Proof of Reserves (PoR): Addressing the Issues of Transparency at Crypto Exchanges

Cryptocurrency exchanges play a vital role in the overall crypto ecosystem, facilitating trading and providing a platform for users to store their funds. However, the lack of transparency in the operations of these exchanges has been a persistent concern for the cryptocurrency community. In an industry built on decentralisation and trustless systems, the opacity of exchange operations raises questions about the safety and security of users' funds. Proof of Reserves (PoR) is an emerging concept that aims to address these transparency issues by verifying the digital asset collateral held by crypto exchanges. In this article, we will explore the concept of Proof of Reserves, its origins, the exchanges implementing it, and the limitations it faces.

Proof of Reserves (PoR) is a mechanism that allows crypto exchanges and other crypto trading firms to demonstrate their verified cryptocurrency reserves on an underlying blockchain network. The purpose of PoR is to provide greater transparency to depositors through public attestations and independent audits. By showcasing their cryptocurrency reserves, exchanges aim to assure users that they hold enough assets to meet their obligations.

Since blockchains are publicly verified and secure networks, exchanges can use them to reliably demonstrate that they have as much cryptocurrency reserves on the blockchain as the total of all their liabilities to clients. PoR leverages the transparency and security of blockchain technology to provide evidence of sufficient reserves, enhancing the credibility of crypto exchanges.

Under the PoR system, exchanges typically aim to demonstrate that they have as much funds in a certain cryptocurrency as they owe to their clients at any given time.

The concept of Proof of Reserves first gained prominence in November last year, amidst the turmoil related to the FTX exchange collapse. Binance was the exchange that championed the idea of PoR, realising that the FTX disaster was driving a precipitous fall in customer trust towards crypto exchanges.

In early November, Binance announced its intention to introduce PoR and, later that month, publicly released its PoR data. The data demonstrated that Binance held Bitcoin reserves at 101% of its liabilities.

Over the following few months, Binance gradually introduced PoR for dozens of other popular coins. Today, most leading cryptocurrencies, such as USDT, USDC, and BNB, have PoR implemented by Binance. In some cases, Binance holds significantly more reserves than its liabilities to customers. For instance, the reserve ratio for BNB coin stands at nearly 124%.

Recognising the importance of customer trust, many exchanges competing with Binance have adopted the PoR model. Exchanges such as Coinbase, OKX, Kraken, and Gate.io have implemented PoR to provide greater transparency to their users. However, it is important to note that not all prominent exchanges have embraced PoR yet. The relative novelty of the PoR model is probably part of the reason why its adoption has been far from universal.

While PoR may sound like a nearly perfect system, there are inherent drawbacks that prevent it from being an infallible solution. Firstly, it is up to the exchange to reveal the complete extent of their customer liabilities. Less-than-honest exchanges might easily hide their liabilities, disclosing only a portion of them and providing PoR for that subset.

Furthermore, PoR does not account for fiat currency liabilities, which can be significant for some exchanges. Fiat currency holdings are not verifiable on the blockchain, making it challenging to provide a comprehensive view of an exchange's total liabilities.

Additionally, verifying PoR information requires a thorough audit. Ordinary users do not have practical means to independently verify if the PoR data published by an exchange is true. To address this, exchanges conduct regular audits to validate their PoR data. However, the availability and reliability of crypto audit companies can be questionable in some cases. Some of these companies have unclear origins, and little is known about their potential affiliations with the exchanges they audit.

Unlike reputed public companies, crypto exchanges do not rely on the "Big Four" for their financial audits. The lack of standardised audit processes and established authorities in the crypto industry adds to the challenge of ensuring reliable and trustworthy PoR audits.