What is proof of reserve on cryptocurrency exchanges and can it be trusted

Proof-of-Reserves (PoR) may become a new trend on cryptocurrency exchanges. This is a certificate that the exchange has reserves that cover customer deposits. Proof of reserves online – myth or reality?

After the sudden crash of FTX, many traders panicked and a massive exodus from the exchanges began. The tech-savvy rushed to the DEX, while the most cautious decided to “sit on the fence”, with bitcoins in their personal wallet.

The bankruptcy of FTX is not related to the shortcomings of cryptocurrencies as a technology, so it is most likely that its consequences will be short-term, despite the amount of information noise. The market is influenced by many other, stronger factors. And yet, it will not pass without a trace for the industry and will lead not to collapse, but to the recovery of the market.

The biggest closures of cryptocurrency exchanges and how to protect yourself from them

Over the years, the cryptocurrency world was shocked by three high-profile ruins of exchanges, which resulted in losses for hundreds of thousands of customers:

February 2014: The bankruptcy of MtGOX, according to the official version, was caused by a robbery of 850,000 BTC, at the date of the declaration of bankruptcy – about $480 million. Later, 200,000 BTC were covered by the owner of the exchange, Mark Karpeles, from a reserve wallet. The “hackers” have not yet been found, and research suggests that there was no instant robbery. It is more likely that bitcoins from MtGOX were withdrawn gradually over two years, possibly with the participation of an insider. Bankruptcy was only a public admission of insufficient capital and the impossibility of paying traders.

July 2017: the closure of the Russian-language BTC-e exchange by US intelligence agencies. In the fall of 2018, the WEX exchange slowly died, an unsuccessful attempt to revive BTC-e on a more legal basis. Even after six years, the actual losses and the number of victims are unknown, as well as the location of the main assets of the exchange. Traders are believed to have lost hundreds of millions of dollars on BTC-e. Many versions have remained unproven. The only citizen of the Russian Federation reliably involved in BTC-e, Alexander Vinnik, is in an American prison. The fate of another alleged BTC-e administrator, Alexey Bilyuchenko, remains unknown.

November 2022: The first crash of a relatively legal and public FTX exchange caused by market factors. Despite the mass of conspiracy theories, no criminal trace has been identified for FTX. The most likely reason for the exchange’s bankruptcy remains poor asset management by its subsidiary, Alameda Research.

Participation in dubious projects, the geopolitical crisis and the fall of the markets led to the formation of a “hole” in the amount of up to $10 billion. The owner of FTX, Sam Bankman-Fried, allocated $4 billion, mainly owned by clients, to save the “daughter”. FTX’s total debt to creditors could range from $3 billion to $6 billion. This is the largest bankruptcy in the history of the fiat currency industry. However, in bitcoin, losses on MtGOX remain unbeatable.

The interesting thing about these bankruptcies is that they all had different causes. This means that each of them needs its own protection. However, the only protection when using centralized exchanges is constant monitoring of the market and news. And when information about the problems of the exchange appears, the most prudent thing will be to take your feet in your hands and flee. If the rumors turn out to be false, it will not be difficult to return the assets to the exchange.

Protection from Gox

In 2013, MtGOX was the largest cryptocurrency exchange. The factor “too big to fail” (“too big to fail”) was the main reason for investor confidence – no one believed in the possibility of ruining the exchange. But the “underwater part of the iceberg” turned out to be unreliable for purely technical reasons. At the same time, it doesn’t matter how MtGOX was hacked, whether the theft was one-time or the exchange was really “milked” for two years.

The main vulnerability of MtGOX was the tying of all exchange operations to one person, Mark Karpeles. He single-handedly developed all the code, made development decisions, managed capital, and even ordered water for the office. As a result of such hypertrophied centralization, the exchange naturally collapsed. Mark Karpeles served several years, and clients are still waiting for payments.

MtGOX did not implement a policy for auditing reserves and code. To protect against such cases, it is necessary to pay attention to the quality of the exchange services, its publicity, the level of corporate governance and the availability of audits of the financial condition. And only then look at low commissions, referral bonuses and other means of attracting customers. This is especially true for exchanges that have recently entered the market.

Large modern cryptocurrency exchanges have already grown from the “handicraft” level and are not tied to one person. They have their own development staff and a complex management structure. Due to the huge number of new projects, hacks happen frequently. However, in recent years, usually do not lead to critical consequences for large exchanges.

Protection against BTC-e

In terms of the degree of anonymity of both owners and customers, BTC-e was unique even for its time – now there are no such sites left. But cryptocurrency exchanges are still associated with the shadow economy, which means they run the risk of being investigated or even raided by special services.

When choosing an exchange, you need to pay attention to the jurisdiction and disclosure of information about its owners. If the real beneficiaries of the exchange are unknown, not public, or there are suspicions that they are only figureheads, this should be taken into account as a serious risk factor. Offshore jurisdiction also increases the risk.

Most cryptocurrency exchanges are still not public enough, but the biggest players in the industry are already doing a lot in the fight for clients.

