Proof of reserves is a method used by cryptocurrency exchanges and other financial institutions to demonstrate that they have sufficient assets to cover all of their outstanding liabilities.
The FTX collapse and its consequences
In the wake of FTX’s dramatic collapse, sentiment concerning the crypto industry is relatively negative. The exchange was forced to pause withdrawals after concerned investors withdrew over $6 billion in 72 hours amid liquidity concerns. Things continued to spiral out of control for the firm after its only ray of hope was extinguished once Binance’s proposed bailout fell through. Binance stated that the deal was abandoned following due diligence, while its CEO Changpeng “CZ” Zhao called for more detailed disclosure of liquidity through the use of Proof-of-Reserves. It’s worth noting that FTX did not use PoR.
So far, the main effect of this crisis has been uncertainty and a general loss of trust. Price drops were seen across most cryptocurrencies. In fact, the two most prominent cryptocurrencies, Bitcoin and Ether (BTC and ETH), suffered, with BTC hitting a 23-month low of $15,625 on Wednesday. Solana (SOL), a popular Ethereum competitor in which FTX held a significant stake, fell nearly 50% on Wednesday and was down 93% from its 2021 high.
Participants in the space are likely disturbed by the sudden decline of a trusted, successful brand led by an industry leader. While those from the outside looking in see FTX’s downfall as an indictment of the entire sector. After all, in their eyes, if one of the most prominent entities in crypto can implode, it doesn’t bode well for everyone already involved in or looking to enter the space.
For crypto exchanges, it’s imperative to regain trust, as this is one of the foundational principles behind blockchain technology. One of the most effective ways for an exchange to build confidence is via Proof of Reserves (PoR) audits.
What is Proof of Reserves
A Proof of Reserves (PoR) is an independent audit conducted by a third party to ensure that a custodian holds the assets it claims on behalf of its clients. This auditor takes an anonymized snapshot of all balances held and aggregates them into a Merkle tree — a privacy-friendly data structure that encapsulates all client balances. The auditor then obtains a Merkle root: a cryptographic fingerprint that uniquely identifies the combination of these balances when the auditor takes the snapshot.
The auditor then collects digital signatures produced by the exchange, which prove ownership over the on-chain addresses with publicly verifiable balances. Lastly, the auditor compares and verifies that these balances exceed or match the client balances represented in the Merkle tree and, therefore, that the client assets are held on a full-reserve basis.
Clients can independently verify that their balance was included in the Proof of Reserves audit by comparing certain pieces of data with the Merkle root. Any changes made to the rest of the data, however small, will affect the root – making tampering evident.
Exchanges flock to audit.
Some notable exchanges already use PoR to enable greater transparency by making it easy for users to verify that real assets back their held balances. Kraken uses PoR as part of its commitment to transparency and gives users a detailed guide on verifying their balances.
Following his firm’s involvement in this week’s chaos, Binance CEO “CZ” pledged to implement a Proof-of-Reserve mechanism to provide “full transparency,” tweeting, “All crypto exchanges should do Merkle-tree proof-of-reserves. Banks run on fractional reserves. Crypto exchanges should not.@Binance will start to do proof-of-reserves soon. Full transparency.” – CZ Binance (@cz_binance) November 8, 2022.
In the wake of this, a host of other crypto companies have rushed to reassure their investor by compiling proof or reserves. Gate.io, KuCoin, and Bybit, among many others, have released statements that they would publish their Merkle tree certificates in a bit to increase transparency.
There is a real sense that the crypto industry has a lot of damage limitation ahead of it. Calls for mandatory proof of reserves audits are a good starting point to restore some of the recently lost trust. However, some argue that even audits are redundant if a company’s liabilities aren’t also transparent. FTX had an alleged $900 million in liquid assets against $9 billion in liabilities, which shows the importance of complete transparency. Considering that it is a sector built with openness as a core principle, everyone involved must ensure we maintain transparency and not stray from blockchain’s identity.
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