What does Proof of Reserves Mean? Is it an Ideal Way of Assuring Trust?

Following the FTX saga, there has been a worry about users' trust in centralized exchanges. One of the ways through which centralized exchanges can show transparency and gain users' trust is by issuing their exchange "Proof of Reserve (PoR)." What do they mean by PoR? What are the benefits and limitations?

What is Proof of Reserves?

Proof of Reserves (PoR)is a strategy adopted by using cryptographic verification to verify ownership of digital assets. Centralized exchanges use it to ascertain their solvency and assure customers that the exchange will be eligible to pay out customer deposits in market volatility.

PoR refers to digital assets verified through on-chain methods like tracking wallets. It does not include off-chain assets like cash reserves or other fiat assets.

What Makes PoR Important?

1. It boosts Users' Trust: A Proof of Reserves (PoR) attestation signals vigilance regarding a centralized exchange's solvency. It enables user trust in a custodian and testifies to a certain degree of transparency the custodian guarantees. While it is clear that proof of reserves can deliver a different transparency than non-custodial, blockchain-based platforms, their advocates argue that more transparency is better than nothing.

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. When combined with public and legally binding disclosure of liabilities, users can view proof-of-reserve attestations to verify on-chain that the custodian has enough assets to back a third-party audit of deposits.

3. It helps to kick against bad behavior: Proof of Reserve (PoR) makes it more challenging to hide illegal and unethical business practices like rehypothecating user deposits.

The Benefits of Proof of Reserves

• Trust: Exchanges can regain the trust of their users and the general crypto community by conducting a truly transparent Proof of Reserve (PoR). If the audit is done in good faith, it will help restore trust and adoption.

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

• Fraud: PoR creates a baseline for decent practices regarding financial transparency and disincentivizes users from engaging with companies that don't provide such attestations. Users can easily detect any exchange that is not financially transparent, and they can move away from such exchanges.

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

Limitations of Proof of Reserves

• Proof of Reserve (PoR) cannot prevent hacks. From 2020 till now, hacks have been a significant way through which exchanges have lost money.

• Proof of Reserve (PoR) is not secured as your coins are in your private wallet. Don't forget that "Not your keys, not your coin." Trust no one, not even the largest centralized exchange. The future is toward total decentralization. Some exchanges may not report their liabilities while showing proof of Reserve (PoR).

• PoR is not trustless. It relies on voluntary engagement and does not guarantee full transparency of a custodian's financial situation.

Final Thoughts

Exchanges should ensure that their audit is done in good faith, and regulators should always be at the door to sanction any exchange manipulating their PoR.