How Exchanges are winning back the Trust of Users through Proof of Reserves

Crypto Winter gets colder – HODL the Door

he Digital Wild Wild West couldn’t have gotten any wilder. This month, the FTX debacle spilling over to Celsius and Genesis, has managed to garner more critics than ever before. Once again, crypto has reached the headlines, all for the wrong reasons for the umpteenth time.

The recent events have triggered all kinds of responses from all kinds of people. The ‘crypto bros might just treat this as a Monday and lament the crypto-naïve users for depending on custodial service providers, while the Congressmen would have just gotten another reason to heavily regulate (and suffocate) this industry under the garb of the protection of end users.

All said these events do not mean the end of crypto nor the end of such centralized exchanges. People will keep using such intermediaries since they do provide utility; considering how daunting it can be for an average user to maintain a cold storage wallet coupled with the responsibility of safeguarding its private keys.  

This just means that the existing custodial service providers have to get better, for their own sake. But, how should they do it?

Enter – Proof of Reserves (PoR)

Proof of Reserves is how such providers can win back the trust of users. The Collapse of FTX can be summed in a sentence – Its inability to match up the customer withdrawals with its assets or reserves.

Proof of Reserves mean that the company assets, if not more are at least equal to the customer deposits (liabilities). The idea is that an entity with a PoR program can publicly prove that it has sufficient reserves or assets to match its customer deposits (liabilities for such an entity)

The concept itself is not something new. It was just that it did not gain enough traction. And these recent events have created the need for such PoR programs.

How are these PoR programs even conducted?

1. Traditional Third Party Auditors
2. A cryptographic method with the help of data structures known as Merkle Trees

So theoretically in a Full PoR, users can verify whether their deposits are added up as liabilities in the custodian’s books. Sort of like the user auditing his/her deposit instead of like a traditional auditor doing so. As a user, the procedure for verifying deposits is pretty straightforward. For instance in Kraken, the user simply has to log in to his/her account and click verify, which thereafter confirms that the deposits are a part of the Liability Merkle Tree.

Exchanges moving to Proof of Reserves

Binance-

In an attempt to bring further transparency and accountability to its users, Binance has provided Proof of Assets by disclosing its Wallet addresses (hot and cold wallets) It has also committed a detailed Merkle Tree proof of Funds in the near future, indicating its intention to move to a Full PoR.

Kraken-

Kraken, the US-based exchange was the first exchange that conducted regular PoR audits on a semi-annual basis, involving a comprehensive approach that verifies both reserves and liabilities. They have also engaged an accounting firm to perform such PoR engagement.

BitMEX –

BitMEX is also one of the few exchanges that has conducted a Full PoR. It has published a list of all addresses as a Proof of Reserves and conducted a Proof of Liabilities process via Merkle Trees. They also intend to bring in significant improvements by automating the publication of proof of reserves and liabilities on a daily or weekly basis and providing each client with a feature to check their inclusion in the Liability Merkle Tree.

CoinSwitch –

The Indian Crypto Exchange engaged a consulting firm to inspect and arrive at AUP (Agreed Upon Procedures) in accordance with SRS 4400 (Indian Standards on Related Services – equivalent to International Standard 4400) as a part of their Proof of Reserves procedure to confirm that their reserves exceed total user holdings

Apart from the above-mentioned exchanges, KuCoin, Huobi, Crypto.com, and various others also have expressed their desire to publish their PoRs

So, are Proof of Reserves foolproof?

First of all, it is of prime importance to understand that users will only be able to confirm a company’s solvency with proof of reserves and proof of liabilities. Only disclosing the reserves without the liabilities shows an incomplete picture.

Secondly, proof of reserves and liabilities need to be in real-time. Attestations at a particular time provide little value as funds can easily be moved in for a short-term basis into the company wallets to depict liquidity.

Not only that, but the governing law also plays a vital role in determining the position of users in case a liquidity event is triggered. It might be possible that the company has some undisclosed liabilities and the creditors have seniority over depositors in case of insolvency. Accordingly, as a part of their policies, exchanges should clearly mention that the depositors shall be senior to creditors.

Accordingly, the proof of reserves procedure isn’t exactly perfect. However, we cannot afford to not do them especially since they prove to be a strong measure in the benefit of users at large and also keep exchanges in check. PoRs provide transparency and show the commitment of the exchange towards customer deposits.

Normalizing PoR is the way to go ahead. Custodians that have done their PoR programs and attestations will be considered to be more trusted. The ones not doing so shall raise eyebrows and their users might also withdraw their holdings if such custodians continue showing their reluctance to publish reserve balances.

Outlook – Bleak or Bright?

An irrefutable fact is that the adoption of PoR approach by centralized platforms will immensely be in the interest of the entire cryptocurrency industry.

Implementing real-time PoR might prove to be a task for custodians. However, a self-regulatory measure can prove to be much better than an actual measure from regulators, which might have harsh consequences.

Centralized platforms providing published Full PoR on a real-time basis is the way to move ahead. These are the times of tumultuous tides and PoRs look like the beacons that can chaperone us to safe harbors.

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