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Lack of Expertise Raises Concerns in Virtual Asset Auditing

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The recent collapse of FTX has highlighted the need for robust auditing practices in the virtual asset (VA) industry. However, a lack of expertise among auditors and exchanges is leading to compromises in the credibility of audit reports.

Challenges in VA Auditing

According to the Securities and Futures Commission (SFC), disclosing liabilities of VAs poses considerable challenges. Many exchanges, including OKX, Binance, and Bybit, employ Merkle Tree technology to validate their liabilities. This process involves:

  • Hierarchical data processing
  • Sequential transmission of results
  • Checking the integrity of nodes before and after each step

While Merkle Tree is considered an “optimal solution” for VA auditing, it still faces challenges. Trust in centralized data remains a concern, and verifying ownership of private keys or confirming whether audited assets are temporarily borrowed presents ongoing difficulties.

Proposed Solutions

To address these concerns, VAs should consider:

  • Introducing fraud penalties
  • Increasing the frequency of Merkle Tree data updates
  • Collaborating with third-party providers to enhance transparency regarding asset status

Technical Security Concerns

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The Hong Kong Financial Secretary has emphasized the importance of establishing appropriate safeguards for the development of Web3.0 technology. To address these concerns, major companies are investing in technology development and hiring more technical professionals.

Key Areas of Focus

Two key areas warrant particular attention:

  • Security of Fund Custody: The SFC mandates that 98% of virtual assets must be stored in offline cold wallets, and assets should not be held by third-party companies but rather by subsidiaries.
  • Cybersecurity: Major VAs have implemented measures to improve security, including:
    • Expanding cold and hot wallet infrastructure
    • Employing online/offline storage systems
    • Multi-signature authentication
    • Multiple backups

OKG Research has also provided suggestions to the SFC, advising VAs to pay close attention when implementing fund custody, particularly regarding cold and hot wallets.

Anti-Money Laundering Concerns

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The United Nations estimates that money laundering reaches $800 billion to $2 trillion globally, accounting for approximately 2% to 5% of GDP. In 2022, global financial institutions faced fines exceeding $8 billion due to anti-money laundering violations.

Recommendations

VATPs need to implement:

  • More stringent screening on their on/off-fiat service
  • A comprehensive approach employing:
    • Traditional and innovative big data analysis techniques
    • Network analysis to systematically monitor suspicious funds and transaction channels

Conclusion

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The shift in Hong Kong’s stance provides a more robust framework for the development of virtual assets. Recent documents have presented more detailed and rigorous requirements for VAs, highlighting the importance of avoiding conflicts of interest, restricting certain business practices, and prohibiting inducement of investments.

OKG Research aims to promote the application and sustainable development of digital technologies such as blockchain, cybersecurity, and RegTech.