More than $450 billion vanished from the crypto market following the collapse of TerraUSD in May 2022. Then, in November, another $200 billion disappeared following FTX's bankruptcy. While many investments carry the risk of loss (including stocks and bonds), these spectacular collapses arose largely from a failure to maintain proper reserves.
The crypto industry clearly needs a better way to prove the safety of customer deposits independent of external parties to maintain its decentralized approach while complying with financial regulations. But until recently, there was little urgency in deploying widespread solutions to increase trust among customers and users.
In this article, we'll look at how proof-of-reserves techniques aim to help, how they work, and some examples in action.
Why It Matters
The collapse of TerraUSD and FTX underscores the need for a reliable way to prove crypto platforms properly manage customer deposits.
Coinbase addresses these concerns by reporting its assets to regulators in compliance with being a publicly traded company in the United States. Since independent auditors verify their financial statements, users can trust the exchange holds sufficient reserves to cover deposits. And the platform even has insurance in place in the event of a hack.
Of course, the involvement of third-party auditors moves the platform further away from centralization. Users must trust that a centralized authority (the auditor) is telling the truth. A more crypto-native approach would leverage cryptography and algorithms to prove the reserves exist without opening the books to third parties.
Proof-of-reserves (PoR) is an attempt to deliver on these goals. In short, it is a technique to validate that a crypto platform has sufficient backing for digital assets it holds in custody for clients. But unlike third-party auditors, PoR strategies don't disclose sensitive information nor rely on trusting a single centralized authority.
A robust PoR mechanism provides three pieces of information:
- The sum of a platform's liabilities.
- Cryptographic proof of each account and the sum of account assets.
- Signatures proving control over the wallets.
Unfortunately, many existing PoR techniques fail to factor liabilities into the equation. Of course, 1-to-1 backing of assets to deposits means little if a platform has a lot of other liabilities. The good news is that some crypto platforms are experimenting with ways to report liabilities in an automated manner to improve transparency.
How It Works
Proof-of-reserves remains an evolving concept in the crypto industry, but there are a few early attempts at implementation.
Merkle Trees have become the most popular way to prove reserves. Using this method, a crypto platform generates a Merkle Tree hash that includes the deposit addresses they hold on behalf of customers. Anyone can verify that specific addresses appear in the Merkle Tree using the root without revealing any other addresses or other information.
The platform may also provide cryptographic proof that the balance of all deposit addresses in the Merkle Tree equals the total cryptocurrency they claim to hold. That way, anyone can verify the platform is holding all customer deposits in reserve. For instance, Binance recently released its Merkle Tree-based proof of reserves system for Bitcoin and Ethereum.
Chainlink Labs launched another approach in 2020 to help projects across Web2 and Web3 ecosystems prove asset reserves through automated verification. By connecting to an exchange's API, vault addresses, and proof-of-reserve smart contracts, it automatically and independently determines if its reserves are equal to or greater than its deposits.
While these efforts are a leap forward in transparency, many don't provide any window into liabilities, limiting their usefulness. BitMEX is a notable exception with a Bitcoin proof-of-reserves and proof-of-liabilities system. However, the system remains a work in progress, and the process of computing these proofs is too complex for most users.
How to Verify Reserves
Several crypto exchanges, DeFi platforms, and others have implemented proof-of-reserves to reassure users.
CoinGecko provides an easy way to access proof-of-reserves data across multiple exchanges. When visiting the exchanges page, you can see a column titled "Reserves Data" that shows if an exchange provides proof-of-reserves data and if there are third-party audits. After clicking on an exchange, you can visit the "Exchange Reserves" tab for a breakdown.
That said, the "liabilities" section of GeckoTerminal is often missing, and exchanges have a way to go before providing absolute transparency without third-party auditors.
Frequently Asked Questions
How do I verify an exchange's proof of reserves?
CoinGecko provides the easiest way to verify an exchange's proof of reserves (as discussed earlier). However, if you want to dive deeper, you may need to follow exchange-specific procedures or rely on an auditor's snapshot prepared on a periodic rather than ongoing basis.
What is Chainlink Proof of Reserve?
Chainlink Proof of Reserve provides crypto and traditional financial institutions with a way to boost transparency through on-chain proof of any asset's true collateralization. With its cross-blockchain capabilities, the system is capable of helping all kinds of crypto exchanges and DeFi platforms increase transparency.
What is Coinbase's proof of reserves?
Coinbase does not offer a proof of reserve mechanism because it's already audited by the SEC as a publicly-held company. However, the company did issue a developer grant allocating $500,000 to support people or teams advancing on-chain accounting and privacy-preserving techniques related to proof of asset or liability approaches.
The Bottom Line
The collapse of TerraUSD and FTX underscores the crypto industry's struggles with transparency. Fortunately, proof-of-reserve (PoR) techniques could help increase transparency and reassure users without exposing data or trusting third parties. While many of these systems remain at an early stage, some are starting to address key shortcomings.
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