By Larry Wright
Introduction
The cryptocurrency market has been called a nascent industry. Because cryptocurrencies have only been around for only a decade, it also seems true. In comparison, other financial products such as commodities, i.e. gold, paper money, and stocks, have been around for at least more than a century.
Therefore, many financial experts claim that cryptocurrencies, both as a technology and a financial instrument, are in the process of going through evolution until their mainstream adoption.
The reader will learn about proof of reserves in this article which is a new solution for DeFi protocols to overcome the latest challenges.
What is Proof of Reserves?
Proof of Reserves or PoR is like a financial audit conducted by a third-party organization to ascertain the financial claims of a DeFi protocol. Companies are operating under the regulations of centralized monetary agencies.
By the force of the law, these financial enterprises are required to conduct an audit through a neutral financial checker to make sure that they are compliant with the laws and ensure the safety of their clients.
However, DeFi enterprises are not under the purview of the financial regulators; therefore, it is often difficult for the users to ascertain what is happening in the background. This is where Proof of Reserves comes in.
The objective of this type of financial audit is to make sure that DeFi enterprises provide solid evidence regarding their financial claims for the benefit and confidence of the users.
How does Proof of Reserves Work?
Proof of Reserves is very much like a financial audit for a DeFi protocol. However, in this case, the developers prefer to use technologies like Merkle Tree. This is an accounting protocol that can break down the complex data streams stored in blocks, on-chain bits, and smart contracts to ensure faster and more transparent processing of financial reconciliation.
The most important objective of such DeFi audit systems is to find out whether the protocol is financially stable or not.
At the same time, it can also measure the available liquidity, the amount of reserve, and the true ratio of pegging and check any other financial claims.
The users wish to understand how the DeFi protocols are using their custodial funds and how well the financial management is happening behind the scenes. It can improve the situation of FUD spreading in the cryptocurrency markets.
At the same time, the consumers would not want to make massive withdrawals that could bankrupt an organization and bring down the aggregate selling pressure that triggers supply rush and volatility in the DeFi sector.
The Implementation of Proof of Reserves
The context of proof of reserves started from the point of FTX collapse as a result of a conflict between FTX founder SBF and Binance CEO CZ. As a result of the internal conflict between the two largest cryptocurrency exchanges in the world, the internal mismanagement practices of FTX were revealed.
The consumers were shocked to hear that FTX had been siphoning funds from the custodial accounts of the consumers to lend support to its sister organization called, Alameda Research.
Furthermore, there were astonishing revelations, such as SBF having built a backdoor to siphon the funds from the custodial accounts as special access. There were also allegations about collusion between the SEC chief and SBF working in tandem to run a financial scam.
On the other hand, the controversial enterprise was known to make sizeable donations to a particular political party to aid in election campaigning. The result of these claims was a panic situation in the market where FTX investors rushed to dissolve their positions, and it resulted in the collapse of the exchange in a matter of a few days.
The entire situation is still unravelling, disclosing controversial management practices of the regulated cryptocurrency exchange. The DeFi sector, which is known for its attention toward financial inclusion and transparency, suddenly came under the dark cloud of suspicion.
FTX was a giant in the cryptocurrency sector, and its collapse triggered a domino effect that took down other related organizations such as Solana, Gemini, Genesis, and BlockFi. On the other hand, the cryptocurrency whales also went into a division over siding with or speaking against SBF.
Under these circumstances, the volatility increased in the cryptocurrency market and prolonged the bear market that was already under pressure from inflation, fed policies, and recession.
Origin of Proof of Reserves
The idea of Proof of Reserves was first pitched by Ethereum co-founder Vitalik Buterin. Following the FTX collapse, Binance CEO and many other cryptocurrency organizations brought PoR to public attention. It was a way to restore the faith of cryptocurrency users in the market and stop the increasing communication gap.
There are some cryptocurrency proponents like Nic Carter who have advocated for the need for Proof of Reserves implementation for years before FTX’s demise. Carter has maintained on his website with examples that PoR is still in the development phase.
