This is Part 2 of our 2-part series on Proof of Reserves (PoR). Here you can find a link to Part 1. In this article, we look closer at what the benefits, the risks, and the uses cases of a Proof of Reserve are.
So, without further ado, let’s dive into the Proof of Reserves.
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What Are the Benefits of Proof of Reserves (PoR) ?
The benefits of PoR are in establishing trust. It is one of the few ways that crypto exchanges can do this. So, let’s have a look at three PoR benefits.
- It shows that your assets are safe and secure. The crypto market isn’t regulated. If an exchange can show that it can handle a bank run, you know your assets are safe. It also proves that the exchange isn’t using your assets for unauthorized investments. For example, lending or trading.
- It offers greater transparency. It also makes exchanges more accountable. For example, it can prove that wBTC (wrapped Bitcoin) is actually backed by real BTC.
- It keeps track of exchange activities. In other words, your assets are not used, for instance, for lending or trading. So, exchanges don’t start working as traditional banks. They started this trend with lending user deposits. PoR prevents exchanges of putting your assets at risk.
So, the PoR increases general trust in crypto exchanges. In turn, exchanges will experience a better client retention.
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What Are the Risks of Proof of Reserves?
We already covered some risks of PoR in Part 1. However, it is good to remind you of what they are. Here are some of the concerns about PoR, for instance:
- Ownership of wallets. Pointing to a wallet doesn’t necessarily prove ownership of a wallet. The private keys of said wallet could belong to a third party instead of the exchange.
- Does it cover liabilities? Showing your on-chain assets is one thing. However, showing your off-chain assets is a different ball game. On-chain assets may not cover all off-chain liabilities. In case, the liabilities are greater than the reserves, the exchange is not solvent.
- Fraudulent audits. A custodian (for example, an exchange) can be in cahoots with the audit firm.
- Are the assets borrowed? A PoR doesn’t show if assets were merely borrowed to pass the audit. As pointed out in Part 1, this is a reason we prefer a trustless audit.
As a result, real-time tracking of the reserves is ideal. Even better is proof of solvency. This combines a PoR and a Proof of Liabilities. In other words, you can see both on-chain assets and off-chain liabilities.
Different Use-Cases for Proof of Reserves
Proof of Reserves has various use cases. For example, for crypto exchanges, but also for stablecoins. So, let’s have a look at that:
1. Crypto Exchanges
We have seen already that the use case for a crypto exchange is to establish trust. By having PoRs, exchanges can show that have an ‘X’ amount of on-chain assets.
It can also prove that exchanges don’t take part in risky activities like lending or trading. This can be an important feature towards regulatory institutions. It indicates that the crypto industry is implementing transparency. At least from an exchange perspective.
For stablecoins, it is a great way of showing that another asset backs a stablecoin. The best sample is the TUSD or TrueUSD. They claim to be; ‘The first regulated stablecoin fully backed by the US Dollar’.
On their website, they have a real-time reserve balance dashboard. It’s powered by LedgerLens. You can download it or view it in real-time. As shown in the picture below. It also has a great FAQ that explains how it works.
This is Part 2 of our review of the Proof of Reserve. You can find a link to Part 1 here. We looked at the benefits and the risks of Proof of reserves. Furthermore, we also looked at some use cases.
Proof of Reserves is a good feature to have. However, it’s not the end result, it’s rather a start of how transparency in crypto can improve.
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