‘Proof of reserve’ is the new catchphrase and promise by crypto leaders eager to allay investor fears. But loopholes remain and audits might not mean what you think, writes Anndy Lian.
Proof of reserves plays a critical role in the cryptocurrency industry by providing a vital security mechanism for investors. Given the industry’s lack of regulation and transparency, investors may have reservations about putting their money into the market. In response, many leaders in the industry are stepping up to assure users of their reserves.
“The #Binance Proof of Reserve system has now integrated with zk-SNARK, a zero-knowledge verification method. It will also be made open source. We hope this would help the entire industry benefit,” Changpeng “CZ” Zhao, the CEO of Binance, recently tweeted.
Ben Zhou, CEO of Bybit, has also reassured clients that “Bybit has always [been] committed to client fund safety and guarantees 1 to 1 reserves.”
OKX, led by founder, Mingxing “Star” Xu, recently announced their fifth proof-of-reserves report showing over US$8.9 billion in “clean assets” held in the exchange reserves, including over 100% reserves for BTC, ETH and USDT.
This past week, Texas also jumped on the “proof of reserves” bandwagon as its House of Representatives passed a bill that would require it for crypto companies operating in the U.S. state. By requiring adequate reserves, the proposed legislation seeks to prevent situations where a company is unable to meet its obligations to customers due to insufficient funds.
These words and measures may help alleviate some investor concerns that their digital assets held by a crypto exchange are safe and not being used by the exchange for other purposes, such as trading or investment. However, many crypto users still do not understand the concept of “proof of reserves” and how it works.
Here is an overview of what proof of reserves is all about, the potential gaps in how it’s being carried out, and how investors can demand more accurate and timely data for protecting their crypto holdings.
What proof of reserve does
Proof-of-reserve audits are crucial in verifying that exchanges hold the total amount of crypto assets they claim to have on behalf of their customers. This gives investors the confidence to know that their assets are securely stored and not at risk of being lost or stolen. It is especially important given the recent high-profile hacks and security breaches in the industry, which have resulted in the loss of millions of dollars worth of digital assets.
Proof of reserves provides a level of accountability for crypto exchanges. By ensuring that they are holding customers’ assets safely and securely, exchanges are incentivized to maintain high levels of transparency and openness. This can help to prevent suspicious or illegal financial activities from occurring on the exchange, which is vital for the overall credibility and legitimacy of the industry. Thus, it plays a crucial role in maintaining investor confidence and promoting the growth and success of the cryptocurrency industry.
But many people have a mixed understanding of what proof of reserve means and what it entails. There are three methods for proof-of-reserve verification, including “public wallet address,” “third-party audit,” and the most widely used “Merkle tree” proof.
- Proving reserves through public wallets
A public wallet is one method for proving reserves, which entails an exchange publicly sharing the addresses of its crypto wallets that contain customer funds. This approach offers a transparent and verifiable mechanism for both customers and regulators to confirm that the exchange is indeed holding the funds it claims to possess.
Through public wallets, customers of a crypto exchange can monitor the wallet addresses and ascertain that the funds contained in those wallets match the amounts they have deposited with the exchange. Such a high level of transparency can bolster trust between customers and the exchange and reassure customers that their funds are safe.
Apart from total transparency and enhancing accountability, a public wallet can also serve as an early warning mechanism for investors to detect any irregularities in a crypto exchange’s financial situation. For instance, if the balance of a wallet suddenly decreases without any explanation, it could signal potential fraudulent activity.
Just a word of caution: A public wallet may not be sufficient in revealing how the reserves are being managed or invested. Hence, it is critical to view a public wallet as just one part of a more extensive transparency and oversight framework, which includes other techniques such as live audits and continuous proof of solvency.
- Third-party audits
Third-party audits of proof of reserve are a method of validating an exchange’s reserves through an independent auditor. This approach aims to provide an unbiased evaluation of an exchange’s financial status and can enhance trust between customers, regulators and the exchange.
During a third-party audit, the auditor investigates the exchange’s records and verifies that the funds the exchange holds correspond to the amount owed to its customers. The auditor also confirms that the funds are held in secure and auditable accounts while scrutinizing any potential irregularities or discrepancies that may indicate fraudulent activities.
Using third-party auditors can yield several benefits, including preventing crypto exchanges from exaggerating their reserves or engaging in fraudulent activities, fostering confidence among customers and regulators, and promoting transparency and accountability within the largely unregulated cryptocurrency industry.
There are some drawbacks to relying on third-party audits for proof of reserves. Finding an impartial auditor with the required expertise and experience to carry out the audit may not always be feasible. In addition, the audit may only reflect a specific snapshot of the exchange’s financial status at a particular moment in time, potentially overlooking other fraudulent activities or ongoing mismanagement.
- Merkle tree
A Merkle tree is a cryptographic technique that plays a significant role in securing the blockchain. It employs a complex process that creates a series of hash values representing a block of transactions stored on the exchange. This process is done by combining the hash values of each transaction within the block, thus producing a unique hash value for the entire block.
The creation of this unique hash value is crucial as it provides an extra layer of security for the digital assets held by the exchange. Any attempt to tamper with a single transaction within the block would result in a change to the hash value of the entire block, which the system would detect. As a result, any unauthorized modification of the block can be quickly detected and prevented.