Types of Proof of Reserves
Proof of Reserves is not a singular entity, and it can be further divided into types and sub-types for better understanding:
Cross-chain Reserves
Cross-chain Reserve is a type of DeFi audit where the protocol tracks all the sources where the total reserves are stored. It does not limit itself only to the on-chain pathways, such as the Bitcoin blockchain but extends to all its connected payment paths, such as Chainlink Node, using external adaptors.
The scope of cross-chain reserves is extended to custodial service providers, and it can run a query for a dynamic list of addresses through a composite adapter. It can be further divided into two methods:
Wallet Address Manager
By way of IPoRAddressList address via management contract and it could self-attest the addresses under ownership.
Self-Attested Wallet API
It works on identifying all the wallet addresses that are present on the self-hosted API networks.
Off-Chain Reserves
Off-chain reserve proofs are mostly dependent on APIs and conducted using external adapters. Here are its three basic methods:
Third-party API
The auditor who is present on a third-party network is going to look into the total reserves outside of the on-chain purview. The data report would be compiled on an API submission.
Custodial API
Using this method, a banking API or a custodian API will read all the available reserves directly.
Self-attested API
The auditing API, in this case, is under the ownership of the token issuer’s native platform, and they will read and perform the reserves audit for the whole DeFi protocol.
The Process of DeFi Audit Using the Proof of Reserves Method
It is important to break down the entire process of the Proof of Reserves network to develop an in-depth understanding of this system. The basic idea is that any DeFi protocol owns the funds submitted by its clients in the form of hot wallets.
The users are free to make withdrawal requests. These funds move between hot and cold wallets when withdrawal or deposit requests are made. Therefore, the audit protocols can measure the cash flow by tracing these transactions between hot and cold wallets.
On the other hand, the funds also move in other ways, such as staking, swaps, and several other options. Therefore, much more work needs to be done to get an accurate fund flow history or audit of reserves. This is where Merkle Tree is used.
What is Merkle Tree?
In simple words, the Merkle tree is a data structure spread like a real tree. At its base, there is the root called Merkle root. All the branches of the Merkle data structure are spread out to collect data to report back to its main root.
These branches are distributed in a manner that each one can be accessed as an individual entity and as a collective; they also junction the information at every retracement point. Therefore, all the branches are autonomous, but they are connected to a single root.
Furthermore, the Merkle root also ensures that the correct amount of data is stored in each autonomous branch and acts as a singular verification port. At the same time, the root prevents data manipulation or damage.
It is scalable concerning the native blockchain in the way that it keeps growing adjacent to the DeFi host. The Merkle Tree stores the data in the form of hashes rather than on-chain. Therefore, a comparative analysis of hash and chain data can be used as an audit.
On the other hand, the liabilities of the blockchain are stored off-chain by Merkle Tree. Whenever there is a change in the balance of a single custodial reserve, it is recorded on the Merkle Tree autonomous branch immediately, which triggers a visible shift in the overall data structure.
One important use case is that it can be used to generate a unique digital signature to identify digital signatures.
Importance of Proof of Reserves
In the aftermath of FTX’s decline and insolvency, the entire cryptocurrency market is in a state of shakedown. To contain the frenzy, some of the major cryptocurrency exchanges, such as Coinbase, Bybit, and Binance, have decided to make their Merkle Tree certificates public.
On the other hand, other DeFi enterprises are planning to make it happen in the future. Imagine a bank that is in danger of going out of business without warning.
Naturally, the consumers of the said banks are going to want to withdraw their funds and save them as soon as possible. It is a fact that most financial enterprises use custodial reserves for different ventures rather than keeping them static.
However, every DeFi protocol must ensure that it has enough liquidity to retain stability despite any major selling pressure wave.
To this end, Bybit CEO Ben Zhou has recently tweeted that the exchange platform is committed to making the keep clients’ funds secure and ensuring keep them in a 1:1 ratio despite being only a custodial services provider.
Many cryptocurrency proponents believe that there is a lack of transparency in the DeFi sector. It is paramount that the cryptocurrency community demand implementation of PoR to evolve the blockchain network to the next level.
Thus far, only the most exclusive consumers of the biggest financial enterprises can get a detailed report on the performance of the company through an independent audit.
DeFi has a chance to make these services available for the average user to increase the efficiency of the DeFi networks and make them more valuable in turn.
