Proof of Reserves has become all the rage in the wake of FTX’s collapse. For instance, just today, Coindesk is out with an article detailing the proof of reserve efforts of OKX.
I’ve previously criticized the crypto community for failing to professionalize their conduct; the proof of reserves push is yet another half-baked and half-assed solution to a problem that is not being adequately addressed.
For anyone who is looking at these and taking some degree of comfort from them, my answer to you is basically this:
What are Proof of Reserves?
First, let us talk about what Proof of Reserves intend to be, or at least, should intend to be.
When you have a crypto exchange in the current market, what happens is that you list a bunch of pairs for trading on the exchange. It might be something like BTC/BUSD or ETH/USDT or MATIC/USDC; note that most of these pairs are crypto asset vs. stablecoin, as this is the usual market standard for how things trade.
Customers can then deposit assets onto the exchange in order to trade them; if you have BTC you could put it in the order book against BUSD, for example, in this case. Or if you had BUSD, the reverse. Point is, you will be sending your assets to an exchange address in order to trade them, which means the exchange ends up in possession of customer assets and is a custodian, in fact if not in legal form.
This, unsurprisingly, leads to custodian risk. What if the exchange loses your assets? Lends them out? Lets some other person withdraw more than they deposited and are in deficit? Just straight up steals them? Liquidates them for other stuff?
Pretty much all of these are things that have actually happened in crypto, and in a just world, the custodian and the officers of the custodian should have liability for these acts. Issues of this sort are one of the core reasons why SBF is likely to end up in jail, for example.
Proof of Reserves
What are proof of reserves, then? That’s a way to show that if the exchange is supposed to have…