The widespread deployment of proof of reserves by exchanges will increase the security of your assets, but how exactly?
Centralized exchanges are under growing pressure to provide Proof of Reserves (PoR) for their customers as the cryptocurrency industry and investors struggle to recover from crises like Celsius, Voyager, 3AC, and the most recent disaster, FTX. Some companies, like Bitmex, Ledn, Gate.io, and Kraken, have already made this information available to their users. Other significant exchanges, including Binance, OKX, Kucoin, Huobi, and Poloniex, have announced they intend to follow suit in the next few weeks.
With the PoR mechanism, exchanges can assure users they have enough cash to support client deposits and, more importantly, withdrawals in the event of a “bank run.” It is regarded as a critical component of exchange security and transparency. However, PoR publication is just half the fight. Exchanges must go one step further and submit to a PoR Audit to validate the data they provide to their users.
Why Conduct a PoR Audit?
The bankruptcy of regulated financial firms is seldom a concern in the traditional financial industry. For example, even during the 2008 financial crisis, governments and central banks continued to tighten prudential and capital adequacy criteria to safeguard the sustainability and stability of these crucial institutions.
In contrast, no regulatory agency is in place to support a company like FTX or Celsius in the digital asset market. As a result, investors were left holding an empty bag when these exchanges and others abruptly stated they were bankrupt. These circumstances provide a compelling argument for the need for verification of reserves and an even stronger one for a follow-up audit.
A proof of reserves audit is carried out by a competent, independent third party to confirm that a custodian (exchange) maintains the assets it claims to hold on behalf of its clients. The auditor creates a Merkle tree from an abstracted snapshot of every customer balance. All customer balances are included in this data structure in a way that preserves their privacy. A Merkle root, a cryptographic record that specifically identifies the combination of these balances at the time the snapshot was created, is then acquired by the auditor.
Finally, the exchange will provide digital signatures showing ownership of on-chain addresses to the auditor. The auditor will then check whether these balances match or exceed those of clients represented in the Merkle tree.
Why Exchange Self-Reporting Is Beneficial to Crypto
Cryptocurrency exchanges are critical components of the digital asset ecosystem since they provide liquidity and enable price discovery. As a result, these exchanges must be transparent and ethical.
Self-reporting is one approach for exchanges to show their commitment to transparency. This includes revealing PoR, hacking or theft occurrences, and giving information about their listing rules and processes.
And there are other reasons why exchanges should self-report, including preserving public trust, safeguarding users, and creating an industry precedent.
Keeping End Users SAFU
In the end, crypto investors stand to win when exchanges self-report and share information on Proof of Reserves. Sharing proof of reserves data also helps to build confidence across exchanges. When one exchange provides its data, it establishes a standard for others to follow. It also incentivizes users to deposit their funds on exchanges that provide this information.
A Roadmap to a Better Future
The recent run of bankruptcies among large cryptocurrency exchanges has led many end users to lose faith in these platforms and cryptocurrency as a whole. It is a reasonable reaction, considering that these platforms are accountable for protecting user capital. When self-reporting and audits become standard practice, crypto exchanges, launchpads, and other custodial platforms can show their communities that transparency is central to their operations, enabling DeFi to reach new levels of global acceptance.
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