Definition and function of proof of reserves in the crypto economy

The crypto industry is on a new stage of innovation and many custodians are showing interest in setting up a proof of reserves. What is it and what does it do? Many believe that it is a step in the right direction while others show concerns about what it entails for crypto trading. 

Proof of reserves (PoR) isn’t a new concept in the crypto space. Its first formal use dates back to 2014 by Bitfinex, a renowned crypto exchange. It wasn’t seen as essential until recently and more institutions revolving around crypto trading show interest in integrating them into their practice. Here’s everything you need to know about PoR—from what it is to how it is envisioned to help in crypto trading:

Basic definition of the term ‘proof of reserves’ (PoR)

Defining the PoR can be a complex matter because of its many important factors. Its broadest definition is that it’s a method of verifying if an institution has enough money to cover the assets it holds on behalf of their customers. The algorithm used is always from a third-party to serve as an auditor with a neutral stance between the customer and the custodian or exchange. 

Its more specific definitions can be further elaborated with proper understanding of its factors. Here are the details you should know about crypto proof of reserves and its functions:

Auditing meaning

‘Audit’ is an accounting term meaning an official inspection of an entity’s financial documents. It aims to balance the assets and liabilities to see a company or individual’s viability to continue running a business. The results are shown both to the entity for the sake of improvement and to their customers to establish trust. 

Auditing involves going through various records like balance sheets, income statements, cash flow statements, and bank statements. Invoices and receipts are also important in this activity no matter how small because micromanaged finances are part of the company’s budget. 

Traditionally, auditing also involves interviewing key personnel like the treasury, human resource, and managers regularly to verify documents. Crypto-based businesses like exchanges don’t need that because all transactions are tracked on a transparent blockchain. Thus, a proof of reserve blockchain typically uses cryptography for a quick and accurate assessment of liabilities and assets. For proof of reserves crypto, all of these details are typically counted in smart contracts as well as ongoing transactions. 

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Difference between liabilities and assets

The most basic definition of liabilities and assets is that one refers to expenses while the other is property and resources respectively. In finance, they are two opposite categories in the company’s balance sheet. Liabilities account for all commitments like payable loans, taxes owed, and obligations to business partners as well as investors. Assets include investments, loans, inventory, and company property. 

Third-party auditing meaning

‘Third-party’ means that neither the customer nor the company directly controls the PoR auditing the latter’s accounts. It’s important to establish neutrality between the two parties for the sake of transparency. Besides that, customers also benefit from this arrangement because the auditing results are more likely to be accurate. For companies, they can have an accounting department under their control to do this for them but it would be costlier than outsourcing the task. 

Acceptable reserve level

There is no exact standard for an acceptable reserve level because it scales with the company and its customers. The general rule of thumb is that the company needs to have a sufficient level of reserves to pay for all their customers’ assets. How this is traced depends on the auditor but this is similar to tracing liabilities and assets in a balance sheet. 

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How PoR function in the economy

What is proof of reserves in crypto and why is it important? The most direct answer to that question is that PoR establishes company transparency and gives the customers reassurance. A more complex answer is that it prevents a liquidity crisis, a situation where assets are unable to be liquidated. 

Prevention of liquidity crisis

This is possible if the financial institution lacks the reserves to refund all assets to their customers in case everyone needs to cash out. It is next to impossible to recover from a lack of short-term cash flow but it is preventable with the proper insight. Auditing through PoR is the best way to foresee such a future and give the institution time and insights to solve it. 

Importance of PoR for exchanges

Regular auditing is crucial because it’s easier to solve a liquidity crisis the sooner it is foreseen. Proof of reserves blockchain can also help pinpoint specific weak points in the company’s accounts. Despite how helpful it is in theory, many exchanges and customers alike consider it unnecessary in the grand scheme of crypto trading. Therefore, it can be considered non-mandatory but highly recommended.

Recent trends regarding PoR 

Crypto exchanges who are in support of implementing proof of reserves explained that 2021-2022 customers need to take this method seriously for the good of the economy. Crypto assets are now regular topics in mainstream news but distrust is a common concern from the public and here’s why:

Surge of demand for PoR after FTX meltdown

The biggest news that rocked the crypto industry in 2022 was the collapse of FTX. It was one of the leading cryptocurrency exchanges but it filed for bankruptcy on 11th November following a surge of withdrawals from customers. Former CEO Sam Bankman-Fried reported that the company didn’t have enough reserves to support the liquidity demand at the time. 

Major exchanges regular public PoR report

Customers are now wary of exchanges following FTX’s bankruptcy. If such a large company failed, then it’s possible for any to meet the same fate. Distrust in these trading platforms can be alleviated if not solved by PoR. Regular auditing and public reports of reserve levels can at least prevent the same problems that FTX faced even if it were against a hacker. The customers simply need proof that the company has enough money to pay for all assets deposited whether they get a surge of withdrawals. 

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Concerns over PoR

It’s already agreed among crypto traders that they need any kind of proof of exchanges’ accounts being enough to cover their liquidity demand. However, there are still some concerns over what is proof of reserve as a credited service. There are three possible issues that customers need auditors and exchanges to address:

False sense of security

Cryptocurrencies are volatile and there’s no telling when they’d surge in price. Therefore, a reserve of these digital assets is likely to outscale the reserve level unless the auditor counts an equally volatile source. Likewise, it’s also possible for the value to drop for the same reason. This is why even the most accurate and transparent PoR report can cause a false sense of security in an otherwise volatile market. 

Omission of liabilities

Many customers want to point out that PoR in crypto is different from a traditional auditor because it will be entirely on the blockchain and it’s run by cryptography. The best way to make an accurate balance sheet is to have all liabilities and assets recorded on-chain like in transaction records or in smart contracts. However, many liabilities do not exist on-chain like taxes and loans (unless it’s on a smart contract). These can be overlooked, intentionally omitted, or inaccurately communicated in PoR. 

Proof of reserve: A step in the right direction

Despite its concerns, there is a strong argument that the proof of reserve is a step in the right direction for exchanges and customers alike. Everyone needs proof that liquidity needs to be available at all times in the economy. After all, you’d want to claim your profits quickly whether you are a trader or a gambler at Gamdom. Simply knowing that an exchange can cover your assets is enough to maintain a peace of mind. There just needs to be further innovations in proof of reserves methods to instil greater confidence among crypto users. 

FAQ

Proof of reserve as a concept is a bit complex. There are plenty of rabbit holes to delve into, sprouting more questions the more you learn. Here are some of the most frequently asked ones:

What is a proof of reserve?

A proof of reserve (PoR) is an independent audit of a crypto business’ accounts. The goal is to balance their liabilities and assets to ensure that they have enough reserves to cover liquidation. 

Why is proof of reserves important in crypto trading?

Proof of reserves gives crypto traders confidence in an exchange with high reserve levels. This also shows transparency in a crypto company, an important trait in the trading industry.

How does a proof of reserve help an exchange?

Low reserve levels can indicate an eventual liquidation crisis in the exchange. PoR audits can help foresee these events and provide insights into what needs to be done to solve it. 

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Words: Clarence Clarke