The presence of Proof of Reserves is going to provide an overall view of the internal management practices conducted by a DeFi network.
Retail investors must learn how to read and understand these reports to make sure that they can grasp the full picture. Here are some important steps that users can follow to access the information and break it down into micro components:
Official Website
The DeFi Community is unique in the way that the founder, node validators, miners, and other key personnel in the space are always available to the users. These key persons can set up cryptocurrency communities on social media platforms or start a blog where the native participants of their community can ask questions and vote for a new request.
In this manner, the consumers who are looking for Proof of Reserves reports can visit the site map or the official blogs of these DeFi protocols. They are likely to find the results already there, or they can also contact the key influencers in the sector to run queries.
Third-Party Auditor
In many cases, third-party auditors can perform Proof of Reserves runs on DeFi protocols because they are open-sourced and permissioned networks.
Consumers who wish to do in-depth research can also run a comparative analysis between PoR reports conducted by different third-party platforms to ensure transparency.
Trust Pilot Page
Trust Pilot is one of the oldest and most trusted online review platforms. This platform has also affiliated with DeFi protocols. The consumers and the local community members who are present there can gain access to the PoR reports if they are working in tandem with registered custodian services provided, such as Armanino.
Custodial Service Providers
Custodial services providers are one of the best ways to collect or reconcile the information related to the PoR requirements.
The dashboard of these custodial services sites that are working in tandem with the DeFi services often contains live projections of the total reserve outflows and inflows.
Merkle Tree Certificates
Merkle Tree is a very specific and specialized tool for DeFi audits. The bigwigs in the cryptocurrency sector are very likely to go with this option.
The consumers can demand a Merkle Tree certificate, and they can also visit the pages or download it from the official website of the respective DeFi protocol. Some exchanges also provide access to the Merkle Tree hash for the benefit of their users.
Open-Source Download
At present, BitMEX is the only exchange that allows users to download the proof-of-reserve software from an open-sourced page. In this manner, the users can track all the results live on their computer systems.
At the same time, the users can also run specific commands on the PoR software to gather information about different types of reserves.
Dashboard Bulletins
Cryptocurrency aggregator Nansne.ai is a dashboard that displays live information about the reserve changes in different exchange platforms. Cryptocurrency investors who wish to check them for technical analysis or confirmation can visit it to collect the PoR details.
The PoR stream for each exchange has been broken down into cryptocurrency assets, transaction history, and associated wallet addresses.
Limitations of Proof of Reserves
Nic Carter, who has been a longtime proponent of PoR, has pointed out that there are some limitations associated with the current PoR practices. Here are some listed for the benefit of the investors:
Liabilities
There are some organizations, such as BitMEX, that have included liabilities in their PoR disclosures. It means that the users who are unable to make a distinction would not understand what it stands for.
The current interface and report structure of the PoR is complex, and only a small percentage of investors can diagnose and break it down.
Fund Embezzlement
There is a notion that many cryptocurrency organizations pass around funds among each other to pass out of the PoR audit phase. The rumours are not yet proven, but they are enough to invoke an air of panic and distrust among the investors.
Therefore, PoR needs to come up with a live updating solution that checks all the reserves at all times and broadcasts it in real time for the benefit of the investors.
Private Keys
Several cryptocurrency organizations reserve private keys under their ownership. It simply means that they can do whatever they want with the custodial funds of the users at any given stage. PoR does not do anything to address this important issue.
Dynamic Audit
The PoR report is static and done in one sweep. At other times, the exchange platform might get away with borrowed funds, or it might refrain from projecting its off-exchange liabilities.
Therefore, PoR needs to be ingrained with the basic structure of the DeFi protocol to ensure complete transparency and security for its investors.
Conclusion
The CEO of BitGo, Mike Belshe, has interjected that PoR is a good start. The idea is the foundation for ensuring transparency and fair practice in the DeFi sector without the intervention of the regulators.
As soon as financial regulators are involved, the crypto sector is exposed to taxonomy laws automatically. For the evolution of financial networks, these cryptocurrency enterprises must comply with PoR and work on updating it to address all the issues as they arise.