Proof of Reserves: How Does It Work and Why Is It So Important?

Demands for centralized crypto exchanges to adopt routine “Proof of Reserves” (PoR) programs have recently intensified. This is especially true in the wake of the November 2022 bankruptcy declaration by FTX who used customer funds for risky investments, leading to a liquidity crunch.

In the digital currency space, “Proof of Reserves” is a method that ensures that a given crypto exchange or project holds the reserves necessary to cover all customer deposits. By publishing both the total amount of cryptos held by the exchange and the total amount owed to customers, exchanges can prove that they have the reserves on hand to meet customer withdrawal requests.

Custodial companies that keep cryptocurrencies are encouraged to establish public-facing attestations of their reserves, which would then be paired with a “Proof of User Balances” (liabilities). This merger is described as a “Proof of Solvency.”

How exactly does “Proof of Reserves” work?

Reserves can be proven in two distinct ways. The first is through having independent third parties conduct audits. These assessments help guarantee that a project’s reserves match its assertions. We previously discussed how periodic PoR audits could help exchanges build trust and enhance security.

The second method for demonstrating reserves is through public addresses. By publicly publishing all addresses holding reserve currency, exchanges can show that their liquidity claims are factual. While audits provide more concrete evidence, anyone can utilize the public address option to verify the reserve status of a particular exchange or project.

Why is Proof of Reserves so important?

• Trust: Proof of Reserves is essential since it aids in establishing trust in projects. For example, suppose investors in a stablecoin project perceive holdings in an issuer’s reserve are insufficient to maintain a peg. This could create enough unease to cause a sell-off, thus creating a drop in price. Alternatively, if investors are convinced that a currency is sufficiently collateralized, they will be more likely to HODL the coins and perhaps purchase more, driving up the price. Consequently, ensuring that investors have faith in a project’s proof of reserves is crucial for ensuring the project’s continuity.

• Security: Another crucial result of Proof of Reserves is that it creates a secure and healthy ecosystem. At its core, Proof of Reserves is a self-regulatory practice that promotes openness by mandating that exchanges regularly disclose their reserve holdings to the public. This enables market participants to make informed judgments regarding where to trade and ensures that everyone plays by the same rules. Ultimately, PoR is essential to guarantee a secure and reliable environment for value exchange in the crypto-verse.

• Accountability: The unique transparency of routine PoR programs confers a sense of accountability around a project. Crypto traders and investors are no strangers to projects seemingly led by shadowy figures. Demonstrating a willingness to disclose information about reserve holdings is a surefire way to instill confidence in the broader market about the leadership’s accountability and responsibility. This could especially benefit projects during challenging bear crypto market cycles.

Challenges to implementing a Proof of Reserves audit

For users, assessing an exchange’s PoR poses significant challenges. It is difficult for cryptocurrency exchanges to demonstrate to depositors that the cryptocurrency held on deposit corresponds to user balances. While it is relatively straightforward to demonstrate that the exchange controls some funds on its platform, they could always borrow these funds on a short-term basis. This is why point-in-time attestations have little significance. Moreover, exchanges may have concealed liabilities or have creditors claim priority over depositors, particularly if client funds are not legally segregated on the platform.

Liabilities are difficult to establish and typically necessitate a thorough examination by an auditor. To “cheat” a PoR assessment, for example, exchanges may omit certain obligations. For this reason, it is recommended that a reputable independent third-party auditor implement a full audit of the crypto exchange or project to ensure maximum security for depositors and traders.

Should my company do a Proof of Reserves audit?

PoR audits are a vital tool for ensuring the security of the digital assets of users as well as their trust and faith in the system at large. If you want to learn more about how blockchain organizations can secure their digital assets or how Halborn can help with your PoR audit, connect with our blockchain security experts at halborn@protonmail.com.