What is Proof of Reserve?

Proof of Reserve (PoR) is a concept in cryptocurrency, especially for stablecoins and asset-backed cryptocurrencies, that provides collateral verification. Essentially, PoR is a receipt that shows that a crypto exchange or issuer has enough collateral to back the total number of issued tokens.

In cryptocurrency, a reserve refers to a pool of assets held by an entity, such as a cryptocurrency issuer or a decentralized protocol. These assets are commonly referred to as collateral. For example, a fiat-backed stablecoin would need a reserve of fiat currency. Similarly, a commodity-backed cryptocurrency would need a reserve of the physical asset pegged to it, such as precious metals or oil. Reserves can be on-chain, such as high-value cryptocurrency, or off-chain, such as money or natural resources. People in charge of safekeeping these collaterals are collectively known as custodians.

In an ideal world, investors should be able to trust that issuers have enough underlying assets in reserve for redemption. In practice, this is often risky for investors, as seen in events such as the downfall of FTX. Therefore, investors and issuers strive to come closer to a trustless world without a single point of failure. Therefore, PoR is integral to instilling trust and transparency in stablecoin issuance and crypto as a whole. 

Proof of Solvency and Proof of Liability

Proof of Reserve, along with Proof of Liability (PoL), makes up Proof of Solvency (PoS). In very brief terms, PoS demonstrates that an entity holds assets exceeding its liabilities, ensuring its ability to meet financial obligations in unforeseen circumstances. PoS is a broader assessment of an entity’s overall financial health. 

A simple equation to show the relationship between PoS and PoR is:

PoS = PoR – PoL

There are two main ways to verify PoS. Traditionally, issuers may enlist the help of a third-party accounting firm to conduct audits on their solvency. Some issuers and exchanges also use an innovative technology called “zero-knowledge.” Using this approach, an organization can generate cryptographic proofs (zk-proof), enabling one party to verify the accuracy of its solvency statement to a third party without divulging any information.

Why did Proof of Reserve exist?

In early 2022, one of the largest crypto exchanges ever existed experienced major liquidity issues after customers began taking money off its platform en masse. Earlier that month, it was discovered that there was no fiat currency or any other valuable cryptocurrencies in its reserve. 

Years later, FTX still struggles to return client funds in full, seemingly never recovering from its downfall in 2022. Due to precarious financial accounting on reserve assets, FTX paved the way for its demise and indirectly reduced trust in crypto investing.

FTX is a prime example of the need for a credible PoR system to mitigate counterparty risks for investors. PoR serves as a tool to promote more transparency in crypto using verifiable and unmanipulated information. PoR exists primarily to provide transparency and assurance to digital currency users, particularly those of stablecoins and asset-backed cryptocurrencies. 

How does PoR work?

PoR is one of the building blocks for crypto issuers. PoR is built on the basis of the Merkle tree, a data structure used to encode blockchain data more securely and efficiently. Additionally, most crypto exchanges and issuers often publish reserve balances on their website, with some even providing daily or monthly attestation.  

The Merkle Tree

The Merkle tree is crucial in implementing PoR without revealing sensitive information. In a PoR system utilizing Merkle trees, the reserve holdings are structured and organized into a Merkle tree data structure, as shown below.

In this diagram, the last row from the top is called the “leaf nodes”, the intermediate row is called the “internal nodes”, and the first is called the Merkle root. If a custodian or exchange deposits their funds in several financial institutions, information about these amounts will be hashed (encrypted) into the leaf nodes. On the diagram, these are represented as Hash A, Hash B, Hash C, and Hash D.

These leaf nodes are then jointly hashed into pairs, represented in the diagram as Hash AB and Hash CD. Ultimately, these paired hashes are grouped and encrypted into one point, represented as Hash ABCD. Hash ABCD serves as a single hash representing the entire set of reserve holdings.

When providing PoR, the entity can publish the Merkle root along with a subset of Merkle tree leaf nodes corresponding to a sample of reserve assets. Users can then independently verify the integrity of the reserve holdings by recalculating the Merkle root using the provided leaf nodes and comparing it with the published Merkle root. 

For example, if you want to verify the existence of Hash A, you can query the network about it. It will return Hash B, Hash CD, and Hash ABCD. Given that we have B, CD, and ABCD, the only missing hash is Hash A, which gives you sufficient proof of its existence (as Hash A must exist as the building block for the other hashes). The same mechanism applies to prevent changes from being made undetected, which makes PoR less prone to tampering.

