Can Proof of Reserves Bring Transparency to Crypto?

The barrage of news about FTX’s collapse means that it will take time to disentangle the many narratives emerging from it. But that hasn’t stopped many people from suggesting solutions to ride out the current crisis of confidence in crypto.

One of those proposals comes from Binance chief Changpeng Zhao, an instigator of the current crisis in crypto. His suggestion is for cryptocurrency exchanges to publish Proof of Reserves or the composition of their wallet addresses online. [There is, of course, rich irony that the founder of a crypto exchange – a centralized reservoir of coins – is asking for transparency in an ecosystem founded on principles of decentralization but we can leave that aside for later discussion].  

For the uninitiated, Proof of Reserves are the sum of balances of anonymized individual wallet addresses, verified by actual users and authenticated by auditors, from an exchange.

Proof of Reserves: A Problem to Solve Another Problem

The idea behind Proof of Reserves may sound like a simple concept but it is difficult, even, impossible, to implement.

One of the possibilities is that of fraud. It is possible for a single entity to create multiple wallet addresses. What is to stop crypto exchanges then from artificially boosting their asset holdings by stuffing new wallets with tokens issued by the exchange itself or one issued by a related concern? For example, FTX’s biggest holdings, amounting to $2.2 billion, were of a thinly traded token called Serum – a decentralized exchange in which Sam Bankman-Fried, cofounder of FTX, was an investor.

Presenting anonymized addresses in a Proof of Reserves report also presents a problem. Auditors will find it difficult to verify that all addresses have been included and that these addresses belong to actual users and entities (as opposed to bots or a crypto exchange’s affiliates and companies) without verification by users themselves.

This is akin to a bank asking customers to verify their account balances each time they are audited by regulators. Whether crypto exchange users will choose to participate in such a costly and complicated process is open to question.

The situation becomes even more complex for customers with large balances at crypto exchanges. They might choose to self-custody their digital assets for additional protection, meaning the exchange will not have access to their private keys. Available balances in such wallets could be misrepresented, or even excluded, by the exchange if they contain toxic assets.

Another problem in the creation of a Proof of Reserves report relates to nature of crypto trading. Crypto volatility makes it difficult to ascertain an accurate valuation for crypto assets, leading to creative accounting practices to justify risks. It does not help matters that the Financial Accounting Stability Board (FASB) has not provided guidance related to crypto accounting. A report is only as good as the issuing authority’s credibility. Crypto lacks credibility from established institutions.

Maintaining transaction logs also becomes a necessity to ensure integrity of accounting. For example, exchanges can easily transfer balances between entities when they publish a Proof of Reserves report to give the illusion that they have sufficient crypto on hand to cover withdrawals.    

A Problem of Liabilities

As the sequence of events in the past six months have shown, it is the backroom dealings and interconnections between various entities that determine winners and losers in the crypto ecosystem. The incestuous relationships between major players in the crypto industry means that a liquidity crisis at one quickly snowballs into insolvency for many.  

A Proof of Reserves report provides no information about such dealings. FTX had $2.2 billion worth of Serum on its books. Could a Proof of Reserves report have alerted users to the problems on its balance sheet?

Not really, since users would have remained unaware of its liabilities and relationships with other entities. At least on the face of it, Serum had a market capitalization, even as FTX’s unraveling was making news, of $88 million on Friday.

While the market capitalization of thinly traded cryptocurrencies is a matter of debate for those who are well-versed in crypto machinations, that figure might look respectable enough to investors enamored with the big names peddling FTX to customers.

A Usability Problem  

Apart from lacking credibility, Proof of Reserves may also suffer from a usability problem. The reports published, so far, have been either bland statements (such as this one from Binance) or a garble of hashed addresses, such as this example from Hong Kong-based Bitfinex, owner of stablecoin Tether.

The latter report provides zero useful information to the average user and simply lists wallet addresses and cryptocurrencies associated with them. It does not provide account balances or information about recent activity. Transaction logs are important because exchanges can boost holdings of wallets temporarily by shuffling holdings between their entities.    

In the end, a Proof of Reserves report may be another attempt by exchanges to evade comprehensive audits. Without a window into the liabilities of an exchange, such a report will end up as another useless artifact manufactured by the crypto industry for its own purposes.

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