Proof of reserves and liquidity in crypto explained

Finst proudly stands as the first and only Dutch cryptocurrency platform to release an extensive Proof of Reserves. proof of reserve audit Every investor deserves access to accurate and comprehensive information about their exchange’s financial situation and overall safety. We firmly believe that regular Proof of Reserves disclosure should become the standard for all crypto exchanges.

Proof of Reserves attestations are heterogeneous

However, in this data structure, no single node stores the information for any single wallet. Instead, the data is split across the whole tree, with each node inheriting a piece of information https://www.xcritical.com/ from its parent. The root stores all of the data – in this case the wallet and transaction data. At the end of each branch, there is a node – with each node capable of storing information.

Why is proof reserve audits in crypto exchanges hard for traditional auditing firms?

Probably the biggest misconception around PoR is that it represents “only half of the equation”. It’s commonly said that Proof of Reserves only pertains to assets, not liabilities. In the wake of FTX, some exchanges did informal asset attestations as a short term stopgap measure in which they shared coldwallets without corresponding liabilities. PoR has always meant proving ownership of client assets and demonstrating outstanding liabilities owed to clients. That has been the meaning of PoR since it was first discussed in 2013 and that’s what it means today.

Why is Proof of Reserve Important for Assets?

Such fraudulent activities can lead to devastating consequences, including loss of funds and a collapse of trust in the financial system. DeFi UsersDeFi investors can utilize our solution to have transparency in auditing their wallets to gain trust in backing off-chain collateral with on-chain reserves. PoR gives us a snapshot of a company’s assets, like a still picture, at a specific moment. But what it doesn’t do is show us how these balances change over time – it’s not a live show. Whether it’s regulators, investors, administrators, or end users, everyone is on the lookout for reliable information and trustworthiness.

What are the limitations of traditional Proof of Reserves audits?

It is a way for customers of exchanges and custodial platforms to hold the custodian accountable. It helps users know that liabilities held and the amount of cryptocurrency they have on the platform is backed up by like-kind assets. So far, every PoR that has been done with the assistance of an audit firm – Armanino, Mazars, etc – has been an “Agreed Upon Procedures” engagement. An AUP is a process whereby a firm asks an auditor to verify that it has followed a specific procedure within narrow boundaries, in this case, a faithful extraction of liabilities and a proof of assets held. Specifically audit firms stake their reputation on their oversight in a financial statement audit – they are actively determining whether the financials surveyed appropriately reflect the firm’s financial position.

We can debate the morality of this, but if you take a harm reduction approach, supporting PoR is an unalloyed positive. While no proof of reserve legislation could compel offshore exchanges to undertake the procedure, if all onshore exchanges were doing it, that would put pressure on their offshore peers to do the same. Additionally, a regulatory compulsion to use PoR domestically would create a market for more and better technical tools and CPA firms to oversee the attestations, making it more convenient for offshore exchanges to engage in PoR. PoR is most useful for exchanges where traditional assurances don’t exist. There are many of these, so standardizing PoR and encouraging CPA firms to cover them would improve the overall credibility of these exchanges, even if offshore. Imagine a parallel Earth identical to ours in every way, except for the fact that crypto exchanges had embraced PoR far earlier.

Blockchains already employ Merkle trees as their primary data management technique and a fundamental building block to manage the ever-expanding amount of data that its users generate. As each block contributed to the chain is recognized by a hash, the Merkle tree offers a storage and identification system that saves the data according to their hash rather than an entire chain. As a result, data in the block may be confirmed using the block’s hash, which avoids the requirement to compute the entire network’s blocks. The Merkle root ensures that the correct data is stored in each data branch by serving as the data branch’s sole point of connection.

An AUP doesn’t grant these same assurances – but that doesn’t mean that a PoR with an AUP is worthless. It’s just that consumers of the PoR are placing their trust more in cryptography rather than the reputation of an audit firm. Undeniably, an audit firm supervising a PoR helps provide assurances that the liabilities were extracted faithfully – but it isn’t the be all end all. Within the blockchain space, proof of reserves is commonly known as an independent verification that enables centralized exchanges to publicly report the value of their reserves and prove their solvency.

Back in 2021, we engaged PCAOB-certified auditor Armanino LLP, one of the 20 largest accounting firms in the US, to perform an industry-first real-time attestation. Armanino has since become a leading provider of proof of reserves reports. The auditor then matches up the amount of assets held in Kraken’s on-chain crypto wallet addresses with the balances shown in the Merkle tree. Our reserves are verified through audits conducted biannually (twice a year) by an independent, top-25 global accounting firm. As an independent third-party, the auditor attests to the accuracy of both our client liabilities as well as the assets held by Kraken to cover those liabilities.

Merkle trees are extremely handy in blockchains, acting like a super-efficient filing system. When we’re talking about “Proof of Reserve” audits, think about exchange platforms or custodians teaming up with an external crypto detective, or in a more formal term, an auditor. It’s basically a way for crypto exchange platforms to show that, “Yep, we do have the amount of cryptocurrency we say we do! You know, in the world of crypto, being upfront and trustworthy is a big deal. Learn how wrapped tokens play a critical role in enabling cross-chain interoperability and in providing new financial services within the blockchain ecosystem. As such, DeFi platforms must perform regular Proof of Reserve audits to monitor their checks and balances.

