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The Importance of Proof of Reserve Audits for DeFi and Crypto

November 26, 2021 - 8 min read

Proof of Reserve Provides Essential Transparency for Stablecoins, Crypto Exchanges, Protocols, and Institutions 

Image Credit: Michael Wuensch/Pixabay

The DeFi and cryptocurrency industry is growing at an exponential rate, and with it, new protocols and applications that exercise full or partial custody over a customer’s assets. However, for the industry to thrive, customers need to trust that protocols and institutions truly hold the assets they claim. To do that, they need to show proof of reserve. 

Proof of reserve demonstrates that centralized and partially-decentralized digital asset custodians truly hold the funds that they are holding for their clients. They also can show that digital assets, like currency-backed stablecoins and wrapped tokens, are backed, or collateralized, by the correct amount of assets. 

While the most decentralized DeFi protocols are self-custodial, allowing funds to be locked into smart contracts, proof of reserve can still be essential to verify the code of a smart contract to ensure that assets are being held safely and correctly. 

“Break Testing” Smart Contracts for DeFi Protocols and Exchanges 

A smart contract audit can involve attempts to “break test” a contract, or perform a simulated attack on the contract to determine whether it can be effectively hacked, draining the funds and sending them to a cybercriminal’s wallet. This ensures that the contracts a DeFi protocol uses actually work in the way intended, and are not easily manipulated, both by outside bad actors and the protocol itself. This is not quite the same as a proof of reserve but functions in a similar capacity by ensuring the stability of the protocol’s contracts. 

That being said, proof of reserve is still most important for centralized crypto and digital asset exchanges. Proof of reserve will also be increasingly important as banks, asset managers, and other centralized organizations begin to hold more digital assets for their customers. 

Preventing CeFi Applications From Insolvency 

A proof of reserve audit is one of the best ways to protect a custodial protocol from insolvency. An audit will involve checking the reserves of coins or tokens utilized as collateral for any other services the protocol provides, which could include crypto lending or yield farming. 

At the current moment, most centralized exchanges and CeFi crypto platforms hold collateralization and asset data in their own, proprietary databases. The fact that exchange or loan funds from different customers are often held in the same wallet is another potential cause for concern. 

Proof of reserve ensures that protocols do not engage in secretive fractional-reserve activity, in which they loan out more money than they have on reserve, hoping that borrowers will not withdraw assets too quickly. If this happens, it could trigger a “run” on the protocol, much like a “bank run” in the days of old. 

The Federal Reserve is not entirely opposed to fractional reserve banking for crypto assets, but it does warn that engaging in fractional reserve activity in the digital asset realm holds new risks, even if the protocol has insurance and strict reserve ratios are held. 

Unlike U.S. bank accounts, which are generally insured by the FDIC up to $250,000, centralized crypto exchange accounts and other protocols that hold digital assets are not insured. This means that if a centralized exchange, or even a traditional bank, holds digital assets, there is no legal guarantee that those assets will be safe should the protocol become insolvent or close down. 

While digital asset platforms in the U.S. do have to submit audited financial statements from a CPA to state regulators to keep their current money transmission licenses, this information is often not available to the general public. 

Proof of Reserve is Particularly Important for Stablecoins

Top Stablecoins by Market Cap, November 2021 (in Billions)

Stablecoins are crypto assets that are intended to hold a specific, steady value, typically linked to a real-world currency, such as the U.S. dollar. There are a wide variety of stablecoin options available on the market, with the largest being Tether (USDT). Tether has been the subject of a wide amount of controversy due to questions about the reserves it holds. 

Tether initially claimed to hold 100% of the UDST it issued in actual dollar reserves, and even claimed that UDST was fully exchangeable for real U.S. dollars. However, their story has changed repeatedly, with the company now claiming that it holds a substantial amount of its reserves in commercial paper (short-term loans to other companies).

It’s currently unclear how much, or what type of assets Tether holds to back its stablecoin. Some regulators fear that a “run” on Tether, which currently has a market cap of more than $70 billion, could lead to a crypto market crash, which could lead to further destabilization of the overall financial markets. 

