Over the past decade, the cryptocurrency space has never failed to amaze us. Since the arrival of cryptocurrencies, they have had their bit of adrenaline-fueled highs and crushing lows. Media outlets, experts from financial institutions and governments have both; praised as well as criticized cryptocurrencies and the overall decentralized finance (Defi) system.
Despite treading through fertile grounds for growth and receiving considerable attention worldwide, cryptocurrencies continue to remain in the grey area for many investors, and for good reasons. Events such as the recent FTX collapse have perturbed investors and unsettled the overall crypto and Defi sector. Even today, investors do not have convincing answers to this question – “Is it worth investing in crypto?”.
The lack of liquidity, glaring mismanagement of funds, and shady practices by admins were some of the main reasons behind the FTX collapse. The FTX collapse had a grave impact on the value of Ethereum and Bitcoin. What do such events teach us?
Well, they teach us a lot of things, out of which, is the dire need for verifying liabilities for exchanges and custodial institutions. Proof-of-reserve has sprung up as one of the solutions to address issues around transparency in the decentralized system.
In this article, we will dive deep to understand the concept behind proof-of-reserve and how it can help crypto exchanges become transparent.
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What is proof of reserve?
Despite garnering considerable popularity and witnessing consistent growth in terms of adoption, crypto exchanges are still not as transparent as one would expect. The lack of transparency will continue to remain one of the main reasons why investors will never be able to trust such exchanges completely.
Proof-of-reserve could be the answer to solve this problem. However, many experts are of the opinion that a mere proof-of-work audit will not be enough. We think this could be the start, laying down the foundation for better and more concrete solutions.
But before we get there, let’s understand what proof of reserve is.
Proof of reserve is nothing but a system for crypt exchange platforms to prove that they have the amount of crypto that they claim to have. It could be referred to as a crypto audit which addresses a few issues around the transparency of digital assets secured on exchanges. Many call it a much-need saviour that will ensure that the crypto reserve of exchange is backed by real assets.
Proof of reserve primarily means due diligence performed by third-party auditors that inspect the accounting statements of different blockchain projects. This provides clarity into the overall reserve help by a company. Advocates of proof of reserve audit include popular names including Binance CEO, Changpeng Zhao who believe that it could enhance transparency and trust in the crypto market. Proof of reserve for crypto is a boon for customers as they can hold an exchange or a custodial platform accountable if things went south.
Importance of proof of reserve audit
Let’s understand the importance of proof of reserve audit in this section.
It is no secret that custodial platforms and crypto exchanges rule the roost in the crypto world. However, since the crypto sector is largely unregulated, it becomes extremely important to have a system in place that safeguards investments and works in favour of crypto investors.
When users buy assets on an exchange, their assets are stored in a hot wallet. A hot wallet is primarily used to serve withdrawal requests. A small chunk of the money deposited by a user is stored in a cold wallet. Typically, customers are given a wallet address to make deposits that are circulated between hot and cold wallets.
Custodial financial platforms do not provide their consumer’s complete custody of their assets as they hold the private keys to these addresses. We can learn about the assets stored in the financial platform by tracking transaction information involving their cold and hot wallets.
Although it should specify how much of the total assets belong to specific users, it just displays a consolidated view of all the assets on the custodial platform. Users may not trust one another as a result of their lack of understanding of ownership.
In this situation, the proof of reserve audit can be used to perform an in-depth analysis of the entire assets held by the institution and determine what percentage of these assets the individual users own. While there are plenty of people who oppose the concept of proof of reserve, it has received a warm welcome from the crypto market. Why? It combines the best of both worlds, i.e., the privacy of customers and the transparency of an exchange. It is worth noting that when a particular crypto exchange does not comply with the proof of reserve commitment, it is prone to the following:
- There is a chance that the users’ assets will be stolen.
- Inability or delay in cashing out assets.
- Inability to withdraw funds when there is high demand.
- Vulnerable to bankruptcy or asset losses.
Therefore, it becomes imperative for Defi systems to conduct routine proof of reserve audits to keep an eye on their checks and balances.
What are the benefits of deploying proof of reserve?
There are numerous benefits linked with implementing proof of reserve. Some of these benefits are mentioned below.
1. Proof of work audits instil trust among Defi platform users
Investor faith continues to dwindle due to events such as the recent FTX collapse and negative press around custodial institutions. Existing users that use custodial institutions are becoming more weary and fearful and are treading with caution. If recent mishaps continue, we could soon see people move away from such shady crypto exchanges and invest money in traditional mediums.
Therefore, when proof of reserve is established it makes custodial institutions more accessible and also helps reputed exchanges forge a trustful relationship with their customers.
2. Users are not in the dark
The alarm bells have rung before regarding this issue. While a lot of people bestowed their trust in crypto exchanges over the past few years, the momentum has taken a hit due to shady exchanges, frauds, hackers, and scams.
While a lot of efforts have gone into rectifying past mistakes and enhancing security, investor trust has taken a massive hit in recent weeks.
A proof of reserve will serve as an extra pair of eyes that will ensure the records for accurate and verifiable on-chain.
3. Users know that their assets are safely handled
The primary goal of Proof of Reserves is to enable customers to verify the assets maintained by their institutions.
These technologies allow investors to keep track of changes made to their personal accounts, get insights into how their money is managed over time, and demand that their institution remain transparent about all activities.
4. Proof of reserve ensures users can perform a background check on custodial platforms
Investors are always advised to research and do some background study on the crypto exchange before opening an account in a custodial institution. In simple words, it is better to know more about the overall reputation, integrity, and financial operations of the organization before. A proof of reserve enables users to do just that.
It allows users to gain useful insights into how a certain exchange handles clients’ assets. By doing this, it minimises the chances of losing money in case of an unfortunate event caused by a custodial institution’s negligent handling of clients’ assets. Investors have the option to modify or withdraw their assets to limit losses if they feel that the platform’s custody protocols have become excessively risky over time.
Proof of reserve in crypto markets to boost customer trust is the need of the hour
Although Defi services are more affordable, quicker, and global, the evaluation and assessment services should primarily be quicker than conventional approaches. To keep up with the Defi services’ quick pace, it is often necessary to replace obsolete technology with newer ones. As a result, regulators, investors, management, and users would have more clarity into how their assets are handled, building trust. The current state of the DeFi industry calls for an automated software solution that fosters trust and openness between investors and custodial institutions.
Customers of the platform can view the findings of an audit with the help of software, increasing consumer confidence and transparency. It is essential to note that even though several exchanges and custodial institutions conduct regular audit proof of reserve audits, users are unable to access these reports.
Users and regulators can easily view the entire audit report, its summary, and much more. This audit report includes information concerning asset ownership, client account balance obligations, the audit methods carried out by the external firm, and more.
There is little doubt that cryptocurrency is a disruptive force. Just when we thought that it has exploded like an active volcano, the FTX collapse made the headlines, denting investor confidence to a whole new level. Thus, implementing proof of reserve has become an imperative step if custodial institutions want to stay relevant and gain traction from worldwide investors.
Regular Proof of Reserve audits can improve the platform’s reputation among investors, regulators, and users by fostering trust and transparency.
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