The adoption of cryptocurrencies has continued to increase. Hence, the need to ensure transparency and accountability has become more prominent. In recent years, cryptocurrency exchanges have been subject to numerous hack attacks. This hacks cast significant doubt on the safety of the funds in their custody. To address this problem, the concept of proof of reserves service was developed.
What is Proof of Reserves?
Proof of Reserves refers to the concept that prescribes that exchanges or custodial organizations that hold cryptocurrencies should provide attestations to the public. This attestation states that the assets in their custody are synonymous with the assets they have declared. As a cryptocurrency exchange, Proof of Reserves service functions to prove to your investors and users that you control the volume of assets that you claim to hold. It is a form of financial audit that analyses all crypto balances within an exchange to identify liabilities and asset inadequacies.
During a Proof of Reserve attestation, a third-party company examines an exchange’s lending activities and client balances. This is to ensure that the exchange has properly accounted for the funds in its custody. To kick-start the process, the auditor aggregates the asset balances made available by the exchange. Then he or she verifies ownership of the on-chain addresses detailed in the balance, and compares the verified balances with the assets that the exchange has declared.
Why is Proof of Reserves Important?
As investors continue to flood the crypto market, there is an increasing need to conduct in-depth research on a wide range of crypto projects. This is the most suitable route for investors to make informed investment decisions. However, the ability to conduct such research has been hindered by the unavailability of accurate information. This makes the investment process particularly difficult. For instance, when exchanges do not release Proof of Reserves, investors have no way to confirm that an exchange holds the volume of assets it has declared.
Similarly, Proof of Reserves is essential because it builds trust. There are many reports detailing the fact that customers often opt for exchanges that regularly conduct Proof of Reserves, as they rest assured that their funds are safely held. One of the primary benefits of Proof of Reserves is that it is broadly accessible. Thus, a user of an exchange can verify the audit by simply checking that their funds or transactions are accurately recorded. This accessibility ensures that audits are not manipulated since the reviews are public and decentralized.
Problems with Proof of Reserves (PoR)
One of the primary problems with proof of reserves is the risk of data privacy breaches. Because exchanges often have to surrender all forms of data on their accounts, there are risks that clients’ information will invariably be leaked to an unapproved third party. Also, because Proof of Reserve reports has to be made public, there are concerns on whether the public availability of clients’ information could make exchanges more vulnerable to hack attacks.
There is also the issue of lack of simplicity. Because Proof of Reserves service is a highly technical process, many users find it challenging to access Proof of Reserve reports and verify their transactions on the chain. This is particularly problematic, as it could defeat the purpose of the PoR.
How Third-Party PoR Providers Solve the Problem
Despite the sensitivity of PoR processes, some exchanges are increasingly adopting the DIY (Do It Yourself) approach to provide attestations on their assets. However, this is highly problematic, as it reduces trust.
Aside from this, third-party providers possess systems that duly anonymize data during the PoR process and when the report is eventually released. This significantly reduces risks related to hacking attacks or system compromise. For example, third-party providers like the CRD Network provide cutting-edge PoR services to build public trust, prioritize simplicity, and safeguard users’ data. The platform utilizes a wide range of contributors like Amine Lahrib —its founder— who has a wealth of experience across centralized and decentralized financial systems.
The entire concept behind cryptocurrencies is transparency. As such, crypto exchanges need to align their systems towards prioritizing accountability. This would foster clients’ trust and increase cryptocurrency adoption in the long run.