All You Need To Know About “Proof of Reserve”

What Is “Proof Of Reserve”?

It is not a particularly new concept to the blockchain industry. It is a method to verify that it possesses sufficient reserves of assets to another party through a form of proof. This concept originally was a method for centralized digital asset exchanges and custodians (collectively, digital asset platforms) in order to show customers that they possess sufficient tokens to meet customer liabilities. On the whole, proving reserves is a method in which the organization provides the information to generate trust regarding custodial digital asset holdings, it can pertain to the following:

  • A specific customer or the wider market;
  • Current or future partners, regulators, the digital asset platform’s management or any combination of thereof.

From another perspective, Proof of Reserve may be defined as using cryptography to promote transparency and trust signals where a user, customer or counterparty depend on another party to hold digital assets on their behalf.

However, there is no explicit and clear definition to conduct a Proof of Reserve yet.

Why Is It Important?

For the digital system, Proof of Reserve is vital for the participants as well as constituents. Narrowing it down, the primary reasons are the creation of norms, guidelines and standards. Having clearly defined standards and norms to verify digital asset reserves shall provide users with transparency, enhanced risk assessment, eliminate bad actors, exhibit the ability of self-regulation, and address the systematic risks that may threaten further adoption and innovation of digital assets.

In the last few years, there have been consistent attempts from global regulators aiming to develop policies that encourage innovation, at the same time protecting market integrity and investors. There is a vast scope of change for public blockchains but it also comes with complexity in the interpretation and advancement of regulatory structures. However, it also offers the opportunity to make use of technology to modify current norms of risk management, audit execution and regulatory oversight.

Key Factors For The Need Of Proof Of Reserve:

1.Trust And Transparency For Consumers, Markets And Regulator

After the release of the much talked about white paper for Bitcoin by Satashi Nakamoto, digital assets have significantly grown both in terms of total market capitalization and total number of tokens in circulation. One thing that is agreed upon globally as a policy concern is that lack of transparency is a hurdle to further investment and innovation.

Digital assets are touted for their auditability and transparency. While these public blockchains provide a paradigm-shifting level of transparency, centralized parties’ databases complicate transfers and balances.

The urgency to verify that a centralized party indeed exercises control over assets held in a reserve is becoming more prominent. Some of the examples for this are:

  • The Office of the Comptroller of Currency (OCC) issued a guidance for national banks that provide cryptocurrency custody services and payment activities;
  • The European Central Bank (ECB) issued a white paper that attempted to address regulating and overseeing stablecoins and asses reserves and stablecoins under the following situations:
  • An alternative store of value;
  • As a digital asset function;
  • As a new payment method.

The abovementioned attempts were made by regulators to apply regulatory standards and address financial stability measures.

2. Auditability

The inherent and general nature of blockchain technology is to provide tamper resistant, decentralized trust and auditability. However, there is a drawback for digital asset platforms is that as centralized intermediaries majority of transactions and account balances are not tied to public blockchains. Rather, these transactions are held in proprietary databases of these central service providers ( off chain transactions). It is a general practice for digital asset platforms to in co-mingled wallets ( i.e. Omnibus wallets ). These co-mingled wallets are not publicly accessible or auditable. Thus, the concept of publicly available auditable ledger and transactional data can face hurdles due to the usage of co-mingled wallets and off chain transactions commonly used by digital asset platforms.

3. Fraud Deterrence

If the Proof of Reserve is standardized and is made publicly viewable, it can potentially prevent and bring clarity about holding partial reserves or not disclosing loss of reserves. Also, similar to centralized platforms, digital asset platforms and custodians are often targeted by hackers. Having an uniform and standard audit practice across the industry can help decrease and may also reveal with a reasonable assurance any such loss of reserves.

4. Customer Protections

Here we are taking the example of the United States. They have a transmitter licensing regime that is spread across the states, it presents detailed compliance requirements for consumer protection. State regulators generally impose certain customer protection measures on money services businesses (MSB). These impositions include but are not limited to maintaining certain capital reserves and attaining audited financial statements yearly.

For instance, New York had dual protection in this regard. It includes a money transmitter licensing statute and a virtual currency business activity license. This adapts the money transmitter requirements to service providers for virtual currency business activity.

Conclusion:

The conversations and discussions around Proof of Reserves is evolving, it is evident that addressing the gaps in the market due absence of a standardized regulation has to be addressed sooner or later. The beginning of centralization in the blockchain space has already begun, with stablecoins, central bank digital currencies, and financial institutions beginning to offer cryptocurrency related products and services. However, centralization and regulations can also pose further complications in the future. Ultimately, the market demands transparent and consistent information. WACEO is here to help cryptocurrency exchanges and other general blockchain projects with audits and other allied services.

For more information on WACEO and our work and to keep yourself updated on the latest developments in blockchain organizations, visit our website.

Author: Trisha Biswas

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Providing the Road to Regulatory Clarity in the Blockchain Industry.

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Providing the Road to Regulatory Clarity in the Blockchain Industry.

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