Understanding Blockchain Verification vs. Traditional Financial Audits: Implications for Hedge Funds

R Tamara de Silva

Crypto transactions will likely continue to have a greater presence in financial statements. So what happens when they have to be audited? As a lawyer whose practice is focused on regulatory and compliance, I am accustomed to working with entities such as Commodity Pool Operators (“CPOs”) and Introducing Brokers (“IBs”) that require annual certified financial audits. It is inarguable that the rise of cryptocurrency and blockchain technology will impact financial audits and the compliance requirements of regulated financial institutions. But the verification processes for assets on a blockchain and not differ.

Chain verification of blockchain and a certified financial audit, serve to verify and ensure trust but in fundamentally different ways. This article addresses the concerns of investors interested in the security of their crypto assets and how blockchain audits can protect their investments, as well as financial institutions seeking to integrate blockchain technology into their services and ensure regulatory compliance. Blockchain and crypto startups may also benefit from understanding how to assure their stakeholders of the security and integrity of their technology.

Understanding Chain Verification of Blockchain

Imagine a digital currency that operates without any central authority, purely based on technology. That's Bitcoin. It runs on blockchain, a decentralized ledger that records every transaction ever made with Bitcoin. Picture it as a giant, transparent notebook where everyone can see every entry, but no one can change past entries. Chain verification is like the security guard of Bitcoin. It checks every transaction from the beginning to make sure they all follow the rules.

In chain verification, transactions are grouped into blocks. Each block (book) contains a bunch of transactions (pages) and links to the previous block, forming a chain of blocks. Miners are like contestants in a puzzle-solving game. They use powerful computers to solve complex puzzles. The winner gets to add a new block to the chain and earns some Bitcoin as a reward. Every participant (node) in the Bitcoin network has a copy of the entire blockchain. They independently verify transactions and blocks to ensure they’re legitimate. The network agrees that the longest chain (the one with the most work put into it) is the true version of the blockchain. This consensus keeps the system secure and consistent.

Certified Financial Audits

A certified financial audit is like a health check-up for an organization’s finances. An independent auditor examines the company’s financial statements and operations to ensure they are accurate and comply with laws and standards. During a financial audit, auditors review financial records such as balance sheets, income statements, and cash flow statements. They verify that the organization follows relevant laws and accounting standards. Auditors also evaluate the effectiveness of the organization’s internal controls over financial reporting. After their examination, auditors issue a report that provides an opinion on the accuracy and fairness of the financial statements.

Differences Between Chain Verification and Financial Audits

The scope of these processes is different. Chain verification focuses on the integrity of the blockchain, ensuring all transactions are valid and the chain has not been tampered with. In contrast, a financial audit covers a wide range of financial information, ensuring financial statements accurately reflect the organization’s financial position. The methodologies also differ. Chain verification is automated, relying on cryptographic proofs and decentralized consensus mechanisms like Proof of Work. On the other hand, a financial audit is manual, involving detailed examination, transaction sampling, and application of accounting principles by auditors.

The purposes of these processes are also distinct. Chain verification ensures the security and correctness of blockchain data, while a financial audit provides assurance to stakeholders (investors, regulators) about the accuracy and compliance of financial statements. Consequently, the outcomes are different. Chain verification confirms blockchain data is intact and follows protocol rules. A financial audit issues an audit opinion on the financial statements, indicating whether they are free from material misstatement.

Blockchain Code Auditing

Blockchain code auditing is a detailed review and analysis of the code that runs blockchain networks and smart contracts. This process is carried out by security experts to identify vulnerabilities, bugs, or weaknesses in the code that could be exploited by hackers. Initially, automated tools scan the code to detect common vulnerabilities. Security experts then manually review the code to identify more complex issues that automated tools might miss. Simulated attacks are conducted to test the code’s resilience. A detailed report is provided, outlining the vulnerabilities found and recommending fixes. The development team then implements these fixes to enhance the security of the blockchain. Within the permissioned and private blockchain, one of the node participants could be an auditor or regulator node to complete the audit directly from the blockchain.

Blockchain code auditing is useful for maintaining the security and integrity of blockchain networks and applications because by identifying and fixing vulnerabilities, it helps protect against potential attacks and enhances user trust.

Legal and Compliance Considerations

Both chain verification and financial audits are essential for ensuring transparency and trust, but in different contexts. Chain verification ensures the security and integrity of cryptocurrency transactions and helps prevent fraud and double-spending in the cryptocurrency network. Financial audits ensure organizations present accurate and fair financial statements, providing confidence to investors, regulators, and other stakeholders regarding the organization’s financial health and compliance.

Will Future Regulations Require Blockchain Audits?

It is possible that future regulations and compliance protocols will increasingly require blockchain audits. The U.S. Government Accountability Office (GAO) has emphasized the need for regulatory oversight of blockchain-related financial products and services, suggesting that formal mechanisms for identifying and addressing risks in the digital asset space are crucial. As blockchain technology becomes more integrated into various industries, the demand for comprehensive blockchain audits to ensure security, functionality, and compliance with industry standards will likely grow. Blockchain audits offer numerous benefits, including enhanced security, improved compliance with industry standards, increased trust and credibility, cost savings from avoiding potential vulnerabilities, and continuous improvement by providing valuable insights for better system functionality.

Auditing Decentralized Finance (DeFi)

Given that a significant portion of cryptocurrency trading takes place on decentralized finance (DeFi) platforms, auditing these platforms may become a best practice or possibly required by regulators in the future. If you are looking for someone to perform a DeFi audit be prepared to have less choices. There are fewer choices when it come to finding vendors that can perform this task.

DeFi security audits involve several steps: initial assessment, threat modeling, manual code review, automated analysis, penetration testing, and final reporting. These steps help identify and mitigate vulnerabilities in smart contracts and protocols. Regular audits can enhance the security and reliability of DeFi platforms, building trust among users and investors. Such audits ensure that the platforms comply with industry standards and provide a secure environment for crypto trading.

Concerns about DeFi Vulnerabilities

Performing a chain audit can help address concerns raised by the FBI about vulnerabilities in DeFi platforms. The FBI has warned that cybercriminals are increasingly exploiting weaknesses in DeFi platforms to steal cryptocurrency. This is supported by a Chainalysis report, 97% of all crypto hacks are linked to decentralized finance.

By conducting thorough code audits, vulnerabilities in smart contracts and platform protocols can be identified and rectified before they are exploited. This proactive approach aligns with the FBI's recommendation for DeFi platforms to implement rigorous testing and monitoring of code. Chain audits may also help mitigate instances of fraud and enhance the overall security of DeFi platforms.

Conclusion

Understanding the differences between chain verification of blockchain and a certified financial audit is essential in today’s financial landscape. While both processes aim to provide verification and build trust, they operate in distinct domains with different methodologies and purposes. Chain verification ensures the integrity of cryptocurrency transactions through decentralized and automated processes, whereas financial audits provide assurance on financial statements through detailed, manual examinations by auditors.

For guidance on blockchain technology or regulatory and compliance matters in the financial services industry, feel free to contact us for a consultation.

Endnotes:

1. https://www.sciencedirect.com/science/article/pii/S0890838923001270
2. https://www.ic3.gov/Media/Y2022/PSA220829
3. https://www.chainalysis.com/blog/2022-defi-hacks/
4. https://www.certik.com/products/l1-chain-audit

NB This information is provided as a service to clients and friends for educational purposes. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from a legal professional.