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How Proof of Reserve Establishes Transparency for DeFi Platforms

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The recent collapse of one of the largest exchanges in the world, FTX, has shaken the crypto and DeFi space. Becoming the talk of the town, it has caused many to reconsider their decision to invest in cryptos. The lack of liquidity, mismanagement of funds and questionable practices of its administrators have led to the crash of FTX, taking down with it some other exchanges and the value of major coins like Bitcoin and Ethereum. However, this major incident has once again proved the significance of verifying liabilities for exchanges and custodial institutions.

In the decentralized crypto ecosystem, where systems are designed not to have a single point of failure, it is crucial to have checks and balances in place. Even before the FTX crash, there have been several instances of bankruptcies in the case of traditional financial institutions. As such, a standard practice needs to be formalized to verify liabilities which can be a tricky process where usually a third-party auditor needs to be engaged for a full assessment. Conducting a Proof of Reserve audit can be considered the standard practice to assess the checks and balances of exchanges and DeFi platforms.

For the crypto world to flourish, Proof of Reserve is much required. It should be made the norm as it can ensure transparency and security for investors and put the regulators concerned about some crypto companies’ shady practices at ease.

What is Proof of Reserve?

Proof of Reserve is a method or a way to prove that an exchange platform possesses the amount of cryptocurrency that it claims to have. It is an auditing practice addressing the transparency concerns of assets kept on exchanges. It is a much-needed inspecting technique to ensure that real assets back crypto in a decentralized space.

Proof of Reserve refers to specific due diligence where trusted third-party auditors go through the statements of blockchain projects and give you a clear picture of all the reserves held by the company. Proof of Reserve audit is a way to improve the trust and transparency of the crypto market. It is a way for customers of exchanges and custodial platforms to hold the custodian accountable. It helps users know that liabilities held and the amount of cryptocurrency they have on the platform is backed up by like-kind assets.

Why is Proof of Reserve important?

Custodial platforms reigning the crypto space keep their users’ assets in a hot wallet, which is used to serve withdrawal requests of users. A portion of the user’s deposits is then safely kept in cold wallet storage. Customers acquire a wallet address to make deposits which are moved between the cold and hot wallets.

Custodial financial platforms do not provide total custody of assets to their users, as they keep private keys to these addresses. We can acquire the details of assets held by the custodial institution by tracing transaction details that involve their cold and hot wallets. But it needs to pinpoint individual users’ portion of the total assets. Rather, it showcases only a combined view of the custodial platform’s total assets. This inadequate knowledge of who owns what can lead to a lack of trust among users.

Proof of Reserve audit can be leveraged in this scenario to make an in-depth study of the total assets that the institution holds and find out what portion of these assets the individual users own.

Proof of Reserve integrates the best of both worlds: transparency of asset management and the privacy of customer assets. When a custodian or exchange does not stick to a 100% Proof of Reserve commitment, the platform is prone to the following:

  • The assets of the users are at risk of being misappropriated.
  • Delay or inefficiency in cashing out assets.
  • Inability to cash out assets during crowded withdrawal requests.
  • Prone to bankruptcy or suffer asset losses.

As such, DeFi platforms must perform regular Proof of Reserve audits to monitor their checks and balances.

Let us understand how a Proof of Reserve audit works.

How does a Proof of Reserve audit work?

In Proof of Reserve auditing, the exchange or the custodian partners with a third-party crypto auditor to verify that its balance sheet has enough assets to balance the customer holdings. It ensures that customer holdings are correctly used and real assets back the cryptos held. It offers security and privacy to the DeFi ecosystem as these third-party reports are cryptographically reconciled.

The whole process of auditing is performed using the Merkle Tree technique.

What is the Merkle tree technique?

Invented by the popular computer scientist and mathematician Ralph C. Merkle, the Merkle tree is a method to store data accurately and securely. It is a data structuring approach that eases attempts to access data and upholds its verifiability.

Merkle Tree Technique

The Merkle tree is designed to split up related data into discrete chunks that can be accessed without going through each branch of data. As the name hints, the Merkle tree involves distinct data combined into autonomous branches but bridged to a single root, known as the Merkle root.

The Merkle root ensures that the correct data is stored in each data branch by serving as the data branch’s sole point of connection. It offers a single point of verification for the entire data tree. Additionally, it offers a uniform data protection system, ensuring that the data kept in the branches cannot be altered or destroyed.

Blockchains already employ Merkle trees as their primary data management technique and a fundamental building block to manage the ever-expanding amount of data that its users generate. As each block contributed to the chain is recognized by a hash, the Merkle tree offers a storage and identification system that saves the data according to their hash rather than an entire chain. As a result, data in the block may be confirmed using the block’s hash, which avoids the requirement to compute the entire network’s blocks.

An exchange’s assets and liabilities are represented on-chain in a miniature Merkle tree by a Proof of Reserve. An auditor first makes a regular record of the assets held in custody by an institution before checking the records.

How is a Proof of Reserve audit conducted?

