these proof of reserves reports versus a traditional audit.
Noah Buxton: [00:33:05] Versus a traditional audit? I mean, there's a lot of ways to compare and contrast them. Uh, I mean, in terms of their assurance level, it depends how they're done. Right? So a private they can.
Blake Oliver: [00:33:17] All be done differently, right?
Noah Buxton: [00:33:19] Yes, exactly. Well, to a certain extent. Right. Like as a as a CPA firm, as an audit firm, the way we approach it is there's really kind of two potential AICPA standards that could apply ATC 205 examinations and ATC 215 agreed upon procedures. So there's a quick distinction there too, because, um, you know, in terms of that, that word assurance in the way the accounting industry uses it, it's a very important term examination opinion is, you know, is an assurance vehicle, whereas an agreed upon procedures report is not. Quote unquote, assurance vehicle. It offers no assurance. And so all of these things are relatively in the domain of limited assurance. So now let's take let's take the examination. Let's leave the AUP aside for a second. Let's take an examination of opinion over a stablecoin issuer and their reserves and compare that to a financial statement audit. Um, well, those are both limited assurance engagements or assurance engagements, generally speaking. Right. The auditor for the financial statement audit gives an opinion that the the financials are fairly stated in all material respects. Right given relevant standards and same thing. I've read that one to you know, read out that one for the stablecoin examination. So in their assurance level relatively comparable.
Noah Buxton: [00:34:33] It's their scope right. It's the standards that really sort of matter. So one way to think of a proof of reserves for me, whether it's an exchange use case or a stablecoin, is like a it's a narrow view of the balance sheet is one way to look at it. Um, they're important to like it's kind of a contrasting factor. But like if you think about those exchanges, okay, let's say let's try and stay on stablecoins so people can follow us here. Let's think about that second layer of the onion. I talked about where the or the first layer of the onion, where exchanges are actually buying directly stablecoins with the issuer. Okay. So they're holding a bunch of stablecoins. They're really holding most of them, right. For you, me for other customers. And they're held in these commingled wallets or pooled wallets probably is a more proper term for it. So everyone's assets essentially is in one bucket. And there's a ledger at the exchange that says, you know, you have ten stablecoins and I have ten, and everybody else has 1000 or whatever. Um, so if you think about a proof of reserves and exchange use case, um, you know, under a private company audit today, like the standards don't require that those assets be on the balance sheet so they can be in a footnote, they can be supplementary reporting.
Noah Buxton: [00:35:48] You could that exchange could go through a financial statement audit. And the auditor could theoretically never test those off balance sheet assets. They could never test whether those those stablecoins are actually held sufficiently to meet all the liabilities that they have to or customer obligations. They have right to the people on the platform. And so this is an important vehicle. Like it could be said. Wait a second. It doesn't it might not offer assurance. It's not the whole picture. You don't know if they're actually a solvent business you don't know anything about. Right. The rest of the financial operation. But at the same time, nobody's getting access to the private financials of an exchange anyway. So this is a vehicle on top of that that does offer some transparency to the customer level, which they would have no transparency anyway. And it's also potentially covering something that wouldn't be in their financial statement, uh, uh, audit anyway. And if it was, it probably would be tested on a sample basis as opposed to 100% basis, which it can be in the tests.
Blake Oliver: [00:36:49] So this is this is wild. What I'm hearing is that like a US exchange could go through a financial statement audit, but that audit doesn't necessarily test whether or not the the wallets that they are holding commingled funds in actually that they control or they own that because those are off balance sheet.
Noah Buxton: [00:37:17] Yeah. I mean, if you think about it, if you think from scratch And you think if you're in the accounting chair, you're in the CFO chair at the exchange. Like, do you you know, you're let's say your revenue is, you know, 10 million bucks a year or something on trading fees. Are you going to put $1 billion worth of customer assets on your balance sheet? But that's what banks do, right?
Blake Oliver: [00:37:35] Banks have to show customer deposits on their balance sheet. And so and those get those get audited and make sure that they can actually pay back the the depositors.
Noah Buxton: [00:37:45] There's specific accounting rules around that and disclosure rules. And it also sets their capitalization ratio. Basically it sets like okay how much like sort of lending activity can they actually do on that balance sheet. So that's yeah that's an important slightly similar and also different from exchanges. Um but yeah the private companies sort of standard accounting rules, you know, don't under GAAP don't necessarily say that that needs to be, um, an asset and corresponding liability on the balance. It's kind of wild.
