Education Ecosystem Blog

Seems as though every quarter a major crisis in the crypto industry awaits us. Still in recovery from the Terra LUNA crash in May, the industry has been hit again this November with the FTX collapse, causing great panic and a mass exodus from crypto.

With losses amounting to billions, the aftermath is a mass withdrawal from crypto space. Many are opting out of crypto due to a lack of trust. But core crypto enthusiasts, the crypto natives believe there’s a fix and have sought a means to improve transparency in the industry. This means of transparency has presented itself as Proof of reserves (PoR).

In this article, we’ll explore the concept of Proof of reserves in the crypto industry, how it works, its limitations, and most of all, its ability to bring back trust.   

What is Proof of Reserves?

The concept of proof of reserves in crypto can be traced back to the traditional financial markets. Banks in the early traditional market were known for what seemed like rug pulls at the time. Banks which had been in operation for years suddenly went bankrupt, leading to losses on a massive scale. The government, seeing this recurring trend, in a bid to protect the people, pushed for insurance through fractional reserve banking. This meant a certain percentage of banks’ total deposits would be kept with the central bank. 

The crypto industry has witnessed a similar situation this year with the Terra/LUNA and FTX collapse, which led to billions of investors’ funds going down the drain. Crypto natives have called for transparency in the form of proof of reserve. The goal is a well-designed and constantly updated proof of reserves which will give a detailed account of companies’ balance sheets, providing assurance to investors and possibly restoring trust in the crypto industry.

How are audits conducted in the Crypto Industry?

Similar to the traditional financial market, audits in the crypto space are undertaken by a third-party auditor. This process involves taking anonymous snapshots of all balances on the exchange. These balances are then integrated into a Merkle tree. Digital signatures are used to verify the validity of these balances. This also allows customers to verify that their balances have been included in the audits.

Merkle Trees Proof of Reserves

For effective reserves verification, constant update of balance sheet is required. Many crypto companies have sought transparency by utilizing an annual or semi-annual audit, but this is insufficient as the interval is too large. For better assurance, a real-time audit is required.

The Merkle trees PoR is a privacy-friendly means of tracking a company’s balance sheet using hash trees. It allows users to easily verify that their account balances are included in the exchange’s reserves. With the implementation of the Merkle trees PoR, investors would easily notice discrepancies in a company’s balance sheet and immediately withdraw funds.

Is proof of reserves necessary?

Central exchanges are of great importance in the Crypto industry as they serve as an entry point. The need for their proof of reserves is of paramount importance. Though it may not provide the same level of assurance as the fractional reserve in the traditional markets, the cases of insolvency in the crypto industry have had users clamoring for credible transparency in the form of proof of reserves.

Proof of reserves audit concerns

Though proof of reserves seems like the choice solution, it doesn’t come without disadvantages. The points below prove how it could be a more deceptive means of verification rather than provide assurance.

– Duplication of Private Keys – Proof of reserves is limited as it cannot prove or detect ownership of private keys.

– Inability to Prove Borrowed funds – Prospective investors will be unable to verify the source of assets and whether they’ve been borrowed just to prove funds. 

– Regulation of Crypto, losing its decentralized nature – The crypto industry could cease to be decentralized as the involvement of third parties will have other parties in control of transactions.

Conclusion – Verification is better than trust.

The crypto industry requires a safe environment to flourish, this can only be achieved with the right amount of transparency to retain its core tenets. Low entry barriers and high profitability makes the crypto industry host to many investors, but these investors are at the mercy of the crypto exchanges they trust. Simply trusting crypto companies based on a one-time audit and partnerships isn’t enough; a means to constantly verify assets is required for better acceptance.