What’s a Proof of Reserves and Why Does it Matter?
Since the collapse of crypto exchange FTX, proof of reserves has made headlines, with investors demanding exchanges provide records of their crypto holdings.
But what’s proof of reserves (PoR), and why is it important?
PoR refers to a technique of verifying that a crypto exchange actually has 1:1 backing of all the digital assets that it’s holding on behalf of its clients.
Crypto companies often contract external organizations to carry out the attestation. After that, they release the results to help their customers understand the state of the firm’s finances and whether they have sufficient funds to match client deposits.
Several types of attestations have been conducted in the past few months, with some boosting more confidence in a crypto company than others.
Merkle Tree-Based Proof of Reserves
One way for a crypto firm to conduct an attestation is through contracting a PoR protocol that employs a Merkle Tree proof which integrates huge amounts of data into just a single hash and then confirms the integrity of that data set.
Crypto exchanges can decide to publish the Merkle Tree-based PoR attestations in two ways. First, they can release them at regular intervals, that is, on a monthly, quarterly, or weekly basis. Second, the companies can deliver real-time attestations on their trading platforms.
While the first option may be adequate to prove that an exchange has enough funds at a particular time, many consider real-time attestations to be superior since they allow customers to verify the firm’s reserves at any time.
Chainlink Labs Rolls Out Proof-of-Reserves Protocol
Oracle network developer Chainlink Labs launched its version of the PoR system in 2020, intending to enable crypto companies to prove their asset reserves via automated verification.
For example, an exchange’s API, a PoR smart contract, and vault addresses can be connected to Chainlink nodes to determine whether reserves equal customer deposits.
Furthermore, Chainlink’s PoR system provides data in regard to how much is borrowed, deposited, or staked at a certain protocol at any given time.
Exchanges can as well use the system to restrict the issuance of more tokens than the funds available in reserves.
Which Exchanges Have Proof of Reserves?
Some exchanges, including BitMEX, Gate.io, and Kraken, rolled out their proof of reserves prior to FTX’s collapse. But the implosion of the Sam Bankman-Fried-owned company pushed more exchanges to consider having their own PoR. They include Binance, which launched a Merkle Tree-based system for BTC and ETH, along with Crypto.com, ByBit, and OKX.
Meanwhile, US leading exchange Coinbase claims that, as a publicly listed firm, its reserves are proved through SEC fillings.
What are the Concerns?
While PoR is essential in ensuring customers the safety of their funds and that the crypto firm has enough liquidity, it can also give them a false sense of security. This is because most attestations only provide an overview of assets without disclosing the firm’s liabilities to clients. Meaning it is possible that an exchange can use proof of reserves to seem transparent while hiding its true solvency risk.
To bury this concern, Kraken CEO Jesse Powel said last November that all attestations must include three essential elements: Signatures that prove the custodian has control of the wallets, along with a sum of customer liabilities, and user-verifiable cryptographic proof that every account was added in the sum.
Powell’s statement came after Binance released its November attestation. The Kraken boss called it an ‘intentional misrepresentation’ because it did not include liabilities.
