Proof-of-Reserves (PoR), a method implemented by some exchanges, enables users to instantly audit the reserves of crypto exchanges. Changpeng Zhao, CEO, recently argued that all exchanges should now provide this feature. Proof-of-reserves are independent audits by third parties that provide transparency & proof that a custodian owns the assets it claims to hold on behalf of its clients.
In 2021 Ledn, a digital asset lending platform, became the first lender to undergo a PoR attestation with a certified public accountant.
Last week, Chainlink Labs launched its Proof-of-Reserve product for verifying centralized exchange asset reserves, off-chain bank account balances, cross-chain collateral, real-world asset reserves, etc.
PoR programs enable users to cryptographically verify their digital assets are entirely reserved on their exchanges.
Today, the digital asset industry needs adequate standards to ensure that the providers of digital asset services own enough assets to cover customer deposits. This will to an extent, prevent counterparty risks. Proof of Reserves is based on the belief that transparency and individual verifiability are paramount.
Formula
Proof of Reserves + Proof of Liability = Proof of Solvency
Why is there a sudden demand for the adoption of the Proof-of-Reserve Program?
The recent development concerning the meltdown of FTX, once the third-largest crypto exchange in terms of volume, pressed the need for cryptocurrency exchanges to implement a PoR program.
Proof-of-reserves is a rhetorical form of saying: “here is evidence to prove that we have what we claim we have.” Let us understand this with the help of an example: Let us assume you have five bitcoins that you purchased on an exchange known as “XYZ,” and you leave them there for “XYZ” to take care of these five Bitcoins on your behalf. For all practical purposes, these five bitcoins are your bitcoins; XYZ is just holding them for you. Due to the Bitcoin blockchain’s transparency, some proof (cryptographic) must exist that XYZ actually has your five bitcoins in its reserve.
From a financial point of view, XYZ should be able to readily prove that its assets (the bitcoin it holds) are in line with its liabilities, the guarantee that XYZ will make a customer about their bitcoins when they ask for them.
Since the FTX debacle and other related meltdowns, exchanges like Binance, KuCoin, OKX, Poloniex, Bitget, Huobi have been contemplating issuing a proof-of-reserves attestation (or identical) shortly.
Flaw with Proof-of-Reserves audits:
Despite so many advantages, a missing slice to the effective implementation of PoR can be seen as a potential flaw. In practice, the need to hire a third-party auditor to attest to the proof-of-reserves will bring in more third parties, thus potentially centralizing the whole process.
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