The past year was quite eventful for the cryptocurrency industry. The events were the crypto winter, the numerous hacks, and notably, the collapse of leading crypto exchanges.
The year started with the decline of crypto prices from their all-time highs recorded between October and November 2021. By the end of the first half, Terra, the company behind LUNA and UST, collapsed, losing 100% of its value.
While the contagion was still spreading, FTX, the second-largest crypto exchange at the time, also collapsed. As a result, there was a demand for transparency, with many seeking ways on how to get more information about a crypto protocol’s reserve. This cumulated into the drive for the use of proof of reserve in crypto.
Proof of reserve is a mechanism that allows cryptocurrency exchanges and other custodial services to prove to their users that they are holding sufficient reserves to cover their liabilities.
Binance soon led the way in offering to prove to its customers and the broader market that it has the assets it says it does. The recent trouble being faced by Binance as a result of the Security and Exchange Commission’s clampdown on several protocols, including Binance, goes to show that Binance may be getting it wrong in managing its assets and reserves.
While the proof-of-reserve mechanism may seem like a good idea on the surface, there are some reasons why it may not be what the crypto industry needs.
Firstly, proof of reserve may not be effective in preventing fraud or insolvency. The mechanism only provides a snapshot of the reserves at a particular point in time, and it does not guarantee that the reserves will remain sufficient in the future. It also does not provide any information about the quality of the reserves or the risks that the custodian may be taking with them.
Secondly, proof of reserve may not be practical for all types of custodial services. For example, decentralized exchanges (DEXs) and peer-to-peer marketplaces do not hold custody of user funds, so proof of reserve may not be relevant in these cases. Additionally, some custodians may not have a clear definition of what constitutes a reserve or may hold assets that are difficult to value, making it challenging to implement a proof of reserve mechanism.
Lastly, proof of reserve may not be a priority for many users of cryptocurrency exchanges and custodial services. Many users may prioritize factors such as security, user experience, and access to a wide range of assets over proof of reserve. Therefore, implementing a proof of reserve mechanism may not provide a significant competitive advantage or be a key differentiator for custodial services.
While proof of reserve may seem like a good idea, it may not be a practical or effective solution to the challenges facing the crypto industry. Custodial services should focus on implementing a range of measures to ensure the security and transparency of user funds, rather than relying solely on proof of reserve.