Proof of Reserves (PoR)

What Is Proof of Reserves (PoR)?

What Does Proof of Reserves Mean?

In theory, proof of reserves should assure customers of a custodian’s solvency and increase confidence in their business. In practice, however, proof of reserves can be manipulated or tampered with or can simply not reveal the full picture.

For instance, PoR can be tampered with by borrowing assets on a short-term basis while the balance sheet snapshot is provided. Thus, PoR should always include wallet addresses to enable the tracking of fund movements. 

Who Does Proof of Reserves?

Exchanges

• Kraken (auditor-assisted, user validation with merkle approach, point in time) (11/2022)
• BitMex (self-assessment, user validation with merkle approach, ongoing) (11/2022)
• Coinfloor (self-assessment, user validation with merkle approach) (08/2021)
• Gate.io (auditor-assisted, user validation with merkle approach, point in time) (05/2020)
• HBTC (self-assessment, user validation with merkle approach, point in time) (05/2021)

Lenders

• CakeDeFi (quarterly attestations with proof of assets) (11/2022)
• Nexo (auditor-assisted, ongoing) (daily attestation)
• Ledn (user validation with merkle approach, ongoing [semi-annually]) (08/2021)

Another set of exchanges provided a proof of assets with no corresponding liabilities:

Why Do We Need Proof of Reserves?

PoR is useful for several reasons:

1. A PoR attestation signals vigilance regarding an exchange’s solvency. It increases user confidence in a custodian and testifies to a certain degree of transparency the custodian guarantees.

2. PoR is a means of self-regulation. Even though some exchanges are not regulated in the United States, PoR may result in more favorable treatment by US regulators and more confidence from their user base.

3. PoR makes it more difficult to obscure illegal and unethical business practices like rehypothecating user deposits. 

Still, PoR is not trustless. It relies on voluntary engagement and does not guarantee full transparency of a custodian’s financial situation. However, given the industry’s poor record of transparency concerning customer funds, it is, by many, considered a start to establishing a minimum standard of self-regulation. Moreover, exchanges and lenders are encouraged and free to seek additional regulation to increase their reputation in the market, and in doing so, gain their customers’ trust.

Benefits of Proof of Reserves

The benefits of PoR can be summarized as follows:

• Trust: PoR attestations increase the trust of customers and industry operators alike.

• Auditability: PoR is a first step toward demonstrating full solvency and allows the tracing of digital assets owned by a company.

• Fraud: PoR establishes a baseline for best practices regarding financial transparency and disincentivizes users from engaging with companies that don’t provide such attestations.

• Customer Protection: PoR demonstrates a willingness to protect customer assets and put the customer’s interest first.

• Counterparty Risk: PoR can help mitigate fear-driven bank runs that result from uncertainty over the solvency of a custodian’s asset holdings.