In light of everything that’s transpired in the last week, it feels appropriate to talk about an important concept known as the Proof of Reserve.
For some context on why this felt timely, I recommend reading about the SBF-FTX-Alameda fiasco first (in case you haven’t already heard of it).
“Don’t trust, verify” is a phrase often associated with crypto (those familiar may or may not be rolling their eyes), which refers to the fact that you don’t need to trust anyone based on their word - anyone can verify a transaction for themselves on the public distributed ledger known as blockchain.
Proof of reserve is an important part of this process - let’s dig into what it is, and why they are needed.
What is Proof-of-Reserve?
Proof of reserve is an independent audit of a custodian performed by a third party, verifying that it actually possesses the assets that it claims to hold. Centralized crypto exchanges, lenders, hedge funds and other ‘CeFi’ custodians handle much larger amounts of funds than the average person does, so to gain the trust of potential customers and investors, they must publicly attest that they are solvent and can cover customer liabilities.
Think of a reserve as a savings account for a custodian. They are there to ensure that if things go south in a hurry, they have sufficient funds to cover customer liabilities (can also think of it as an insurance plan).
Example: Terrible news about a major exchange and its CEO breaks out, and everyone who has funds on that exchange says ‘Screw this’ and decides to pull out their funds. If that exchange has a sufficient reserve, it can deploy those assets to ensure there is enough liquidity for everyone to pull out of the exchange. If that exchange did not have enough in their reserve to cover for such a scenario, however, that’s bad news for everyone. TLDR; a bank run is the classic “why” scenario for reserves.
How does PoR work?
Proof of reserve works through cryptographically secure verification methods, known as merkle trees, or hash trees. These are crucial for preventing data manipulation and ensuring transparency, as even the slightest change in value will be reflected.
In a nutshell, an auditor will take a snapshot of all user balances held on a custodian, like an exchange, and organize the data into a merkle tree as shown below. The auditor then calculates user balances according to the merkle tree, and compares it with the balances the exchange claims to have. Since even the slightest change in value will change the overall structure and be clearly reflected, merkle trees provide wholly accurate information when you simply just need the truth to be truth…
Once again, don’t trust- verify.
Why do we need proof of reserves?
The answer is pretty simple - transparency for the greater good.
Proof of reserve ensures custodians have enough ‘safety’ funds available to cover customer liabilities, are acting honestly, and are not doing shady stuff with their depositors’ assets (like investing them into volatile assets, or lending out more collateral than it actually holds).
Proof of reserve also helps ensure that fiat-backed stablecoins like USDC or USDT have sufficient USD available to actually back the digital assets it provides.
What is currently happening?
Simply put, the need for transparency in crypto has been exacerbated by the recent unveiling of SBF’s greater-than-average financial troubles. The blockchain is a beautiful piece of technology with transparency baked into its core principles. And yet, it is being neglected by the biggest market participants in crypto.
The saying “not your keys, not your crypto” has never been more relevant - centralized exchanges may provide a valuable service in helping onramp users to crypto from their bank account, but when push comes to shove they can ultimately freeze withdrawals and leave your assets frozen (or simply gone).
On that note, CZ posted Binance’s balances yesterday, starting a trend as up to 9 major exchanges have announced that they will publish their merkle tree reserve certificates.
A little too late for those who lost funds on FTX, perhaps, but still a positive trend to see in crypto. Personally, I’m pretty ashamed that I didn’t pay attention to CEX reserves and PoR before, but black swan events like these are oftentimes how most people learn valuable lessons.
Btw, you can view reserves for Binance, OKX, Crypto.com, Kucoin, and Deribit (with more expected) on Nansen for free here
We need a future where Proof of Reserve is an industry standard, and CeFi custodians are held liable to the same principles of the blockchain as everyone else is.
We need crypto to be a better alternative to tradfi, not to repeat the same mistakes.