To guard against potential misleading claims and ensure the crypto exchange custodians are acting appropriately, PoR audits are employed to ensure that a company’s holdings match the investors’ assets. An independent third-party firm is brought in to conduct these procedures, mitigating any potential fraud or bias. Additionally, the transparency afforded by proof of reserves helps to prevent or detect instances of fractional reserve practices, where an exchange claims to hold more funds than it actually possesses. By allowing external scrutiny, exchanges deter fraudulent activities and promote a healthier cryptocurrency ecosystem. By embracing proof of reserves, financial institutions and platforms demonstrate their commitment to maintaining the trust of their customers and strengthening the overall integrity of the financial ecosystem.

• By prioritizing the verification of reserves, the system offers users the assurance that their funds are secure, fostering a more robust and reliable financial ecosystem.
• By doing these detailed check-ups, the hope is to make the crypto market a place full of trust and honesty.
• It’s like a digital receipt that allows anyone to verify the presence of a particular piece of data in the Merkle Tree without revealing any sensitive information.
• It is frequent, narrow in scope (but covers the specific thing that clients care about), and relatively cheap.
• Proof of Reserve sounds better, and Solvency is a much higher bar to clear.

Anytime you trust a 3rd party with your assets, you introduce a point of failure. In this article, we’ll break down what Chainlink Proof of Reserve (PoR) is and how it helps provide stronger security guarantees and more transparency in the cryptocurrency ecosystem. In addition, we’ll also explore the PoR reference feeds already implemented by top DeFi teams and provide context for future use cases and implementations. In traditional finance, a situation when too many clients withdraw their funds all at once is called a bank run and it can be fatal for an economy. Although Proof of Reserves is a great way to understand the exchange’s financial position, the information is inadequate to confirm the exchange’s solvency.

Proof of reserves is becoming more and more popular, especially with the November 2022 downfall of the FTX crypto exchange and recent comments from crypto exchange Binance about the importance of transparency. It also will become important as regulators look to set industry standards to protect consumers, as proof of reserves is a secure and transparent way to ensure that customer funds are safe. Blockchain oracles can also conduct decentralized proof of reserves audits for exchanges. The PoR from decentralized services such as these guarantees an institution cannot transfer more tokens than it has assets in reserve.

By verifying that an institution holds sufficient reserves to cover all customer deposits, it ensures that there is no excessive lending and maintains the integrity of the financial system. Well, it all boils down to building trust and confidence among their users. By showcasing their reserves through public wallet addresses, exchanges demonstrate their commitment to maintaining solvency and safeguarding customer funds. Proof of Reserve is a method or a way to prove that an exchange platform possesses the amount of cryptocurrency that it claims to have. It is an auditing practice addressing the transparency concerns of assets kept on exchanges. It is a much-needed inspecting technique to ensure that real assets back crypto in a decentralized space.

One of the proposed solutions by centralized exchanges was to bring Proof of Reserves into practice to instill confidence and save them from damage control. Therefore, this piece will discuss the importance and limitations of Proof of Reserves. It will also take you through the possible scenarios for preventing the FTX fiasco. Either way, if you are publicly revealing your addresses, it would be come very clear very quickly if you were borrowing large amounts of funds every month to ‘pass’ a PoR and then sending them back.

But it would also be the most obvious thing ever (as evidenced by the immediate outrage over Crypto.com and Gate’s questionable transaction). Higher frequency assessments – paired with either audit firm oversight or simply the on-chain transparency that comes with a periodic asset attestation – means that it is much harder or impossible to cheat a PoR. For instance, window dressing wouldn’t help with a daily or biweekly PoR attest, as is done by certain exchanges. However, cryptocurrency users have a revealed preference for custodial ownership, at least for a portion of their coins. By encouraging custodial exchanges to adopt PoR, I am hoping that user assurances at custodial exchanges can be bettered. Proving liabilities is tricky, and generally requires an auditor to engage in a full assessment.

So, instead of relying on the exchange or the auditor’s report, the users can independently verify. Requiring financial institutions and cryptocurrency exchanges to prove they hold enough assets to cover their customers’ deposits offers a layer of trust and transparency. This reassures individuals that their hard-earned money is not being mismanaged or lost due to insolvency. Proof-of-reserves is a method cryptocurrency exchanges and other financial institutions use to demonstrate that they hold the funds they claim to have on deposit to ultimately fund customer balances. The concept behind proof-of-reserves is to provide transparency and to assure customers and regulators that the institution has the necessary assets to meet its financial obligations.

Today, most PoRs are done with the Merkle proof method where liabilities are only disclosed on a per-client basis, which creates more possibilities for liability hiding. But this is solved with next generation PoRs which rely on ZK proofs, making disclosure of the full liability set possible without privacy drawbacks. Newer cryptographic technologies have largely made this objection obsolete. First of all, for modern PoR like the ones done by Derebit of BitMEX, the entire liability set is released, so there’s no real uncertainty around the completeness of liabilities. In short, ‘PoR’ is not a singular concept, but the general idea of demonstrating the equivalence of assets held on deposit alongside outstanding liabilities. Today, due to this heterogeneity, PoR attestations must be evaluated individually.