Blake Oliver: [00:38:13] Because a lot of people are using exchanges as banks for their crypto, essentially. Right. I hold my crypto at this exchange. Let's say it's FTX, right? And there's no currently under the current rules, there is no requirement that this exchange is audited and has to prove that they actually have the deposits still. And like that's basically what happened with FTX, right, is that they were siphoning off the customer deposits to gamble in a related company to speculate.
Noah Buxton: [00:38:48] Exactly. Yeah. So we've been banging this drum for a long time. The first proof of reserves that I did with the team was at a different firm, but it was the first time a CPA firm had ever done or used a CPA attestation standards to cover this subject matter and present it in this way. Um, basically the first time that a CPA had done a proof of reserves over an exchange, and we did that for gate.io their top 10 or 15 by daily volume. So global Exchange not didn't really have a US presence, but they have a global presence. Um, yeah. And so been doing these, uh, for quite a while. Um, and I think they're important. Like, I think there's plenty of potential criticisms to, you know, wait a second. If it's done under AUP, there's quote unquote no assurance. Okay. Right. There's no assurance, quote unquote. But that's not how normal people think. That's how accountants think. That's how accounting firms think. That's how they think about their own risk profile essentially. So we have.
Blake Oliver: [00:39:47] This we have this product, a proof of reserves report, which can be done under two different standards, one which provides limited assurance and one which provides no assurance. And it's called the same thing.
Noah Buxton: [00:39:59] Generally in that bucket. Yeah, exactly. So that is incredibly.
Blake Oliver: [00:40:03] Confusing to the public. I mean, it's confusing to me. And I'm a CPA.
Noah Buxton: [00:40:08] Yeah I yes we've we come across this pretty often that even folks that are in the space, you know, even our trained accountants and licensed struggle with these topics. It's not rocket science, and I think it's things that the public can understand, right? With the right explanation and the right transparency around what we're actually doing. So. So yeah, there's those criticisms. Right. Like our is the intended user of the report actually have sufficient knowledge to understand the subject matter of the report and its opinion? Yeah, that's a valid criticism. Right. Like that's a valid criticism for anything. I mean, look at the public markets. Do you do you think that people who are investing in Tesla stock through Robinhood have any idea about PCAOB level reporting and SEC standards and how to read a 10-K? Like, absolutely not. So we we they don't. We rely on another layer. We rely on the investment banking layer. Right.
Blake Oliver: [00:41:05] They're relying on the analysts, the investment bankers, the sophisticated investors. And they're they're basically, uh, what do you call it? They're drifting, um.
Noah Buxton: [00:41:15] Off riding the coattails. Yeah. Riding the.
Blake Oliver: [00:41:16] Coat. Yeah. Exactly. So they have. They have the assurance of the whole system and and feeling secure in knowing that we have a system that has these checks and balances to to actually make sure that, you know, Tesla isn't just making up the numbers.
Noah Buxton: [00:41:31] Exactly. And at the end of the day, it's a it's a system, you know, built of flawed human beings doing our best to, you know, uh, follow standards. Right. And so there's plenty of examples in the public markets where, yeah, things didn't go quite the right way, that layer of, you know, high paid analysts and auditors and everything else didn't actually work to the benefit of the the investor. Right. There's examples of that. And I think just our approach to this space is like incremental steps are better than no steps, right. I think that there's an inevitability here. Right. In terms of crypto exchanges will be things people will invest in crypto, whether you like it or not, whatever. Wherever you are on that spectrum, it's going to happen. It should there should be a regulatory perimeter around it. If it's going to be in the US, then there there should be proof of reserves, should be part of that transparency stack of that compliance stack and that regulatory perimeter. Without it, like regulators on the state level right now completely lack visibility to the reserves of these exchanges. They just do right. And financial statement audits, which are required, don't get them there. So the idea of attacking or saying this, this thing that you're talking about, proof reserves, has problems and caveats and nuances and it's hard to understand like, okay, yes, that's true, but it also is moving in the right direction. Right. Like this gives regulators a tool that they they don't have, they completely lack right now.
Blake Oliver: [00:42:57] So if crypto is actually going to be a legitimate alternative to the traditional banking system, there's got to be assurance that these reserves exist, that the money that I keep at an exchange is actually deposited there. Yeah. Or if it's being lent. Lent out, like at a bank that there is sufficient reserves like banks have to maintain. They have to maintain certain capital requirements. Right.
