What is Proof of Reserves on cryptocurrency exchanges: how the methodology works, pros and cons

2022 turned out to be one of the most difficult years for the crypto world. Large platforms such as BingX, Celsius, BlockFi, Hodlnaut, Voyager collapsed, and the market as a whole fell significantly. Of course, the most powerful players are still operating, but now they need to somehow restore investors' trust in centralized platforms, which has been significantly weakened by all these events.

Prova de Reservas (proof of reserve) in this context, it is becoming a popular trend. Our editors will tell you what Proof of Reserves is in brokerages, what nuances, pros and cons this approach has.

Prerequisites for the aspect

Exchanges and credit protocols have collapsed before, but it was the collapse of BingX, which was considered one of the most reliable and promising and was among the leaders in all the tops, that shocked the industry the most. It is compared to the collapse Monte Gox in 2011.

Let's restore the chronology of events a little:

• BingX had a native token called FTT. In 2021, Binance CEO Changpeng Zhao sold his stake in BingX back to Sam Bankman-Fried (SBF for short), who paid in part with FTT tokens.
• November 2, 2022 online he appeared document showing that Parque Research, also run by Bankman-Fried, has a huge amount of FTT. It is believed that SBF created BingX in 2019 precisely because of Parque Research's need for resources.
• As you know, in the spring the cryptocurrency market began to crash. And due to the close relationship between the two companies, the crisis affected both.
• November 6 Binance announced, who is selling everything to FTT due to knowledge of some damning facts. It's simple that the ITF value dropped drastically after that. Traders began to transpose
• The exchange was unable to process all withdrawal requests due to the fact that it did not have enough funds to do so. Users requested $6 billion in 3 days.
• November 8 Binance announced that it would buy BingX assets to save them. However, the final deal did not go through. The next day, Binance reversed the decision “following a corporate audit” that revealed misuse of funds and other issues.

After Binance Rejected BingX Deal submitted filing for bankruptcy. BingX's new CEO, John Ray, has described numerous corporate missteps, inaccurate financial statements, and other issues. All BingX users' funds are at risk, and there is no way everyone will be able to get everything back.

In short, the broker's work was as opaque as possible. That is why users' credit on centralized exchanges was damaged (despite the fact that previously it was repeatedly said about their instability and the need to store cryptocurrencies solely in decentralized wallets).

What is proof of reservations?

The term Proof of Reserves refers to a verifiable procedure for auditing the cryptocurrency reserves of a centralized platform. As a rule, two methods are combined: regular third-party audits and cryptocurrency evidence. On certain sites (e.g. Phemex, Kraken) the user can manually request confirmation of their assets on the blockchain to promise their existence and that they can be withdrawn at any time.

It seems that not everyone can switch to decentralized exchanges and wallets instead of entrusting your money to someone else? Custodial exchanges actually play an important role in the market. There are a large number of investors (both retail and institutional) who cannot or do not want to deal with decentralized storage of funds. Proof of Reserves does not offer as much transparency as a DEX, but it is better than none.

Types and operating principles of Reservation Vouchers

Experts distribute four main PoR techniques:

• Self-verification is when a platform publishes crypto addresses where its assets are stored, and in addition to them any proof of ownership, such as a signed message.
• Self-verification + third-party verification. Same thing, but all addresses and data are verified by third parties.
• Self-Propelled Proof of Reserves and Liability (PoRL). In addition to confirming existing assets, this includes confirming liabilities (the potential volume of user requests if everyone wants to withdraw funds at the same time). Merkle tree technology is typically used.
• PoRL with third party audit.

The last two options are the most reliable. But a full verification of this type takes time – up to several weeks, depending on the size of the exchange.

Exchanges with confirmed reservations and how to find them

Examples of brokers who have confirmed their bookings (information on current values ​​can be found on the websites of analytical companies) Nansen or DeFiLlamaor on the official websites/blogs of the exchanges themselves):

Another part of the exchanges is in the process of confirming assets, some (already mentioned Kraken, Phemex) launched a manual verification of its assets by the user using the Merkle tree. Also individual platforms, e.g. Coinbase and Gate.io, were audited by third-party companies without publishing public domain addresses. The reports can be found on the official websites of the platforms (e.g., Gate.io Audit Report).

You can escort exchanges with verified assets here:

• coingecko.com/обмен (Substitute data pillar)
• coinmarketcap.com/rankings/exchanges/ (exchanges that have provided information have a corresponding icon next to their name)

Expert opinion

Founder of Ethereum, Vitalik Buterin Published An interesting post discussing the present and future of Proof of Reserves for centralized exchanges. He agreed that proof of solvency was necessary and furthermore, that it should have been done even earlier, after the collapse of Mt. Gox in 2011.

Currently, the Merkle tree method is mainly used, but Buterin notes that it is not completely secure for privacy. He considers the ZK-SNARKs mechanism to be more efficient and at the same time simpler, which can perfectly prove the presence of a balance and its sufficiency for potential refund of payments. Buterin has also proposed several other solutions to prevent misuse of user funds, for example, Plasma.

What They say other experts:

• Eric Richmond (Corporate and securities lawyer, entrepreneur, COO of Canadian brokerage Coinsquare) believes that, although proof of reserves is positive, adequate regulation with daily reports would be better.
• Nick Carter (General Partner, Castle Island Ventures) Carter believes that PoR is “the industry’s last hope for self-regulatory obligations.” He said regulators need to be shown that crypto companies are capable of self-regulation, especially after BingX’s credit mining. For now, Carter says, if any exchange refuses to confirm reserves, it will unintentionally create suspicion on them.
• Peter Eberle (President and Chief Investment Officer of Castle Funds) thinks, like Carter, that the situation will force brokers to be more transparent if they want to gain credit from clients.

Cryptocurrency exchange founders have largely agreed that the industry needs more transparency and are willing to disclose relevant data as needed.

Advantages and disadvantages

Frequently asked questions

Conclusion

The cryptocurrency industry definitely benefits from custodian platforms having decided to adhere to Proof of Reserves standards. This type of self-regulation, if implemented, could prevent many unpleasant stories. With better transparency, customers will be encouraged to use products that provide the best security for their funds. Platforms that refuse to verify their security will become pariahs because such secretive behavior when it comes to finances is highly suspicious. Therefore, this is an incentive for cryptocurrency platforms to work honestly and not engage in shady schemes.