‘Proof of Reserves’ Emerges as a Favored Way to Prevent Another FTX

Crypto exchange FTX collapsed spectacularly into bankruptcy last week as trust in its accounting for billions of dollars in assets vanished.

In the fiery aftermath, some critics are blasting the very existence of centralized exchanges like Sam Bankman-Fried’s, saying they haven’t been reliable stewards for customers’ assets.

But the blowup has reinvigorated the discussion about a potential solution, something called "proof of reserves," or PoR, a way of showing – with little or no doubt – exactly how many tokens are at any exchange that adopts the technique. If in place at FTX, proof of reserves could have in theory prevented customers’ money from being moved where it shouldn’t have been (to Bankman-Fried’s trading firm Alameda Research).

Binance, the world’s largest cryptocurrency exchange by volume, has already shared its wallet balances and says it plans to conduct a proof-of-reserves snapshot “in the next few weeks.” Other exchanges that have made similar commitments include Gate.io, KuCoin, Poloniex, Bitget, Huobi, OKX, Deribit and Bybit.

Read more: Indian Crypto Exchange Giottus Says It Will Provide Proof of Reserves, While Rivals Remain Silent

Proof of reserves is an auditing technique used to confirm assets on hand. Stablecoin issuers like Paxos use it to prove they have sufficient assets backing their tokens, while exchanges like BitMEX use it to prove customer deposits correspond to assets in custody.

“It would have been a pretty solvable problem if there was more transparency on the balance sheet. We already power multiple stablecoins and multiple gold coins and multiple financial institutions, where we prove their balance sheets through proof of reserves,” Sergey Nazarov told CoinDesk in an interview. Nazarov is the co-founder of oracle network Chainlink, which offers a proof-of-reserves product.

How does proof of reserves work?

There are several ways for an entity to prove its asset reserves, from traditional third-party audits by companies like Armanino to "Merkle tree proofs" (cryptographic verification via data structures called Merkle trees).

Read more: Proof of Reserves: Could It Have Prevented the FTX Meltdown?

Then there are methods employed by blockchain analytics companies. Chainlink, for example, separates proof-of-reserves implementation into two categories: off-chain and on-chain.

The off-chain alternative involves a third-party provider like Chainlink receiving API (application programming interface) access from an exchange, its custodian or its auditor to independently verify the exchange’s holdings.

The on-chain route involves a proof-of-reserves smart contract on one network (usually Ethereum) that receives data feeds (on a block-by-block basis) from Chainlink’s oracle network about a provider’s on-chain wallet balances on another network (e.g., Bitcoin).

Either way, the result is users can verify a company is actually holding the assets it claims to be holding.

Industry experts weigh in

Eric Richmond is a corporate and securities lawyer turned crypto entrepreneur. He founded and ran Tetra Trust, Canada’s first licensed digital-asset custodian in 2019. He is now the chief operating officer at Coinsquare, one of Canada’s largest cryptocurrency exchanges.

Read more: Canadian Digital Asset Brokerages Coinsquare and CoinSmart to Merge

Coinsquare is a registered investment dealer that reports to the Investment Industry Regulatory Organization of Canada (IIROC), a self-regulated collection of more than 170 dealers similar to the Financial Industry Regulatory Authority (Finra) in the U.S. Richmond believes while proof of reserves is a step in the right direction, regulation might be a better solution.

“We have an obligation to run daily reports to view our client liabilities versus assets in cold storage,” Richmond explained. “Every single day, we ensure one-to-one in cold storage, which is a requirement of ours under IIROC registration.”

Cold storage means keeping assets offline, not connected to the internet.

Other experts like Nic Carter believe proof of reserves is “the industry’s last hope in terms of making a strong self-regulatory commitment.” Carter is a general partner at Castle Island Ventures, a firm that invests in crypto financial infrastructure.

“Lord knows we need to represent to regulators that we are capable of self-regulation, especially after FTX shattered confidence like this,” Carter told CoinDesk.

“PoR would inhibit situations like Quadriga, FTX or Gox. If any exchange now refuses to do one, I should expect that people will be extremely skeptical of them," he said.

In the 2019 collapse of QuadrigaCX, Canada’s largest cryptocurrency exchange at the time, it was later revealed its late founder and CEO, Gerald Cotten, had misappropriated and misused client funds, leaving only a fraction of value behind for its creditors to claim. In the 2014 implosion of Tokyo-based bitcoin exchange Mt. Gox, poor security practices and questionable fund activity resulted in a massive hack. Creditors are still fighting to regain some of those lost funds. The downfall of those platforms, like the collapse of FTX, forced the industry to consider significant improvements to fund and custody management.

Peter Eberle, president and chief investment officer of Castle Funds, a cryptocurrency-focused investment firm, echoed Carter’s comments.

"I believe this will force exchanges to be more transparent. They will need to prove that they are not commingling funds and that they are not lending out customer assets. They will have to earn trust from customers that they actually have the assets that they say they do,” Eberle told CoinDesk. “Audited financial statements, proof of reserves, will be standard going forward. This is something that should always have been the case, but wasn't."

Johnny Lyu, CEO of KuCoin, one of the largest global cryptocurrency exchanges, also agrees the industry needs more transparency. He says his organization has already started to provide attestations.

“This is a matter of self-regulation within the entire industry. In terms of our next steps, we'll look at our internal data, and then find out what kind of data can really reassure our users. And then we'll work with the third parties to disclose data as needed,” Lyu told CoinDesk in an interview. “So far, we've already disclosed information of the bigger and more influential tokens, including ethereum and BTC.”

Read more: Let’s Actually Commit to Proofs of Reserve This Time, Okay?