Proof of Solvency is a Big Deal

image_pdfimage_print

Leave it to programmers to look at a catastrophic $350M financial-company collapse, and immediately think:

“Why not just code that sort of inelegance out of the economy?”

That’s exactly what’s happening in response to the recent implosion of early bitcoin-exchange MtGox. On the day MtGox filed for bankruptcy protection, CoinSetter, a bitcoin trading-market startup based in NYC, began a public process to determine how to do cryptographic proof-of-solvency.

This idea has profound implications for all financial institutions. Cryptographic proof of solvency refers to a way to publicly prove, beyond any possible doubt, that an organization’s finances are in order. The idea is essentially to link all deposits/liabilities of an organization and use cryptography to prove that they sum to a certain amount. The company can then use the public bitcoin blockchain to provably demonstrate control of at least that quantity of funds. Critically, this proof would not rely on the company’s own statements, or statements by its auditors, but on cryptography; in other words, the laws of mathematics. As we’ve seen so many times before (Enron, Worldcom, MFGlobal, Madoff), it’s probably not a good idea to unilaterally trust what companies, or their auditors, say.

Bitcoin gives the world completely new financial possibilities through the combination of the Blockchain (bitcoin’s public ledger) and cryptography. Proof-of-solvency is just the obvious first-step in giving financial companies the ability to provide customers with unprecedented transparency and control of funds. This has very large potential benefits to society, given the financial-system costs associated with insurance, fraud prevention, auditing, etc. Not to mention multi-trillion dollar public bailouts when those measures fail to be enough anyway.

5 responses on “Proof of Solvency is a Big Deal

    1. Dan McArdleDan McArdle Post author

      Actually, it’s not *at all* baked. The point is not that there are fully ready production solutions coming online tomorrow; it’s that they’re theoretically possible and bitcoin businesses are now focusing on them.

      As a general note, the fact that much in bitcoin is immature is hardly noteworthy. The entire space is (and will continue to be for a while) all about the potential. Distributed trust is an entirely new domain and these things take time.

      1. Craig

        It’s funny how the word “trust” in CS contexts has almost the opposite meaning from what parents teach their kids in the context of interpersonal relationships.

  1. Craig

    Sorry, that comment was not very helpful. What I meant to say is….

    First of all, many healthy companies have debt greater than cash on hand. That doesn’t make them insolvent. Companies can, and should be allowed to, liquidate non-cash assets as needed, on a just-in-time basis, for debt service and other current liabilities.

    Second, it would be economically foolish to require most entities to keep their assets in cash, which typically has a much lower rate of return than just about any other use of assets. Normatively speaking, its a good idea to enact rules and institutions that promote the allocation of assets toward their most productive uses. Holding assets in cash is rarely their most productive use.

    Third, many types of assets are inherently problematic to value. Creating an algorithm to value all non-cash assets is practically impossible, so therefore algorithmically determining balance sheet insolvency is practically impossible.

    Fourth, even if you could algorithmically prove the current liquidation value of all of a company’s assets and liabilities, that still wouldn’t be reasonable justification to take some sort of enforcement action against it. It’s not uncommon for companies to be temporarily balance-sheet-insolvent, while its employees work toward making its (non-cash) investments pay off profitably. Indeed, just about every venture-funded company spends the first part of its life in balance sheet insolvency, and mature companies sometimes dip into insolvency as well.

    Fifth, to enact rules that disallow insolvency would be a drastic regulatory overreach and deleterious interference with the free market forces and the tools that lenders and equity holders already have available to them through contract law (such as debt covenants and shareholder agreements that include protective provisions and oversight clauses).

    Sixth, enacting insolvency regulation would drastically change the landscape for comparing debt financing with equity financing. The implications would be far-reaching. IB activities such as bond issuance to fund stock repurchases, equity financing to de-leverage a balance sheet, LBOs, all sorts of M&A activity would be impacted. This is not a change to make lightly as a knee-jerk reaction to recent events.

    On the subject of knee-jerk reactions, I’m sorry about my initial lack of explanation. In the future, if I don’t feel like explaining myself I should try to refrain from posting anything at all.

Leave a Reply to Craig Cancel reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>