Will Proof Of Reserves Provide More Security?

proof of reserves

(Last Updated On: 12. January 2023)

The FTX crisis has exposed the gaps and flaws in the safety net of many crypto exchanges. Where banks have to complete stress tests and provide evidence of reserves for deposit security, there seems to be a lack of comparable sets of rules for crypto currency providers. This impression is certainly wrong, especially since the European Union has created a comprehensive framework for crypto assets with the so-called MiCA regulation (Markets in Crypto Assets).

MiCA is designed to protect consumers and financial stability. For instance, for so-called stablecoins, the agreement contains clear requirements for the establishment, authorization and administration of reserves. However, many are calling for transparent and detailed disclosure of liquidity through the use of Proof of Reserves.

This demand is supported by leading figures in the crypto industry such as Changpeng Yhao, the CEO of Binance. In a tweet, Changpeng promised investors the introduction of an audit system, which should allow more transparency and control of digital assets on the basis of “Proof of Reserves” (PoR).

What Is Proof Of Reserves?

Monitoring of deposits using the Proof of Reserves method is intended to ensure that custodian banks hold the assets deposited by customers in full. PoR audits, conducted by independent experts, aim to prove to investors and the public that balances and deposits match.

PoR audits should be ideally carried out by independent and certified third parties to eliminate the possibility of counterfeiting. However, there is currently still a lack of independent auditing organizations that could carry out corresponding audits worldwide.

CoinMarketCap as a market researcher and data tracker of the crypto industry has meanwhile introduced a PoR function on the platform. The Proof of Reserves tracker is checking active cryptocurrency exchanges for transparency and the available liquidity at a defined point in time. According to CoinMarketCap, the tracker reports the company’s total assets and its associated public wallet addresses, balances, the current price and value of the wallets.

The data is updated every five minutes. In the current implementation, the tracker can be selected via the “Exchanges” and “Spot” tabs.

According to CoinMarketCap, the trading platforms Binance, Kucoin, Bitfinex, Deribit, Huobi and OKX currently support tracking via Coinmarketcap. Platforms like Bitget, Crypto.com and others also want to offer more transparency and provide data on the wallet addresses.

Are Current Proof Of Reserve Test Methods Reliable?

The listing of assets is based on the rules and verification procedures established by CoinMarketCap. However, even if this data is valuable, it does not meet the requirements of inspection bodies.

Experts like Jesse Powell, CEO of the Kraken crypto exchange, criticizes that PoR has to take into account the sum of all liabilities. This includes user-verifiable evidence that each account is included in the bill in order to be meaningful. Kraken already allows a comparison with the liabilities of the trading platform, but many competitors exclude accounts with negative assets in the PoR balance sheet.

Isolated solutions such as PoR tracking on a voluntary basis are certainly a good sign, but can be deceptive as to the value of the data. Platforms like Binance and Kucoin, which are not licensed for their entire operations, often use RoR to earn customer’s trust, according to Cashaa founder and CEO Kumar Gaurav. In the end, this doesn’t offer much more than a good feeling, but no real security.

Are Merkle Trees The Better And More Meaningful Than Proof Of Reserves?

The topic of Merkle Trees, whose data structure offers security and the possibility of data verification, repeatedly crops up in the security debates. The concept of a hash tree is named after Ralph Merkle, who patented it in 1979.

In the Bitcoin network, Merkle trees are used for data verification. Many crypto exchanges use this method: for example, Bitget, Binance or ByBit have already made a Merkle Tree Proof of Reserves solution available to their users.

In the Bitcoin network, all transactions within a block are summarized in a Merkle tree as a digital fingerprint. Thus, a user can check at any time whether a transaction is included in a block or not.

This transparency of all transactions could be the basis for new monitoring tools. Through this mechanism, it would be possible to control balances, deposits and withdrawals in real time. However, this method does not offer full transparency that also takes liabilities into account.

What Value Have Independent Auditors?

audit, proof of reserve

Independent auditors are now working as crypto specialists and auditors for DeFi and crypto companies. The Wirecard scandal, in which KPMG was the auditor and accompanying auditor, showed that a good name and reputation from independent auditors does not necessarily mean investment security.

Independent accounting firms have a great responsibility. But as the Wirecard case shows, this does not necessarily mean investment security. One reason for this lies in the structure of the market, which is dominated by global companies – Ernst & Young (EY), Pricewaterhouse Coopers (PWC), KPMG and Deloitte. Therefore, some economic experts see independence in the face of restricted competition at risk and are calling for more competition.

In the course of the Wirecard scandal, the German Federal Financial Supervisory Authority (BaFin) was instructed to conduct its own independent audit. In fact, the instruments for monitoring company accounts, the so-called balance sheet control, have since been tightened. In 2021, the legislator fundamentally reformed this with the Act to Strengthen Financial Market Integrity (FISG).

The new rules are intended to help identify balance sheet manipulations at an early stage. A measure that would probably have sent warning signals early in the FTX disaster if it had been a German company.

Can PoR, Merkle Trees and Independent Audits of Crypto Assets Prevent Crypto Exchanges from going bankrupt?

Given the unclear requirements, Proof of Reserves audits are a simple step towards building trust that many crypto platforms are taking right now. Proof of Reserves also helps to ensure the integrity of the transactions by having independent Web3 auditors such as Hacken.io validate the hash values of the Merkle Trees.

In addition, the PoR data provided on a voluntary basis is not openly communicated by all providers. In a tweet, the investment heavyweight Grayscale points out that the crypto assets invested by investors are kept safe, but are not stored directly with Grayscale itself. It is correspondingly difficult to publish information about the respective wallets or to monitor them using automatic PoR tools.

Fully regulated and licensed trading platforms bring more investment security. For example, in the US, Coinbase and Kraken are fully licensed. Yield Wallets, Cashaa, Swissborg, Crypto.com and Bitpanda have appropriate licenses in Europe. Other crypto platforms and financial services providers will follow, with PoR being a stopover on the way to a global solution.

The FTX bust certainly highlighted systemic issues, but it’s certainly not limited to the crypto industry. Even outside the Bitcoin and DeFi world, it is possible to generate billions in losses through criminal energy and fraudulent intentions and to bring investors total losses. From Lehman Brothers to Wirecard, every industry has experienced mega crashes. Such collapses cannot be prevented by inventory monitoring alone.

Until global solutions are available, the desire for assured transparency is little more than a hope based on sound business practice and trust.

For skeptics, at least for the time being, private keys to their own wallet remain the best guarantee not to lose their crypto currency to insecure third-party providers.

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