Audit and attestation

PoR audits and attestations are critical mechanisms in reserve verification. Independent third-party firms or auditors with expertise in financial accounting and blockchain technology conduct these audits. Auditors assess the accuracy and reliability of the issuer’s financial statements, confirm the existence and sufficiency of reserve assets, and ensure compliance with regulatory requirements and industry standards.

Upon completion of the audit, the auditing firm provides an attestation report detailing its findings and conclusions regarding the issuer’s reserve holdings. This report serves as a transparent and credible validation of the issuer’s solvency and reserve backing, reassuring users and stakeholders. In short, the audit checks a digital asset’s underlying collateralization, while the attestation is the written report of the findings to confirm reserve data. 

Why is Proof of Reserve important?

1. Greater transparency and confidence: Cryptocurrencies operate in decentralized environments where trust is essential. PoR helps to build trust by providing verifiable evidence that the digital currency in circulation is fully backed by assets held in reserve, thereby ensuring its redeemability and stability.

2. Risk mitigation: Users of digital currencies face risks such as issuer insolvency or mismanagement of reserves. PoR mitigates these risks by providing evidence that the issuer holds sufficient reserves to cover the circulating supply of the digital currency.

3. Regulatory compliance: In many jurisdictions, financial regulations require issuers of digital currencies to maintain reserves equivalent to the value of the issued tokens. PoR helps ensure compliance with these regulations by providing verifiable evidence of reserve holdings.

4. Market confidence: PoR enhances confidence in the cryptocurrency market by promoting transparency and accountability among issuers. It reduces the likelihood of fraudulent activities or manipulation of reserve assets, thereby fostering a healthier and more trustworthy ecosystem.

PoR plays a crucial role in instilling trust, reducing risk, and promoting stability in the cryptocurrency space, making it an essential mechanism for both users and issuers of digital currencies.

Challenges and drawbacks 

While PoR offers transparency and assurance in the backing of digital assets, it also presents several challenges and drawbacks.

1. Privacy concerns: PoR requires disclosing information about the entity’s reserve holdings, which may include sensitive financial data. Balancing transparency with the need for privacy can be challenging, especially in cases where disclosing reserve details could compromise competitive advantages or expose vulnerabilities to malicious actors.

2. Complexity and cost: Implementing PoR mechanisms, such as cryptographic audits or real-time transparency solutions, can be complex and resource-intensive. Entities may face significant costs associated with audits, technology development, and ongoing maintenance, particularly for large-scale operations.

3. Centralization risk: Some PoR solutions may rely on centralized entities to verify and validate reserve holdings. This introduces a centralization risk, as the integrity and impartiality of these entities become critical factors in maintaining trust and credibility.

StablR’s Proof of Reserve

StablR issues EURR, a Euro stablecoin. Using Chainlink PoR on Ethereum, StablR provides users unmatched transparency into the fiat currency backing our tokens. Chainlink is the leading decentralized network, providing fully automated verifications for off-chain and cross-chain reserves. 

With the Chainlink integration, StablR adds an extra layer of transparency for investors, making EURR a reliable investment to store your asset value or carry out transactions.

Learn more about StablR’s Proof of Reserve

The future of Proof of Reserve

The future of Proof of Reserve is likely to evolve in several directions as the cryptocurrency ecosystem continues to develop and mature.

Technological advancements

Continued advancements in blockchain technology, cryptography, and data analytics are expected to enhance PoR mechanisms’ efficiency, security, and transparency. Innovations such as zero-knowledge proofs, multi-party computation, and decentralized oracles may further improve the verifiability and confidentiality of reserve holdings.

Regulatory developments and standardization

As the cryptocurrency industry matures, there may be efforts to establish standardized protocols, guidelines, and best practices for implementing and auditing Proof of Reserve mechanisms. Standardization can enhance interoperability, comparability, and trustworthiness across different digital asset issuers and platforms.

Growing adoption

PoR is a good solution to the problem of trust in crypto investments, which may make its adoption and use more prevalent among coin issuers, asset custodians, and cryptocurrency exchanges. 

Conclusions

PoR is a mechanism used to inject more trust and transparency into cryptocurrency, especially when it comes to verifying current collateralization for digital assets. Using advanced encryption and automation, PoR promises a trustless world where assets held in reserves are reflected truthfully, making crypto investments more stable. The future of PoR promises greater transparency, trust, and reliability in the cryptocurrency ecosystem, paving the way for broader adoption and integration of digital assets into mainstream finance.