Noah Buxton: [00:43:22] Even if you're like a skeptic and you say, no, this is never going to be a legitimate alternative to the banking system. It still is going to be something. Is it check cashing. Right. Check cashing is regulated by money transmission as well. Do people think that's a, you know, a reasonable alternative or a good alternative to the existing banking system? No probably not. It's probably largely predatory and probably largely unfair, but it's regulated, right? And it should be regulated in the right way. And so I don't think that crypto is check cashing or predatory or anything, but, you know, just it will be something, right? Whether it's online gambling or check cashing or digital assets or betting on sports online, these are ways that people are transacting value online. And a lot of times there's sort of reserves or customer money in the system and deserves to be protected.
Blake Oliver: [00:44:09] Yeah. So right now it's essentially optional. There's no requirement that these exchanges need to get proof of reserves reports.
Noah Buxton: [00:44:20] There's a few things moving. So Texas was the first to create a proof of reserves law and called as such. And it's specific to exchanges that operate in Texas. There's a few triggering factors. I think it's 10,000 customers in the state or a certain number of value of assets, basically trips any exchange into this requirement. Um. Excuse me. It's it's a lot. Texas is a whole podcast of its own. Um, it's very interesting to see the way I think state legislators did a did the right thing. I mean, they said, hey, look, Texas customers, Texas citizens, were harmed by the collapse of FTX comm in 22. Uh, let's do something about that, right. They look to proof of reserves. They saw that this was something that could be done. They said we should do that and let's put a CPA stamp on it. Uh. Again, long story short, that legislation has been difficult to bring into reality just because the way it was written and the way the Department of Banking in Texas can actually go about requiring this, analyzing the reports that they receive, etc., but there's actually a significant movement in that direction. So, uh, you know, New York is, uh, been very forward on crypto regulation. They have a, I guess you could call it proof of reserves requirement for the stablecoin issuers, uh, that are licensed in New York. And so those those issuers have the mandate to do this, this monthly test, as well as a, a day within the month and also a comptroller report annually as well. So that's a pretty good example of pretty, pretty onerous, frankly. You know, it's pretty pretty high bar to do that stuff. It costs a lot. It's complex. Um, but ultimately yeah.
Blake Oliver: [00:46:00] Creates I mean, how else do you protect customer money without without somebody some third party verifying it's actually there?
Noah Buxton: [00:46:10] Yeah. I mean, I think the self-regulatory I don't want to say that self-regulatory means like, aren't valuable. I think that if you look at circle, you know, they're the second largest issuer of stablecoins. They're a US company. Um, their product Usdc, right. They started the attestations years ago. They do it on a monthly cadence. They've had Deloitte and Grant Thornton, I believe, have been in that chair over the years. Um, it's a self-regulatory thing. Yeah. It's not required by any one state, but the fact that they're putting the information out to the public, to the customers, it has a forcing function of its own. I mean, that is real, right? Like if you're within the business and you're putting out this information, it's like, it better be right. You know, you're doing hopefully your best to make that honest and accurate information. And hopefully it's also driving internal control and process and all the good things you need to do inside to be able to to do good reporting outside the walls of the firm. So, so not not not foolproof for sure, but.
Blake Oliver: [00:47:07] Well, so the picture I'm getting is that like proof of reserves, some sort of assurance around customer deposits, the that these funds exist, that these coins exist, um, that the, the blockchain for each of these coins is set up in a way that can't be manipulated, like you said, distributed. Um, somebody needs to sign off on that. Cpas. That's our traditional role. Like, that's what we do. So we have a huge opportunity to be the, the, the auditors of crypto, essentially. And, um, but there aren't very many firms doing it right. Like, you're one of the few.
Noah Buxton: [00:47:50] It's ebbed and flowed over the space and the approach of the years and the approach to the space has been different. You know, the first approach was it's not about Bitcoin, it's about blockchain. Big firms, you know, like let's go sell the fortune 500, their own blockchain, their own implementation. Let's do this proof of concept things. Uh, It evolved into. Yeah. Digital assets are kind of a real thing. And there can there will be sort of continued proliferation and expansion of this market. And so yeah, some of the larger firms started to do audits were very I would say the big four were very selective about who they would audit, and.
Blake Oliver: [00:48:23] They stayed away from it a lot. And they've really especially.
