You can’t rely on crypto exchanges’ proof of reserve (PoR) declarations to determine whether they’re solvent or not. Neither does it show that your funds are SAFU (safe).
In this post, I will be sharing with you everything you need to know about proof of reserves, its purposes and limitations etc.
What is proof of reserve?
Proof of reserve is verifiable evidence that an exchange holds all of its users’ deposited funds to prove its solvency.
Basically, it shows that all users’ deposits on a centralised platform are fully backed 1:1 by real assets.
Proof of reserves shows that in the event of a bank run, an exchange will be able to process all withdrawal requests without going bankrupt.
How are proof of reserves determined?
The best way of conducting a proof of reserve is via an advanced cryptographic accounting procedure based on the Merkle tree or an independent audit.
Ideally, proof of reserves should show the total liabilities of the company, total customer funds in custody, and the company’s own funds separately.
This will show both backing and solvency because a company can have 100% backing of users’ funds but still be insolvent due to excess liability.
Furthermore, there should be a way to verify that the amount in the proof of reserves is equal to or more than the total users’ deposited funds on the platform.
This is necessary for the proof of reserve to serve its purpose.
What is the purpose of proof of reserve?
The main purpose of proof of reserve is to assure investors that their deposits are fully backed 1:1 by real assets.
Furthermore, it’s also intended to show that a company is solvent and can meet all its liabilities without going bankrupt.
The first is what really matters to most users of crypto exchanges as they want to know that they will be able to withdraw their funds at any time.
The problems with existing proof of reserve by exchanges
1. Requires even more trust
The current proof of reserve system by crypto exchanges still requires trust, which is the exact opposite of what it’s supposed to be.
They declare their wallet addresses showing how much crypto they hold but there’s no way to verify that the amount they hold in these wallets is equal to or more than the total amount of users deposited funds.
So, an exchange can have $50 billion in its proof of reserve declarations but the total users’ deposited funds on the platform are $100 billion.
There’s no way you can know that the reported reserve represents all users’ assets on the platform.
As such, therefore, an exchange can have proof of reserve and still be secretly insolvent.
In this regard, proof of reserve in its current state is nothing but marketing-speak and another gimmick by exchanges to steal your trust.
2. Does not paint an accurate picture
Most proof of reserve declarations combines both the customers’ and the exchanges’ funds to paint a more robust picture of solvency.
Normally, proof of reserves is intended to show that all the platform’s users deposited funds are backed 1:1 by real assets.
There should be a clear delineation between the total users’ funds and the company’s own funds as lumping them all together is not very helpful.
Furthermore, most proof of reserves does not include the liabilities of the company.
However, I feel this last point is going beyond the mark of the requirement for proof of reserves.
I believe proof of reserves’ main purpose is to prove 1:1 backing of depositors’ funds because most crypto exchanges are private companies that do not publish their financial statements.
And proof of liability will require an audited financial statement of the exchange which is very unlikely to happen except for public companies.
What’s good about the proof of reserve concept
The only good thing that’s come out of this proof of reserve thingy so far is that it has raised the demand for more transparency from crypto changes or custodians.
Previously, nobody cared about exchanges reserve, but now it’s almost what everyone talks about, especially after the FTX collapse.
Furthermore, it’s increased the level of both internal and external scrutiny these exchanges get which should put them on their toes and in the right direction to save their business.
The real test of proof of reserve
The only sure way to verify whether an exchange holds 100% of users’ deposited funds is for everyone to withdraw their assets into self-custody.
If truly there’s nothing wrong with the exchanges’ reserves the mass withdrawals will prove that.
But if users’ deposits are not fully backed 1:1 by the real assets, the mass withdrawals will expose them early enough and save many people from falling victim.
Unfortunately, it’s almost impossible to get every user of an exchange to withdraw their funds but with enough people making withdrawals, an exchange without good reserves will go bankrupt fast.
Currently, I don’t see anything in the proof of reserve declarations by crypto exchanges that give any assurances.
Rather, what we’re getting is more questions than answers as the exchanges are not ready or ever going to report their liabilities.
Only an independent audit of their financial statements and reserves will be reliable enough but not many exchanges will be willing to do that.
What do you think? Are you assured of crypto exchanges’ proof of reserve? Share your thoughts with us in the comments section below.