Cryptocurrency has come a long way since its inception, with millions of people around the world using it as a means of exchange and investment. Despite its growth, the lack of sufficient transparency in the industry still remains significantly concerning for many people. This is where the Proof of Reserves protocol comes in, providing a solution for increased transparency in the cryptocurrency ecosystem.
What is Proof of Reserves?
Proof of Reserves is a cryptographic protocol for verifying that a cryptocurrency exchange, wallet, or any other service holds the assets it claims to hold. The purpose of this protocol is to increase transparency and provide a way for users to verify that the assets claimed to be held by a service are actually present and can be redeemed. This protocol helps to build trust between the service and its users by ensuring that the service is not using fractional reserve banking practices.
In a proof of reserves protocol, the service provides cryptographic proof that it holds the claimed assets. This proof can be independently verified by anyone, providing a high level of transparency and accountability.
After the FTX saga and crash in 2022, Proof-of-Reserves became an increasingly popular industry buzzword. The event highlighted the need for increased transparency and trust in the cryptocurrency industry, with more and more services implementing the protocol to increase transparency and build trust with their users. The FTX revelation was an eye-opener that it isn't safe to blindly trust anybody or company; despite being a top 2 crypto exchange, FTX engaged in many illicit financial actions that made them illiquid; hence, they didn't have the majority of users' money, and upon an exposition, massive withdrawal requests followed, leading to the fall of the popular exchange. The increasing popularity of the Proof-of-Reserves protocol shows that the industry is moving towards a more transparent future and that crypto/blockchain indeed has all the recipe for success.
As things stand, popular exchanges like Kraken and Bitfinex have launched their Proof-of-Reserve protocols to foster increased user trust. Similarly, Binance, OKX, and crypto.com, among others, have launched a merkle tree-based system to verify Bitcoin and Ethereum holdings for any exchange.
Merkle Tree-Based Proof-of-Reserves
Merkle Tree-based Proof of Reserves is a method used to verify ownership of assets for Proof-of-Work cryptocurrencies. This method utilizes the concept of a Merkle tree, a data structure that allows for efficient and secure verification of large data sets. The Merkle tree is built by hash-linking each item in the set of data, with the hash of the entire set being the root of the tree. In the case of a cryptocurrency service, the data set is the list of assets held by the service, with each asset represented by a unique identifier.
The Merkle tree-based Proof of Reserves allows users to independently verify the assets claimed to be held by a cryptocurrency service without the need for a third-party audit. The service provides a root hash of the Merkle tree, along with a set of hashes that correspond to each asset in the set of data. The user can then verify the ownership of assets by comparing the hashes provided by the service with their own calculation of the hashes. If the hashes match, the user can be confident that the service actually holds the assets claimed.
Why is Proof of Reserves Important?
The Proof of Reserves protocol is important for several reasons, including:
- Increased Transparency: The proof of reserves protocol increases transparency by providing a way for users to independently verify that the assets claimed to be held by a service are actually present. This level of transparency helps to build trust between the service and its users, which is essential for the growth of the cryptocurrency industry.
- Eliminating Fractional Reserve Banking: One of the biggest concerns in the cryptocurrency industry is the possibility of fractional reserve banking practices. This is where a service claims to hold more assets than it actually does, using the excess assets for other purposes - mainly investments. If the investment goes south, then users will suffer major consequences. The proof of reserves protocol helps to eliminate this risk by ensuring that the assets claimed to be held by a service are actually present.
- Regulator-friendly: The Proof-of-Reserves protocol provides a way for regulators to verify the assets held by a service without compromising the decentralized nature of the blockchain or censoring transactions. However, if any red flags are discovered, other actions can be immediately taken to inform the public and avoid theft and money laundering.
Limitations of the Proof-of-Reserve Protocol
It largely doesn’t account for liabilities. Hence, a company with huge liabilities, facing solvency issues and liquidation risks, may appear solvent based on assets alone.
This gathered momentum when Binance released its November 2022 attestation, as Jesse Powell, Kraken CEO, suggested that Binance is either ignorant or dishonest, leading to controversy after he suggested foul play from the market leaders. Following up with a tweet, Powell rightly suggested that all attestations must contain liabilities to show the ideal picture of the scenario and not just the pleasant view of assets.
The Proof of Reserves protocol has become an increasingly important topic in the cryptocurrency industry, providing a solution for increased transparency and trust; with more services implementing this protocol, the industry is moving towards a more transparent future. Despite its few limitations, Proof of Reserves is a crucial step towards a genuinely transparent cryptocurrency ecosystem.