In the evolving landscape of cryptocurrency and digital assets, trust remains a cornerstone of adoption and growth. The concept of Proof of Reserves (PoR), born in the aftermath of the catastrophic Mt. Gox collapse, has become a crucial mechanism to ensure transparency and accountability across various facets of the crypto ecosystem.
- Exchanges: Centralized exchanges often operate as custodians, holding user deposits and facilitating trades. This creates a liability or “promise” to “pay back” customers upon request for withdrawal.
- How PoR Works:
- Assets: Exchanges aggregate user deposits into pooled wallets (hot, warm, and cold storage). Proving assets involves gathering a list of all custodial addresses and proving ownership of each, either via digital signatures, “send-to-self” transactions, or another method that demonstrates control of the private keys holding customer assets. Then, the asset balances are queried for those addresses as of a specific point in time, with the total unit balance equating to “Total Customer Assets.”
- Liabilities: Then, a report of all customer balances from the exchange’s database should be extracted. The summation of these “IOUs” owed to customers is the “Total Customer Liabilities” balance. The equation is simple: Customer Assets should be greater than Customers Liabilities.
- Challenges:
- Large Volume: Exchanges typically have hundreds of thousands or even millions of addresses.
- Customer Liability Database: The customer database tracking liablities owed to customers can be manipulated. This is where independent parties can be valuable in the Proof of Reserves process.
- How PoR Works:
- Stablecoins: Stablecoins like USDT and USDC represent another major application of PoR. Their value is derived from being backed 1:1 by reserves such as fiat currencies or short-term treasuries.
- How PoR Works:
- Assets: For each stablecoin issued, an equivalent dollar value must be held in reserve. The issuer demonstrates cash, cash equivalents, or other instruments held in accounts with financial institutions. The balances observed at each financial institution as of a specific point in time equate to “Total Customer Assets.”
- Liability: The liabilities in this instance are tokens issued on a blockchain, redeemable for the underlying dollar. These balances are public and visible on blockchains! The summation of these tokens issued on the in-scope blockchains is the “Total Customer Liabilities” balance.
- Challenges:
- Historical Blockchain Data: Obtaining historical blockchain data from chains like Solana can be challenging.
- Valuation of Assets: Often times, issuers earn yield on underlying assets. The aaluation of these assets (and disclosing the methodology) is key to ensuring the public is appropriately informed.
- How PoR Works:
- Exchange-Traded Funds: Crypto-based exchange-traded funds (ETFs) like Bitcoin ETFs are a bridge between traditional and crypto finance.
- How PoR Works:
- Assets: ETF’s typically hold “in-kind” assets to back the Exchange-Traded Products. Therefore, for a bitcoin ETF, spot bitcoin is held in custody.
- Liability: The liabilities in this instance are notes or shares issued and tradeable on stock or security exchanges. The summation of the NAV of these notes issued is the “Total Customer Liabilities” balance.
- Challenges:
- NAV Calculations: NAV calculations can be complicated to derive a true liability figure.
- Rebalancing: “Index” products may be rebalanced frequently, causing challenges in ensuring all changes are appropriately captured period over period.
- How PoR Works:
https://www.thenetworkfirm.com/blog/the-power-of-proof-of-reserves