Independent third-party auditors carry out the Proof of Reserve auditing process. The steps involved in the process include the following:

  1. In the initial stage, the external auditor or the auditing company takes a snapshot of the balances the institution has and structures these balances based on the Merkle tree system. The chunks of custodial data for the platform are arranged into a unified data tree, partitioned into branches and authenticated using hash codes.
  2. The auditor then acquires the Merkle root of the data tree, which is the sole point of connection between data in the tree. Leveraging the unique signatures of each account holder, the individual user contribution can be discovered.
  3. To authenticate the individual contributors, the auditor compares the digital signatures to the records on the Merkle tree to verify if the reported balances of the individual are at least equivalent to that acquired from the Merkle tree.
  4. If any contradictions exist in the individual contributions, they will be identified on the Merkle tree, which develops a sharp shift in the data structure. As such, institutions cannot tamper with users’ balances and go unnoticed.

Benefits of implementing Proof of Reserve

Implementing Proof of Reserve offers numerous advantages to custodial platforms and their users.

It offers the following benefits to custodial institutions:

Offers a way to retrieve and maintain users’ trust

Investors’ faith in custodial institutions is rapidly eroding. Investors who use custodial institutions for trading or other financial operations are becoming more fearful due to the shadiness exposed in recent occurrences.

Establishing effective Proof of Reserve facilities and making them accessible to consumers would help reputable organizations restore their customers’ trust.

Gives access to the truth

Despite all efforts to ensure the correctness of an exchange’s internal record-keeping systems, mistakes could still happen, or even worse, loopholes could exist that may be taken advantage of by hostile actors. The hope is that additional sets of eyes will be checking the records for accuracy if they were recorded and were verifiable on-chain.

Incorporating Proof of Reserve can be beneficial to users in the following ways:

Offers a way to confirm that assets are being handled properly

Customers’ ability to confirm the assets held by their institutions is the main objective of Proof of Reserves.

Investors can use these tools to follow changes made to their specific accounts, understand how their money is managed over time, and demand transparency from their institution regarding each activity.

Permit the use of custodial platforms for due diligence

Before opening an account on a trading platform or other cryptocurrency institution, it is recommended to do some background study on the organization, including its financial operations and general integrity. Starting with Proof of Reserve tools is an excellent idea.

Investors will be given the instruments to gather pertinent information about how particular institutions handle their client assets and conduct their own study before entrusting assets to an institution, thanks to the quick development of this concept.

Doing this will lessen the possibility that investors may lose money due to bad circumstances brought on by a custodial institution’s careless handling of users’ money. If investors believe that the platform’s custody practices have grown too risky over time, they can also change or withdraw their investments to reduce losses.

Actual records of transactions

As previously mentioned, applications for Proof of Reserve transparently display an institution’s financial situation. Users of the site can monitor their business operations when done properly.

Using Proof of Reserve audits to build trust among your DeFi platform users

Although DeFi services are cheaper, faster and borderless, the services to evaluate and assess them mostly need to be faster than traditional methods. Outdated methods often need to be revised to cope with the fast-moving pace of DeFi services. This results in an ongoing need for adequate insight and trust for regulators, investors, management, and users. An automated software solution that builds trust and transparency to meet the necessities of the current DeFi space is the need of the time.

A software solution can help portray the result of the audit to the platform’s customers, building trust and transparency among consumers. Because even though several exchanges and custodial institutions conduct regular Proof of Reserve audits, the audit report is not readily available to the users of the platform. Having such an independent hosted site can enable users, regulators or anyone to view the full audit report, its summary and much more. This audit report details the audit procedures conducted by the third-party firm, client account balance liabilities, asset ownership and more information.

Furthermore, features like Merkle verifier for customers can help users verify that their account and balances are included in the Merkle tree. Through this verifier, you can check your path all the way to the Merkle root to see the expanded version of your balance details in the Merkle tree against the brief summary.

Endnote

Proof of Reserve is an audit method conducted by trusted third-party firms to prove that the crypto assets a custodial platform, exchange or DeFi platform possess are greater than or equal to the platform’s crypto liabilities to its customers. Performing regular Proof of Reserve audits can increase trust and transparency among the platform’s users, regulators and investors and build its brand value. It can make the platform financially solid, guarantee the security of users’ assets, build users’ trust and offer 100% cash out in a crowded withdrawal. A 100% Proof of Reserves platform is significant in keeping your platform out of inefficiency and associated bankruptcy.

Need more guidance on Proof of Reserve and how it can establish transparency in your DeFi platform? Connect with our experts.

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Author’s Bio

Akash Takyar

Akash Takyar
CEO LeewayHertz
Akash Takyar is the founder and CEO at LeewayHertz. The experience of building over 100+ platforms for startups and enterprises allows Akash to rapidly architect and design solutions that are scalable and beautiful.
Akash’s ability to build enterprise-grade technology solutions has attracted over 30 Fortune 500 companies, including Siemens, 3M, P&G and Hershey’s.
Akash is an early adopter of new technology, a passionate technology enthusiast, and an investor in AI and IoT startups.

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