What Is Proof of Reserves (PoR)?
Proof of Reserves (PoR) is a method of using cryptographic verification to demonstrate possession of digital assets.
Centralized exchanges use it to demonstrate their solvency and assure clients that the exchange will be able to pay out customer deposits in times of market volatility.
PoR refers to digital assets verified through on-chain methods like tracking wallets.
It does not include off-chain assets like cash reserves or other fiat assets.
What Does Proof of Reserves Mean?
Proof of Reserves gained popularity following the collapse of FTX, which went insolvent by using customer funds to cover balance sheet holes for its trading arm, Alameda Research.
Other centralized exchanges reacted to the call for public attestations to their reserves by publishing or promising to publish proof of reserves.
In theory, proof of reserves should assure customers of a custodian‘s solvency and increase confidence in their business.
In practice, however, proof of reserves can be manipulated or tampered with or may not reveal the full picture.
Addressing Off-Chain Assets
PoR also says nothing about off-chain assets or liabilities.
A custodian may hold additional assets off-chain or in undeclared wallets.
Therefore, a full audit would be needed to guarantee complete information in a PoR testament.
It can be seen as an attempt at self-regulation and increasing user confidence in the face of distrust over the business practices of custodial crypto companies.
Why Do We Need Proof of Reserves?
PoR is helpful for several reasons:
- A PoR attestation signals vigilance regarding an exchange’s solvency. It increases user confidence in a custodian and testifies to a certain degree of transparency the custodian guarantees.
- PoR is a means of self-regulation. Even though some exchanges are not regulated in the United States, PoR may result in more favorable treatment by US regulators and more confidence from their user base.
- PoR makes it more difficult to obscure illegal and unethical business practices like rehypothecating user deposits.
Still, PoR is not trustless. It relies on voluntary engagement and does not guarantee full transparency of a custodian’s financial situation.
However, given the industry’s poor record of transparency concerning customer funds, it is considered by many as a start to establishing a minimum standard of self-regulation.
Moreover, exchanges and lenders are encouraged and free to seek additional regulation to increase their reputation in the market and gain their customers’ trust.
Benefits of Proof of Reserves
The benefits of PoR can be summarized as follows:
- Trust: PoR attestations increase the trust of customers and industry operators alike.
- Auditability: PoR is a first step toward demonstrating full solvency and allows the tracing digital assets owned by a company.
- Fraud: PoR establishes a baseline for best practices regarding financial transparency and disincentivizes users from engaging with companies that don’t provide such attestations.
- Customer Protection: PoR demonstrates a willingness to protect assets and prioritize customer interests.
- Counterparty Risk: PoR can help mitigate fear-driven bank runs that result from uncertainty over the solvency of a custodian’s asset holdings.