Finance

What Is ‘Proof of Reserves’ & Can It Help Avoid Another FTX?

01/18/2023
Bitcoin Ethereum News

As the crypto economy grapples with the epic meltdown of FTX, one of its top exchanges, there are a lot of questions being raised on what the future holds for this market. While scams, hacks, and gross misrepresentations are nothing new for crypto investors, it is very well possible that what happened over the past few weeks is the last straw, and transparency is the name of the game going forward.

The rise of centralized exchanges with a trading app allowed for a seamless way to buy crypto, trade, and transfer assets, helped propel this market to the masses, but going by the debacles over the past year, these exchanges will likely bring the end of cryptocurrency. From FTX to Celsius, and Terra to Mt.Gox, there have been too many, and it’s a miracle that people still have a shred of faith in this market.

In light of increasing scrutiny, and growing regulatory headwinds, stakeholders of the crypto economy have introduced a new concept, aimed at bringing an end to such cases of fraud, once and for all. Known as ‘Proof of Reserves (PoR)’, this is a novel attempt at independently auditing the assets held by a crypto exchange as a custodian of its investors, in the absence of regulatory authorities such as the SEC.

The concept was recently endorsed by Changpeng Zhao, the CEO of Binance, as a means of reinstilling trust among investors and the broader crypto community. Binance is set to adopt PoR as a means of showcasing total transparency for its investors shortly, but in the meantime, questions are still being posed by skeptics, naysayers, and even proponents of crypto on whether this is just another charade.

How Does Proof of Reserves (PoR) Work?

PoR is essentially a cryptographic method of proving to the customer’s of an exchange, where exactly their money is being held, along with the exchange’s ability to process withdrawals without running into liquidity issues. The process of auditing involves taking anonymized snapshots of all balances held, which are then aggregated into something called a Merkle tree, a cryptographic commitment scheme.

A Merkle tree is labeled with a data block’s cryptographic hash in each leaf, or node, which eventually leads to the Merkle root, a cryptographic fingerprint that identifies the combination of all these balances at the time when the snapshot is created. The independent auditor then verifies that these balances match the total funds held by the investors as evidenced by the Merkel tree, and stored as reserves.

A number of centralized crypto exchanges have already completed their proof-of-reserve audits, namely Kraken, Bitmex, Coinfloor, and HBTC. Other popular exchanges such as Binance, Huobi, KuCoin, and Crypto.com are yet to prove the same. All exchanges should adopt this concept to retain their customer’s faith going forward, and the ones who fail to do this, will likely see an extended bank run in the months ahead.

To Save Crypto, We Must Turn To The Blockchain

In the wake of multi-billion dollar debacles, the likes of FTX, BlockFi, and Celsius, many long-term proponents, experts, and influencers have started to think that the rise of centralized exchanges was itself a step backwards for this new financial economy. After all, the core essence of blockchain is its radical transparency, along with decentralized ownership and storage of information.

The ‘Proof-of-Reserves’ concept is essentially blockchain-based evidence, something that existed even during the earliest days of crypto. As such, this turn towards centralized exchanges with opaque business models seems more akin to the AltaVista and the hordes of other search engines that were around before Google arrived on the scene.

Is SEC Regulation Inevitable?

The way things stand, even if all exchanges and major players adopt a stance of radical transparency, it still wouldn’t be enough to regain the trust of investors. It certainly will not do enough to stave off the upcoming regulatory actions by the SEC which aims to classify all exchanges as broker-dealers, while regulating the launch of new altcoins, and heightened scrutiny for stablecoins such as the USDT.

Some in the community have in fact started to welcome this move, citing the involvement of the SEC, backed by the long arm of US Federal enforcement agencies, will only increase the mainstream appeal and adoption of the crypto markets. Others, however, feel that this move will undermine the sole purpose of cryptocurrencies, that is, to stay clear of government regulations and central banking.

Final Verdict

Global cryptocurrency markets remain at a crucial juncture, with regulatory forces, disruptive innovations, and changing trends all coming together for a transformation of epic proportions. With this, it remains to be seen how markets, prices, and valuations will play out one year ahead, following what was the crypto market’s first ever bearish year, being dubbed by some as a ‘Crypto Winter.’

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