Why Crypto Exchanges Need It

Imagine giving your funds to someone and hoping they don’t run away with them. That’s the basic issue of trust that crypto exchanges try to solve using something called Proof-of-Reserves (PoR). Just like banks follow rules to keep enough money aside, crypto exchanges use Proof-of-Reserves (PoR) audits to show they can be trusted, though they still have some flaws. For example, they can’t check for liabilities and only rely on regular reporting. This article talks about Proof of Reserves audits, what they do in crypto, and how they’re changing to make sure exchanges are solvent.

What Does Proof of Reserves Mean?

Increasingly, cryptocurrency exchanges use proof-of-reserves audits to make sure they have enough assets to cover customer deposits. These cryptographic checks give transparency based on Merkle trees and on-chain data, similar to how banks have to abide by capital adequacy regulations.

Is This Idea Taken From Traditional Finance?

Regulators have long told financial institutions they need to keep a certain amount of capital reserves. Losses are avoided, and banks can handle market shocks better. In 2008, the global financial crisis caused by banks with too much debt was a key event. As a result, regulators made procedures stricter.

The Basel III framework from the Basel Committee on Banking Supervision was a big adjustment. Its goal is to regulate and control risk better in the banking sector.

• Regarding CET1 Capital, banks must maintain a certain amount of common equity relative to their risk-weighted assets.
• Leverage Ratio indicates how much a bank can borrow compared to the amount of money it has on hand.
• The Liquidity Coverage Ratio (LCR) makes sure that banks have enough cash on hand to sustain 30 days of tough economic times.
• NSFR makes sure banks have stable, long-term funding.

Collectively, these safety measures are meant to lower systemic risk and make banks more ready for sudden changes in the economy.

Similarly, Proof of Reserves (PoR) audits in crypto try to provide the same level of confidence by proving that digital asset platforms hold the crypto they say they do.

These audits certify reserves for users, and they work especially well for centralized platforms. Some say the reserves are worth dollars, while others say they are worth major coins like $84,137 worth of Bitcoin or $1,982 worth of Ethereum.

How Do These Proof Checks Happen?

For proof that an exchange’s reserves match its user deposits, proof-of-reserve audits use cryptographic techniques, mostly Merkle trees. Notably, they don’t show solvency because they don’t show off-chain liabilities like debts or loans.

The process begins with checking the assets. For verification purposes, exchanges either publish wallet addresses or cryptographic proofs that keep user data safe.

These “Merkle trees” combine the balances of each user into a single hashed root called the “Merkle root,” which can be checked by both users and auditors.

You can also use external auditors to ensure that the reported reserves match the actual holdings. This procedure helps check that platforms aren’t taking on too much. PoR audits also compare total liabilities (user deposits) to reserves.

Some of these traditional Merkle-based PoRs are still not perfect. In addition, they can’t say if the exchange has any hidden debts or assets that were borrowed. Here’s where zero-knowledge proofs (ZK-proofs) come in.

ZK-proofs let exchanges show that they have full support without giving out private information like wallet addresses or account balances. Beyond basic reserve validation, this could allow proof-of-solvency systems that respect privacy. Despite their ongoing development, a few exchanges have already begun testing these systems.

Better audits became abundantly evident following the FTX collapse, where customer funds were misrepresented. If you combine Merkle trees with ZK-proofs, crypto could get closer to having reliable solvency checks that make sure platforms have what they say they have and aren’t hiding anything.

How is Proof of Reserves Linked with cbBTC?

1:1 backing by Bitcoin: Coinbase only gives out cbBTC tokens when they have the equivalent amount of Bitcoin safely stored. This ensures that each cbBTC receives full backing.

Concerning cbBTC assurance, Proof of Reserve (PoR): Coinbase checks its Bitcoin reserves against the number of cbBTC tokens in circulation. User confidence is boosted by these reports, which are published regularly.

No using reserves again: Coinbase doesn’t lend or move the Bitcoin backing cbBTC. It’s kept under protection. That’s why at any time users can trade cbBTC for real Bitcoin.

Coinbase verified users from the US (except New York), the UK, the EEA, Australia, Singapore, and Brazil can currently use cbBTC. They can also access it along with Coinbase Wallet via third-party platforms that support it.

It’s Not Perfect, But It’s a Step Forward

Although proof-of-reserves isn’t perfect, it is an important step in the right direction. There is visibility, even if not all red flags can be found. In the future, Proof of Reserves audits might not only help with crypto, but they might also help with checking tokenized assets and debts in traditional finance.

Ultimately, PoR should change to verify the solvency of any platform, DeFi, CeFi, or TradFi. Proper implementation could establish it as the global benchmark for trust in the tokenized financial world. In short, many believe it’s not perfect, but it’s better than blindly trusting.