FTX Protection

The bankruptcy of FTX was unexpected not only for customers, but even for many employees of the exchange. The company and its founder were public, the technical part of the platform worked flawlessly. A large client base and good marketing, even in a falling market, allowed the exchange to make a profit and delight numerous investors, among whom were large venture capital funds and leading companies in the industry.

It is still difficult to explain why for so long no one paid attention to the risks of providing capital to Alameda Research with its own token, because its reporting was available to investors. Obviously, the FTT token was a reliable asset in their eyes, although the company held itself in the air by the hair, like Baron Münghausen.

It is likely that the “hole” in the finances of Alameda Research and the parent company was discovered really by accident and this was the result of publicity. If the backing of Alameda’s assets with FTT tokens had not been disclosed, Binance CEO Changpeng Zhao would not have been the reason for the devastating tweets.

How can a retail investor and a simple speculator protect himself from the risks of bankruptcy of another exchange if a sudden drop threatens even the largest and most public ones? It is impossible to completely avoid risks in the free market. But exchanges that conduct independent audits and periodically publish reports deserve more trust than others. These now include Coinbase and Kraken, Binance, Bitfinex, Bitstamp, Huobi and other exchanges of the top twenty are actively striving for them. With Asian exchanges, the situation is more complicated, since they operate in a slightly different reality, and their approaches are not always clear to investors who are accustomed to Western standards of information disclosure.

What is Proof-of-Reserves and what will it change

The best tool to combat panic today was invented by the founder of Binance, Changpeng Zhao. He is going to implement a really new concept that brings centralized exchanges closer to decentralized ones. Recently, Binance began publishing information about the total balances of bitcoins on their wallets under the name
“Proof of Reserves” (Proof-of-Reserves, PoR).

While the system is in its infancy. It displays only the amount of bitcoin users in the wallets of the exchange, “withdrawn” at a certain point in time. At the time of publication, one photo is available from November 22. Over time, a more complete and up-to-date impersonal layout of the presence and movement of assets of both users and the exchange itself can be implemented. Now on the service page it is noted that the exchange’s own funds are stored in separate wallets.

Shortly after the launch of PoR, Kraken founder Jesse Powell stated that “the evidence is not real” because it does not take into account liabilities and negative account balances. However, according to the service page and Binance announcement, when calculating reserves, not only the presence of BTC on wallets is taken into account, but also open obligations on them: in margin and derivative trading, as well as Binance Earn services. In addition, it is planned to involve third-party auditors and introduce the zk-SNARKS protocol to “balance sheet” for all user assets. Without detailing the calculations, we still have to choose who to believe (or not to believe).

Binance customers can check the reserves of their own accounts in their Dashboard on the exchange, as well as directly on the blockchain using an open source Python tool. In its current form, such an operation can only be done by technically advanced users.

At the time of publication, the PoR is exclusive to BTC, but in the coming weeks Binance plans to expand it to all major cryptocurrencies and tokens, and subsequently, possibly even to all listed on the exchange. However, in its current form, PoR’s “probative power” is still insufficient, as it only shows the total value, not showing what is behind the scenes. Therefore, Proof-of-Reserves requires an independent audit.

If such an audit system is expanded to include all major crypto assets, it will truly revolutionize the transparency of cryptocurrency exchanges. This level is still inaccessible even for the most regulated stock exchanges and brokers. After all, even the regulator does not see the real picture of their current state. He has access only to periodic reporting, which still needs to be checked, and current transactions passing through the exchange, which can also be distorted.

Since “proof of reserve” is still a new technology, legitimate questions arise about it. Firstly, it is a proof of the correspondence of the data shown to the real crypto assets of the exchange and operations with them. Cheating in a transparent blockchain is much more difficult than with fiat money, where you can draw any numbers without external control. But cryptographic proofs provided on the basis of unverified initial data are not perfect either.

The second, even more important circumstance is that centralized exchanges work not only with crypto assets, but also with fiat currencies. And here online checks in real time are not possible. As the FTX story has shown, a hole in capital can arise for external reasons, independent of the operations of the exchange. And if the debt accumulates in fiat assets, then the PoR system will not be able to show its existence in any way.

Thus, it is possible to fully certify the reliability of the financial condition of the exchange only by traditional methods. This is a periodic cross-audit of its work by independent organizations. That is, one auditor checks the work of the exchange, and the second checks the results of the first. And the exchanges that take such a step can be considered really reliable. But their clients can forget about anonymity and tax evasion, except for obviously criminal methods.

Do not forget about the additional guarantee of the capital of the exchange – its “lodge” placed in the provision of its own stablecoin. Also, subject to an independent external audit, tens of billions of dollars in USDT, USDC and BUSD collateral serve as a weighty argument in favor of the solvency of parent companies. But the recent refusal of Huobi from its own stablecoin may be a negative signal, indicating that the exchange does not have free funds.

The ideal “exchange of the future” could be a platform that could combine the “managed anonymity” and control of capital of traders inherent in the DEX, with the speed and convenience of transactions, which so far only centralized exchanges can boast. But will regulators allow such a hybrid to exist?