The collapse of FTX (one of the biggest exchanges in the world) has shaken crypto and DeFi markets. Many have rethought their decisions to invest in cryptos after it became the topic of conversation. The crash of FTX caused by lack of liquidity and mismanagement of funds as well as questionable practices from its administrators, has resulted in the destruction of other exchanges and the devaluation of major coins like Bitcoin, Ethereum, and others. This incident once again shows the importance of checking liabilities for custodial and exchange institutions.
Decentralized crypto ecosystems have many points of failure. It is important to have checks in place. Even before the FTX collapse, there were numerous bankruptcies at traditional financial institutions. A standard practice must be established to verify liabilities. This can be tricky and requires that a third-party auditor be hired to complete an assessment. To assess the checks on DeFi platforms and exchanges, a Proof of Reserve audit could be considered the best practice.
What is Proof Of Reserve?
Proof of Reserve can be used to show that an exchange platform actually has the amount of cryptocurrency claimed to have. This auditing technique addresses the transparency concerns regarding assets stored on exchanges. It is a crucial inspection technique to make sure that real assets return crypto in a decentralized environment.
Proof of Reserve is an audit that allows trusted third parties to review the statements of Blockchain projects. They then give you a complete picture of the company’s reserves. Proof of reserve audits are a way to improve trust and transparency in crypto markets. This audit allows customers of exchanges or custodial platforms hold their custodian accountable. It lets users know if they are subject to liabilities and how much cryptocurrency is available on the platform.
Why is Proof of Reserve important?
Custodial services that rule the crypto space store their users’ assets within a hot wallet. This hot wallet is used to process withdrawal requests. Cold wallet storage is used to store a portion the user’s deposit. Customers receive a wallet address which allows them to make deposit requests. The cold and hot wallets can be switched between by the customers.
Custodial financial services do not give full custody to users as they retain private keys to these addresses. It is possible to trace transaction details that have been made using their cold and hot accounts to obtain information about assets held by the custodial institution. However, it cannot pinpoint the individual users’ share of the total assets. Instead, it shows only a combined view on the total assets of the custodial system. Inadequacy in knowing who owns what could lead to distrust among users.
In this scenario, proof of Reserve audit could be leveraged to perform an in-depth review of the total assets of the institution and discover what percentage of these assets are owned by individual users.
Proof of Reserve offers the best of both: transparency in asset management and customer assets privacy. The following are signs that a custodian/exchange is not adhering to a 100% Proof of Reserve pledge:
- Misappropriation of users’ assets is possible.
- Cashing out assets inefficiently or with delay
- Inability to cash out assets when there are many withdrawal requests.
- Suffer from asset losses or bankruptcy.
DeFi platforms will need to perform Proof of Reserve audits on a regular basis in order monitor their checks, balances, and other information.
Let’s see how Proof of Reserve audits work.
How does a Proof of Reserve audit work?
Proof of Reserve auditing involves the exchange or custodian partnering with a third-party crypto auditor in order to verify that its balance sheets have enough assets to balance customers holdings. It makes sure that customer holdings are correctly utilized and that real assets are returned to the cryptos. These third-party reports are cryptographically reconciled, which provides security and privacy to DeFi’s ecosystem.
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