In an ecosystem striving for decentralization, the crypto market still heavily relies on centralized projects. However, the collapse of the CEX FTX and the bankruptcy of the lending platform Celsius have significantly increased distrust toward these entities.
As a result, Proof of Reserves (PoR) has emerged as an opportunity for platforms to be transparent about the assets—and therefore the funds—they hold. Through Proof of Reserves, users who are not yet willing or do not know how to hold their cryptocurrencies in a personal wallet can feel a bit more secure when operating.
What is a Centralized Exchange (CEX)?
Within the ecosystem, the fastest and easiest way to buy cryptocurrencies with fiat money (via credit card or bank transfer) is through a centralized exchange (CEX).
For this reason, these platforms are often the entry point for those beginning to be part of the crypto ecosystem. To such an extent that they have become a visible face and even representatives of Web3 development, despite being centralized.
These exchanges allow for easy trading and leveraged operations with cryptocurrencies. Users can open long and short positions with a still highly volatile financial instrument, which can lead to significant gains but also losses in a very short time.
Due to these characteristics, centralized exchanges tend to dominate transaction volumes, as well as the amount of cryptocurrencies held.
It is important to note that those who keep their crypto assets on these platforms are not holders of the private key to their wallet, so the custody of those tokens actually belongs to the exchange.
They are also often chosen by newcomers because they offer customer service and Know Your Customer (KYC) processes, which should provide greater security and transparency. They are even publicly endorsed by famous artists and athletes.
Despite these measures, the cases of FTX and Celsius have alarmed those interested in cryptocurrencies. On the other hand, they have also provided new arguments useful for those dedicated to attacking the crypto industry.
What is the Goal of Proof of Reserves (PoR)?
Due to the recklessness that centralized platforms have shown in 2022 in handling funds and their liquidity, the concept of Proof of Reserves (PoR) has emerged as a demonstration of good practices.
According to Kraken—another renowned centralized exchange—Proof of Reserves (PoR) is an independent audit conducted by a third party, which aims to guarantee that a custodian holds the assets it claims to have on behalf of its clients.
“This auditor takes an anonymous snapshot of all held balances and aggregates them into a Merkle tree, a privacy-respecting data structure that encapsulates all customer balances.”
For Tyler Roessel, Head of Public Relations at Phemex, Proof of Reserves also ensures that a cryptocurrency lender does not lend more money than the collateral it holds, so that its lenders can be fully compensated if something happens.
“Currently, most centralized exchanges and other CeFi crypto platforms, such as lenders and custodians, keep their asset data in private databases. Thus, they can claim that their users' funds are safe with them, but this is difficult to verify. With a Proof of Reserves, customers can not only trust their word but have a guarantee, returning to the basic principle of cryptocurrencies: don't trust, verify.”
After the bankruptcy of FTX, Chainlink, the most important decentralized oracle project in the crypto industry, announced that its service allows these platforms to implement Proof of Reserves (PoR) immediately.
Nevertheless, exchanges can receive audits from other agents, such as the firm Armanino. Currently, platforms like Ledn, Nexo, Kraken, BitMEX, and Gate.io already share their Proof of Reserves.
In mid-November, Binance, Crypto.com, KuCoin, Poloniex, Bitget, Huobi, OKX, and Phemex announced their intention to do so, as it is very likely that Proof of Reserves (PoR) will become a standard.
👉 Explore the best tools for verifying Proof of Reserves
Decentralized Alternatives
If PoR is not enough to continue custodying cryptocurrencies on a centralized exchange (CEX), it is best to look for options that best suit our needs.
In this sense, we can operate with hot wallets (which are connected to the internet all the time, such as the MetaMask extension) or cold wallets (also known as hardware wallets, as they are physical devices).
In both cases, the user is the guardian of their private key, which gives them access to interact with their cryptocurrencies and do with them as they wish. Both cold and hot wallets allow staking with different protocols.
But if we are interested in yield farming, we should lock our cryptos in a decentralized exchange (DEX) or an Automated Market Maker (AMM), with the help of a hot wallet.
Logically, if we only wanted to hold our cryptocurrencies long-term and thus forget about price fluctuations and the possibility of suffering hacks, hardware wallets position themselves as the best option.
We cannot ignore the fact that 2022 has been the year with the most hacks since the origin of Bitcoin (BTC). Generally, these attacks occur on centralized and decentralized exchanges, as well as on the bridges that allow transferring cryptocurrencies between one blockchain and another.
Frequently Asked Questions
What is Proof of Reserves (PoR)?
Proof of Reserves is an independent audit process that verifies a cryptocurrency exchange or custodian holds sufficient assets to cover all client balances. It uses cryptographic techniques, like Merkle trees, to provide transparency without compromising user privacy.
Why is Proof of Reserves important?
It is crucial for rebuilding trust in centralized platforms. Following major collapses like FTX, PoR acts as a verifiable guarantee that user funds are actually held and available for withdrawal, promoting honesty and solvency in the industry.
How can a user verify a platform's Proof of Reserves?
Many platforms that undergo a PoR audit provide a public page or tool where users can cryptographically verify that their account balance is included in the total proven reserves. This often involves checking a hash against a Merkle root.
What's the difference between a CEX and a DEX?
A Centralized Exchange (CEX) is run by a company that custodies user funds. A Decentralized Exchange (DEX) allows users to trade directly from their personal wallets without giving up custody of their assets, using smart contracts.
Is Proof of Reserves a guarantee against bankruptcy?
No. While PoR verifies the existence of assets at a specific point in time, it does not audit for liabilities or overall business solvency. It is a transparency tool, not a comprehensive financial health guarantee.
What are the best alternatives to holding crypto on an exchange?
For security, self-custody solutions like hardware wallets (cold wallets) are considered best for long-term storage. For active trading and yield farming, non-custodial DeFi protocols accessed via hot wallets are popular alternatives.
Conclusion
Proof of Reserves (PoR) allows centralized platforms to demonstrate that they are solvent. This practice also affirms, through data verification, that exchanges are truly the owners of the funds and crypto assets, which would allow users to make withdrawals at any time.
Anyone can review this information, as long as it is available. Due to the insecurity and distrust that exists in the crypto environment at the end of 2022, Proof of Reserves (PoR) is an alternative for developers of centralized applications to offer an honest service, which does not seek to take advantage of others.
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