Table of contents
- Introduction,
- What is Proof of Reserve (PoR)?
- What assets can be considered reserves?
- What makes Proof of Reserve Important?
- How are the audits performed?
- The benefits of Proof of Reserve
- Proof of Reserve without displaying the liabilities is frivolity
- How are a company's reserves verified?
- Limitations of Proof of Reserve (PoR)
- Conclusion
Introduction,
The death of the second largest centralized crypto exchange has caused a shock in the industry, as many investors pulled out of the market because it seems to lack proper regulation.
One of the ways through which centralized exchanges can show transparency and gain users' trust is by issuing their exchange "Proof of Reserve." Binance CZ's CEO tweeted, "All crypto exchanges should do Merkle-tree proof-of-reserves."
If you have been active on crypto Twitter and Reddit, you would have seen people shouting proof of reserve. What do they mean by that? What are the benefits and limitations? This article is going to explain all the questions above. Are you ready? Let's dive in.
What is Proof of Reserve (PoR)?
Proof of Reserves (PoR) is a strategy adopted by using cryptographic verification to verify ownership of digital assets. Centralized exchanges use it to ascertain their solvency and assure customers that the exchange will be eligible to pay out customer deposits in times of market volatility.
PoR refers to digital assets verified through on-chain methods like tracking wallets. It does not include off-chain assets like cash reserves or other fiat assets.
This Proof of Reserve is conducted by a third party called " Auditor." This entity takes a snapshot of all the balances owned and aggregates them into the Merkle tree.
Armanino is the leading auditor for most crypto service providers.
What assets can be considered reserves?
Strong liquidity profiles are a requirement for assets to qualify as reserves. In other words, in a crisis, the exchange and its clients might immediately liquidate the assets. Remember that the defunct FTX exchange stored a sizable portion of its reserves in tokens with a low liquidity profile called FTT.
Bitcoin (BTC), ether (ETH), and stablecoins like tether (USDT), USD coin (USDC), Binance USD (BUSD), and Dai are the best reserve assets (DAI). The exchange's portfolio must include a sizeable portion of hard, liquid assets. even though it is permitted for it to store some of its reserves in other cryptocurrencies as a result of customer deposits.
What makes Proof of Reserve Important?
a. It boosts Users' Trust: A Proof of Reserve(PoR) attestation signals vigilance regarding a centralized exchange's solvency. It boosts user trust in a custodian and testifies to a certain degree of transparency the custodian guarantees.
While it is clear that proof of reserves can deliver a different transparency than non-custodial, blockchain-based platforms, their advocates argue that more transparency is better than nothing.
b. PoR is a means of self-regulation: Even though some exchanges are not regulated in the United States, PoR may result in more favourable treatment by US regulators and more confidence from their user base.
Users can read proof-of-reserve attestations to confirm on-chain that the custodian has enough assets to support a third-party audit of deposits when combined with public and legally required disclosure of liabilities.
c. It helps to kick against bad behaviour: Proof of Reserve (PoR) makes it more challenging to hide illegal and unethical business practices like rehypothecating user deposits.
How are the audits performed?
An anonymous picture of user balances is taken during an audit to provide the third-party auditor with verification of reserves. They are often determined by hashing the account balance of each user with their individual ID.
The auditor then combines them into a cryptographic Merkle tree to create a Merkle root, a cryptographic hash that specifically encapsulates the sum of all user balances.
With the Merkle tree, it is possible to cross-examine a small number of anonymous balances with the verified ones to check all balances' accuracy. Any user can check to see if the tree contained their actual account balance, for instance, and would need to:
Hash their account balance and unique ID; and Search for it in the Merkle tree. A series of these verifications can then be used to prove the accuracy of the whole tree without examining each one.
The final step is to obtain digital signatures from the custodian proving that they control the on-chain addresses holding the assets.
If the balance on the associated digital signatures matches those obtained from the Merkle tree, the auditor can verify that the platform maintains a reserve of all client assets.
The benefits of Proof of Reserve
PoR benefits can be explained as follows:
i. Trust: Exchanges can regain the trust of their users and the general crypto community by conducting a truly transparent Proof of Reserve (PoR). If the audit is done in good faith, it will help restore trust and adoption.
ii. Auditability: PoR is a first step toward verifying full solvency and authorizing the tracing of digital assets owned by a company.
iii. Fraud: PoR creates a baseline for decent practices regarding financial transparency and disincentivizes users from engaging with companies that don't provide such attestations.
Users can easily detect any exchange that is not financially transparent, and they can move away from such exchanges.
iv. Customer Protection: PoR ascertains a willingness to protect customer assets and put the customer's interest first. This will clearly distinguish the bad actors from the good actors.
v. Counterparty Risk: PoR can help mitigate fear-driven bank runs that result from uncertainty over the solvency of a custodian's asset holdings.
Proof of Reserve without displaying the liabilities is frivolity
Proof of reserve is the first step. Proof of liabilities would be great; showing assets without showing liabilities is worth nothing.
There needs to be laid down structures on how the PoR should be conducted. This made a lot of centralized exchanges take advantage of that by publishing the PoR in their favour.
Nexo publishes a one-pager PoR audit which shows that they have an asset that is greater than the $3.2 billion of customer deposits. However, they never disclosed their liabilities.
After publishing its PoR audit, Crypto.com recently moved 280,000 ETH to the Gate.io address, sparking rumours that crypto exchanges may have fabricated their reserve audits. Others theorized that this money was used to bolster Gate.io's books.
More questions were raised when Crypto.com CEO Kris Marszalek publicly said that the $400 million ETH transfer was an error and was intended to go to another cold wallet.
Can an exchange become so immature to the extent of sending such an amount of ETH by mistake?
Both Crypto.com and Gate.io have skeletons in their cupboard. They were borrowing assets to show a healthy financial book, only to return them right after the snapshot.
How are a company's reserves verified?
By putting in place a proof-of-reserves scheme, anyone may more easily confirm a company's reserves. Downloading the most recent audit or attestation report made available by the exchange's third-party auditor is one of the easiest tasks.
Ledn, Nexo, Gate.io, Crypto.com, Kraken, Bitmex, Bybit and Binance have done their Proof of Reserve (PoR).
While OKX, Huobi, Bitget, Kucoin, and Poloniex have yet to do their (PoR).
Limitations of Proof of Reserve (PoR)
Proof of Reserve (PoR) cannot prevent hacks. From 2020 till now, hacks have been a significant way through which exchanges have lost money.
Proof of Reserve (PoR) is not secured as your coins are in your private wallet. Don't forget that "Not your keys 🔑, not your coin. Trust no one, not even the largest centralized exchange. The future is toward total decentralization.
Some exchanges may not report their liabilities while showing proof of Reserve(PoR).
Tracking of Liabilities is one of the challenges of Proof of Reserve because a reliable, clean financial audit is required to succeed.
PoR is not trustless. It relies on voluntary engagement and does not guarantee full transparency of a custodian's financial situation.
Conclusion
According to Stefan Rust, CEO of the data infrastructure company Truflation "Looking at the early implementation of PoR, it appears to be a good first step, but to build more trust and improve transparency, it would be shrewder to examine the overall balance sheet, keep an eye on the liabilities, and maintain transparency regarding capital reserves. Along with the reserves, the company's exposure is another factor ".
Exchanges should ensure that their audit is being done in good faith and regulator should always be at the door to sanction any exchange that manipulates their PoR. This can help to bring sanity to the crypto industry.
Further Reading coinmarketcap.com/alexandria/glossary/proof..
coindesk.com/tech/2022/11/17/proof-of-reser..