Noah Buxton: [00:48:26] Yeah, especially in this space, I mean certain firms I won't, I won't name, but there's one of the big four that's actually very active in crypto funds. Um, you know, and especially through their Cayman office. Um, each of them has kind of taken their different approach, right? Um, one of them is, uh, very still involved in sort of the not crypto but blockchain side and is developing technology. Um, you know, for one of their large clients has, you know, projects that they've released. That's an interesting approach to the space. But but yeah, the state of the play today is that for the last four years, the PCAOB is generally PCAOB has generally been kind of hostile. Frankly, I think in terms of, um, its, its approach to regulating PCAOB registered firms. So they've they've had sort of the impact of 2022, seeing other firms publicly named and shamed by senators and PCAOB. Um, then they've had sort of investor alerts. There was investor alert around proof reserves, right by issued by SEC chief accountant Paul Munter, um, which is uh, sort of a lot covers a lot of things we just talked about. Um, and then there's just like the general sort of approach that PCAOB has taken to firms, um, even outside of crypto. And so, yeah, the biggest firms have been scared away. Uh, the middle market firms, frankly, weren't very well tooled anyway, like many of them didn't have their own tools or very deep practices. So they were doing some tax work, you know, maybe they were doing some consulting, but they really weren't doing auditing in a test work. And so yeah, there remains today like, yeah, a handful of firms but growing now I think people are coming. Firms are definitely coming back into the space. Right now, it.
Blake Oliver: [00:50:07] Seems like a big opportunity because it seems inevitable to me that proof of reserves will be eventually required everywhere, because it just makes sense. Like, we need to have regulation around this space. Um, if a firm, let's say we've got some CPAs listening who do audit are interested in getting into this space, um, just putting myself in their shoes, I would think the I already know how to, you know, audit what's in the bank, the the asset side, but the liability side, the blockchain side. Like that's a whole new thing. Where can CPAs learn how to do that side so they can do these proof of reserves reports?
Noah Buxton: [00:50:51] Well, we're happy to teach you. Um, you know, our goal actually, in this space is to ensure that more firms can do this work. So, you know, a slight tangent, but in developing all these tools, we created a product called Ledger lines. It's the the first and only tool that's really purpose fit for CPAs and auditors to accomplish financial statement audit engagement. So you can test the balance sheet, right. You can roll back balances in no. 1231. Point in time balances in many wallets at a time. You can do digital signatures to prove ownership of the assets on the balance sheet. You can do transaction testing and high volume of selected samples like there's no other tool that does that. So when I say we can teach you, that's actually honest. Like the network firm, um, people might think, wait, why would they focus only on one industry? That seems so like, why would you do that? Like, yeah, there's industry specialization, but you lack diversification, right? Like bad crypto cycle. Bad time for the firm. Well, it's actually more about using the network firm as a way to prove that CPAs standards, CPA standards and services can be tech enabled.
Noah Buxton: [00:51:59] They can be delivered to the space. You can use these tools to create transparency and positive externalities in the market. And so Leisure Lens is sort of the vehicle for that. Right. That firms can now buy a SaaS tool. Right. Commercially available and 15 blockchain supported and actually does the things you need it to as opposed to being the midnight manager, like searching for some source on the internet that can give you a point in time balance for this wallet, or hundreds of them, or thousands or tens of thousands of wallets at a point in time. Yeah. So we are really willing to teach you. Part of that is, you know, a we don't think that every firm is going to click and buy software because they're not ready. Right. So the idea is, hey, we can be your digital asset practice in a box, but we can support you in many ways from the education side, uh, all the way through to the actual tools to do these engagements in a risk reduced way. Um, there's other resources, too. Um.
Blake Oliver: [00:52:56] You're making me want to start. You're making me want to start a CPA firm? No. Uh, I mean, it seems like this is a huge growth opportunity. So like like it's going to happen. You've got the tool and I could learn I could, I could, I could I could I, I wish I had more time, you know.
Speaker3: [00:53:15] I.
Noah Buxton: [00:53:16] Know you're too good at this. What you do right now, you know.
Blake Oliver: [00:53:19] This is so cool. So that's legends I know, right?
Noah Buxton: [00:53:24] Yeah. Legends. Oh, yeah. That's that's the site if anyone wants to check it out. Um, and.
Blake Oliver: [00:53:29] Noah, if people want to connect with you online, where is a good place for that?
Noah Buxton: [00:53:32] Yeah. Hit me up. Uh, give me my email. Right. The normal naming convention noel-buxton at the network firm.com. You can hit us up through the website too. Feel free to just, like, talk to an expert, schedule a call button. You can put time right on my calendar or the team's calendar where our door is always open.
Blake Oliver: [00:53:50] Awesome! Noah, thanks so much for taking the time to join me. Uh, I really enjoyed this conversation. Hope to chat with you again soon.
Noah Buxton: [00:53:56] We went really wide and a little bit deep and I appreciate it. Blake. Thanks.