If stablecoins like Tether were to use proof of reserve, it would assure both regulators and the general public that these coins will indeed remain as stable as the assets they claim to be backed by. 

Asset-Backed and Wrapped Tokens Can Also Benefit From Proof of Reserve 

Wrapped tokens, including wrapped tokens based on commodities, such as wrapped gold tokens utilized on digital commodities exchanges, can also benefit from proof of reserve audits. 

For example, the issuers of wrapped gold tokens, unlike synthetic gold tokens, claim to hold 100% of the gold value they issue in real, physical gold reserves, or, at the very least, the same amount of value in gold receipts or gold ETFs. 

Image Credit: flaart/Pixabay

Wrapped bitcoin tokens are another highly popular token class that can benefit from proof of reserve. Just like stablecoins or gold wrapped tokens, if it were shown that these tokens were not truly backed by bitcoin, the value could crash, resulting in huge losses for investors. 

Without an audit, collateralization claims are particularly difficult to verify. Potential investors would likely sleep much better at night if a proof of reserve audit was conducted on any wrapped assets that they hold or plan to hold. 

However, the need for proof of reserve is not limited to wrapped or asset/commodity-backed tokens. It can also be helpful for cross-chain tokens, liquidity pool tokens, interest accruing tokens, and other types of tokenized assets. 

ETFs, Traditional Financial Institutions May Also Require Proof of Reserve 

The adoption of bitcoin and other digital assets by traditional financial institutions presents a new challenge for auditors, accountants, and regulators. Unlike traditional assets, digital assets (in most cases) currently cannot be directly held in a traditional bank account, and instead must be held in crypto wallets. 

With the launch of the first bitcoin ETF in October 2021, crypto assets are likely to begin flooding into more traditional financial markets and financial vehicles. Whether they hold crypto assets directly or indirectly (such as through derivatives) proof of reserve will be particularly important for these types of funds, as they face relatively strict regulation compared to the wild west environment of crypto itself. The same concept holds for other types of financial vehicles, such as hedge funds that decide to undergo independent auditing. 

Image Credit: Essow/Pexels

Proof of reserve will be even more important if and when U.S. banks begin to hold crypto for customers– and that day is not far off. In October of 2021, U.S. regulators at the FDIC said that they are actively looking for a path for ordinary banks to hold digital assets for their customers. Whether those assets will be insured by the FDIC, another government body, private insurance companies, or will remain uninsured is yet to be seen. 

Oracles Can Trigger Automated Audits, Send Information to Third-Parties

Some protocols provide public, on-chain proof of reserve to clients. Others privately have their reserves audited by a professional auditor. Some do both. In both cases, blockchain oracles can provide essential services. 

Oracles, which feed “real-world” off-chain data to blockchains, can be used to send blockchain data back out to off-chain applications. This data is essential if a custodial protocol, token issuer, or financial institution wants to securely send data to a third-party auditor. 

SupraOracles is Positioned to Provide Highly Secure, Accurate Proof of Reserve Services 

SupraOracles Proof of Reserve enables smart contracts to utilize fast, accurate data to provably demonstrate the true collateralization of any on-chain asset. By using secure data queries, SupraOracles can ensure that a protocol or product is backed by off-chain reserves, such as gold or U.S. dollars, as well as digital assets locked into smart contracts. 

SupraOracles can easily activate a network of decentralized oracles to check custodial smart contracts at preset intervals (say every minute) to ensure that collateralization does not go below a certain predefined limit. Through this service, exchanges, protocols, tokens, and institutions can ensure greater “trustlessness” and demonstrate to investors, regulators, and the public that they are stable, credible, and honest. 

References

  1. Wall, Larry D. (April 2019) Fractional Reserve Cryptocurrency Banks. Federal Reserve Bank of Atlanta. 
  2. (November 2021) Tether price today, USDT to USD. CoinMarketCap. 
  3. Wang, Echo (October 2021) U.S. regulators exploring how banks could hold crypto assets – FDIC chairman. Reuters. 

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