Why Proof of Reserves Is Indispensable in 2023

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December 5, 2022

Why Proof of Reserves Is Indispensable in 2023

Recent developments in the crypto industry have thrown the issue of counterparty risk into sharp relief. High-profile failures and severe stress is faced by large, centralized organizations. With Celsius, BlockFi, Voyager Digital and FTX, the number of bankrupt centralized institutions in crypto keeps growing. Due to lost trust in centralized organizations, the adoption of self-custody solutions is skyrocketing. Safe, Ledger, Trezor and other self-custody solutions are growing tremendously and witness new records of deposits. Some centralized organizations take the required steps to prove their on-chain cryptocurrency balances to third parties. When doing so, in-house solutions or third-party verifiers are often chosen to create the proof. These approaches are difficult to verify for external parties, as they usually require a certain level of specialized technical knowledge. Proof of on-chain reserves is required for greater transparency. In this article, we’ll explore how proof of on-chain reserve (PoR) is defined and why it is one of the most powerful means of building trust.

How is proof of reserve defined?

Proof of reserves is the idea that centralized entities holding digital assets for its customers create publicly available proofs of their reserves and match them against proofs of user balances. Cryptographic procedures are used to verify those user balances. The idea is to show evidence to the public that the cryptocurrency deposited and claimed to be still in existence, actually matches the total user’s balance. It is a method used by an organization to demonstrate to another party that it has sufficient financial reserves through a form of documented evidence of its on-chain holdings. Broadly speaking, a Proof of Reserves is a form of trust that an organization provides towards specific customers, the broader market, a current or prospective partner or a regulator. However, only sharing wallet addresses alone is not sufficient. The liability side needs also to be disclosed in a format that is comprehensible and verifiable for third parties.

Why companies should provide Proof of Reserves

  • Auditability: Through self-regulatory measures it is easier for external parties to perform audits. This avoids strict external regulation and leaves more space for innovation. If exchanges collectively adopted PoR, regulators might be more inclined to adopt a light touch approach. Much better to operate in relative freedom with voluntary self-regulatory measures rather than suffering onerous regulatory impositions later on.
  • Fraud Prevention: Proof of Reserve measures reveal dishonest actors in the market considerably more quickly. By making fractional reserves nearly impossible to conceal, it improves protection against harmful operators. Failures harm the entire sector, therefore avoiding them is in everyone’s best interest. Additionally, good players have no disadvantages at all when implementing Proof of Reserve initiatives.
  • Trust: PoR increases consumer confidence. The increased transparency can facilitate to restore public confidence in cryptocurrencies and blockchain projects. A periodic PoR attestation shows end users that companies are diligent about solvency and that the financial situation is in order.
  • Adoption: It makes it possible for centralized and decentralized financial applications to coexist in harmony. Despite the fact that blockchain and cryptocurrency environments are fully decentralized in an ideal world, centralized institutions have established their legal right to exist. Since DeFi is still not entirely intuitive to use, custodians, lenders, and exchanges will continue to be useful and necessary. A self-regulatory framework with centralized and decentralized players can promote widespread use of cryptocurrencies.

Recent market turmoil has been exacerbated by a lack of transparency and associated counterparty mistrust across digital asset custodians and market participants. Increased transparency will provide more information on counterparty risk, potentially mitigating the chance of systemic default contagion and improving user trust in their custodial relationships. Due to the encrypted and anonymous nature of most blockchains, even transparency of a companies’ on-chain activity is not existent. Crypto bookkeeping and accounting is complex and confounding. Proper crypto bookkeeping and reporting lies the baseline for any proof of reserve analysis. Companies should not rely on manual bookkeeping processes but rely on automated solutions.