Why does Proof of Reserves matter in 2023?

2022 was a challenging year for the entire crypto industry. Declining crypto prices, the collapse of Luna, and several significant hacks resulted in generally negative sentiment and a lot of FUD[1].

However, arguably the biggest news for the web3 industry was the FTX meltdown – one of the biggest centralized exchanges turned out to be insolvent due to inefficient financial reserves.

Would a so-called Proof of Reserves audit prevent crypto users from similar downfalls in the future? We’ll examine it for you in the following paragraphs.

 

What is a reserve audit?

Audits serve as a helping hand for stakeholders whenever and wherever money is involved. Thanks to documents like income statements or balance sheets, customers, shareholders, or employees of a particular company are able to check its actual financial situation. And as such activities are highly regulated and very often performed by specialized, external agencies (to avoid any mischief or biases), they only improve the credibility of a business.

However, due to immaturity and, very often, the absence of fundamental analysis, crypto projects lacked trustworthy and regular reserve audits. The examples of the FTX meltdown, but also Celsius or BlockFi that also collapsed in 2022, proved how fundamental mistake it was.

 

What is a Proof of Reserves audit?

Therefore, web3 space had to find a solution to bring the institutional and users’ trust back to the industry. The so-called Proof of Reserves audits seemed to be a perfect answer to concerns over the future of crypto projects.

Simply speaking, Proof of Reserves (PoR) enables verification of whether the off-chain assets back the on-chain assets of a project. If you, at some point, moved your cryptocurrencies to one of the major exchanges, it should be able to assure you that it actually holds the money you sent. Thanks to that, you can gain confidence that an entity didn’t use your cryptocurrencies to, for example, trade on different platforms. That could potentially result in losing all of them.

Proof of Reserves audit is usually performed by a third party that is obviously unrelated to the analyzed company. It is based on creating a snapshot of all the customers’ balances and comparing it to the financial reserves of the entity.

After a positive verification, all the information is transformed into a cryptographic data structure called a Merkle tree, enabling individual users to check the project’s credibility. Such a combination of external verification (regular audit) and cryptography (Merkle trees) enhances the trustworthiness of the process (each change to the balance sheet will be immediately visible) while maintaining the security of users’ funds (they’ll remain anonymous).

Are centralized exchanges safe?

FTX collapse raised many serious concerns over other centralized exchanges. Regarding how renowned and regulated FTX was, web3 enthusiasts could have some serious doubts about whether their funds are safe while kept on other such entities.

Such concerns led to many people withdrawing their funds from exchanges. Fortunately, practically all of them turned out to be solvent and were able to pay cryptocurrencies and fiat money to users. However, it remains to be seen how such entities as Binance, Kraken, or Gate.io will cope with a serious bank run – as the one experienced by FTX. Would they still be able to cover all the withdrawals?

 

Proof of Reserves on Binance, Crypto.com, and others

The aforementioned Proof of Reserves turned out to be a good way to ensure users that the financial reserves of the centralized exchanges still secure their funds. The biggest entities, such as Binance, revealed their PoR audits, enabling users to check the audit status as well – they could download the actual Merkle tree (that serves as a cryptographic proof of secured funds).

Moreover, CoinMarketCap, the world’s largest cryptocurrency data aggregator, added a special checkmark to their list of exchanges. Thanks to that, you can quickly check whether a particular entity has already revealed its Proof of Reserves. It is also possible to find detailed info about the financial reserves backing entity.

 

Proof of Reserves vs. Proof of Solvency

However, information about the reserves of exchange is not enough. If we want to determine whether the entity is solvent and able to withdraw all of the funds held on users’ accounts at any time, it’d be great to know more about its liabilities as well.

Proof of Liabilities and Proof of Solvency (that combines reserves and liabilities) is currently not perceived as a “requirement” for the industry players. Will it change in the future? Well, if centralized entities would like to ensure users about their funds’ safety, such proofs should become ubiquitous in the short term.

 

Will Proof of Reserves make web3 more secure?

Proof of Reserves is undoubtedly a step in a good direction. Thanks to such audits, crypto projects and centralized exchanges, in particular, can recover at least a fraction of trust lost due to FTX, Celsius, or BlockFi meltdowns.

However, as mentioned above, it’s not enough. Centralized entities don’t work in a trustless manner – such inherent to their decentralized counterparts (and web3 primitives in general). They require users’ “faith” in order to work properly.

Then, if the world of CeFi would like to remain an essential part of the post-FTX crypto era, making Proof of Liabilities and Proof of Solvency standards (along with PoR) is a logical next step.

[1] FUD – an acronym for „Fear, Uncertainty, Doubt”; manipulation strategy aimed at evoking negative emotions over a particular group of assets (in this case – cryptocurrencies) leading to intensified selling and successive price declines.