For crypto investors, verifying the hash value of their digital assets is an essential process that enables them to confirm the security of their assets. By doing so, they can be confident that their crypto assets are stored securely on the exchange and not stolen or compromised. Moreover, verifying the hash value of their assets is crucial because it helps to maintain their personal privacy regarding the total amount of assets held on the exchange.
Merkle tree provides this added privacy by only revealing the specific block of transactions that the hash value represents while not revealing any information about the total amount of assets held by the holder. This privacy protection is crucial for holders who want to verify the security of their assets while keeping the total amount of their assets private.
Importance of proving reserves
Proof of reserve plays a vital role in the cryptocurrency industry for three key reasons. Firstly, it allows customers to ensure the accuracy of their holding balances and verify that their assets are safe and secure. As the cryptocurrency market lacks regulation and transparency, It is an essential tool that empowers customers to confirm that their assets are not being used for unauthorized investment purposes, such as trading or lending.
Secondly, it incentivizes exchanges to operate in a more transparent and accountable manner. By verifying the accuracy of their reserve holdings, exchanges are held responsible for their actions, which promotes greater transparency and responsibility in the industry. This creates an environment that discourages suspicious or illegal financial activities, which is crucial for the growth and legitimacy of the market.
Thirdly, it prevents exchanges from acting like traditional banks by lending customer deposits to third parties. In the past, traditional banks have used customer deposits to make loans, putting depositors’ funds at risk. With proof of reserves, customers can verify that their assets are not being lent out, which provides peace of mind and ensures the safety and security of their assets. This important feature sets cryptocurrency exchanges apart from traditional banks and promotes trust and credibility in the industry.
Can public statements be trusted?
Publicly disclosing proof of reserves can have several benefits for cryptocurrency exchanges and crypto holders alike. By verifying the accuracy of reserve holdings, holders can feel confident that their assets are being securely stored and not being utilized for other purposes. This increased trust can attract more users to trade on the exchange, boosting its reputation and market share. Public proof of reserves can also help enhance the stability of an exchange’s operations by preventing the use of customers’ deposits for investment or other business activities. Many mainstream exchanges, including Binance, OKX, Bitget, KuCoin and Bybit, have publicly disclosed their reserves to showcase their commitment to transparency and security. By doing so, these exchanges create a more stable and sustainable operating environment.
While this is a step in the right direction toward greater transparency and accountability, such disclosures are not foolproof and may have some flaws and loopholes. For instance, exchanges can manipulate their reserves data by temporarily moving funds into a hot wallet just for the purpose of verification. Additionally, it only proves that an exchange has enough reserves at a specific point in time, and it does not guarantee that the reserves will remain the same in the future.
One potential solution to the flaws is combining proof of reserve with other transparency methods. Through the use of multiple methods, it is possible to instill greater confidence in both customers and regulators regarding an exchange’s adherence to its claims of reserve holdings. This is particularly critical as an exchange’s failure to maintain adequate reserves can have far-reaching consequences, including reputational damage and financial losses.
By leveraging additional methods, such as live audits and continuous proof of solvency, it is possible to detect fraudulent activities in real time, thereby providing a more detailed and current view of the exchange’s financial position. This proactive approach to monitoring can enable irregularities to be immediately identified and addressed, in contrast to relying on infrequent or less comprehensive audit approaches.
Necessary but not sufficient
The dynamic nature of the crypto industry suggests that proof of reserve may not be the ultimate solution but rather a building block to the development of more advanced and robust methods of verifying reserves. Despite its limitations, it is a formidable tool in the crypto industry’s quest for greater transparency and accountability. While it is true that disclosing proof of reserve is not infallible, it represents a significant stride in the right direction, as it bolsters confidence in the sector and cultivates a more mature market.
The widespread adoption of proof of reserve could significantly enhance the credibility and legitimacy of the crypto industry. This would benefit investors and open doors to innovative financial tools and services that could revolutionize the broader economy. Ultimately, as the crypto industry evolves and adapts, its limitations could be addressed and overcome, leading to greater trust and confidence in the sector.
To me, trust can be a really “cheap” word. If you are truly worried, withdraw your crypto and keep it all to yourself and only yourself.
The best way to test proof of reserve is to put on a stress test. If the exchange can withstand withdrawals of any sort in a timely manner, this is the best proof.
Anndy Lian is an early blockchain adopter and experienced serial entrepreneur who is known for his work in the government sector. He is a best selling book author- “NFT: From Zero to Hero” and “Blockchain Revolution 2030”.
Currently, he is appointed as the Chief Digital Advisor at Mongolia Productivity Organization, championing national digitization. Prior to his current appointments, he was the Chairman of BigONE Exchange, a global top 30 ranked crypto spot exchange and was also the Advisory Board Member for Hyundai DAC, the blockchain arm of South Korea’s largest car manufacturer Hyundai Motor Group. Lian played a pivotal role as the Blockchain Advisor for Asian Productivity Organisation (APO), an intergovernmental organization committed to improving productivity in the Asia-Pacific region.
An avid supporter of incubating start-ups, Anndy has also been a private investor for the past eight years. With a growth investment mindset, Anndy strategically demonstrates this in the companies he chooses to be involved with. He believes that what he is doing through blockchain technology currently will revolutionise and redefine traditional businesses. He also believes that the blockchain industry has to be “redecentralised”.