Proof of reserves is becoming more effective, but not all its challenges are technical

PoR is benefitting from intense development efforts, but in the final analysis good conduct requires good regulation and a culture of compliance.

Proof of reserves (PoR) has gone from a buzzword to a roar in recent weeks as the crypto world tries to recover from the shock and losses of the current crypto winter. After a flurry of discussion and work, criteria and rankings for adequate PoR are beginning to appear, but the fine points of how to conduct proof of reserves, or even who should do it, remain open questions.

The difference between proof of assets and proof of reserves was pointed out quickly, along with their deficiencies by themselves. Traditional auditors’ attempts at providing PoR were soon frustrated, with major firms stepping up and quickly retreating.

Auditors may never provide the assurance users seek from PoR, Doug Schwenk, CEO of Digital Asset Research (DAR) told Cointelegraph. Audits are done periodically, while crypto trades around the clock “Ideally you would have a way to measure those liabilities and the assets in some kind of real time,” he said.

DAR provides information and vetting services to major firms in traditional finance and produces the FTSE Russell index in conjunction with the London Stock Exchange. “We like to see proof of reserve. […] It’s not enough for us to say we feel satisfied, but it is certainly better than nothing.” He added:

“In the world that we’re navigating right now, better than nothing is sometimes a good starting place.”

To complicate matter further, centralized (CeFi) and decentralized (DeFi) platforms present radically different challenges. Thanks to its transparency, “proof of reserve is worthy of calling [itself] proof of reserve” in DeFi, according to Amit Chaurhary, head of DeFi research for Polygon, a scalable blockchain ecosystem compatible with Ethereum.

Related: Proof-of-reserves: Can reserve audits avoid another FTX-like moment?

Chaudhary told Cointelegraph that the zero-knowledge Ethereum Virtual Machine (zkEVM) being developed by the company brings “battled-tested security” to PoR. That software uses Merkle trees to see both positive (asset) and negative (liability) balances and allows a user to verify their accounts while maintaining a high level of privacy. In addition, zero knowledge protocols can offer dual collateral control for securer settlement and Anti-Money Laundering and Know Your Customer controls while preserving anonymity.

The immutable nature of the blockchain record would allow verification of the audit process. Chaudhary added:

“You can deploy an accounting system on your zkEVM. You can design your own accounting system.”

CeFi presents much greater challenges. “Since liabilities could be incurred off-chain, there is no method to show proof-of-liabilities and that a company can honor all customer deposits,” founder of the Aleph Zero blockchain Matthew Niemerg told Cointelegraph in a statement.

Centralized cryptocurrency exchanges are taking a variety of steps to provide PoR that meets users’ needs. Exchange OKX, which has recently committed to providing fresh PoR monthly, uses PoR based on an open-source Merkle tree protocol along with a Nansen dashboard. Nansen provides real-time, third-party transaction tracking.

OKX told Cointelegraph in a statement that the exchange verifies its holdings of its top three assets, BTC, ETH and USDT, using a Merkle tree, which allows users to verify their holdings, check that their balance is included in the exchange’s total liabilities and compare OKX assets and liabilities.

“OKX discloses its wallet addresses via the Nansen dashboard,” OKX explained further. This allows users to check OKX holdings in real time “to ensure that OKX has enough reserves on-chain for users to withdraw.”

Despite the efforts of OKX and other exchanges to provide transparency, “no amount of math or cryptography can solve the human problem of deceit and fraud, even if the books are audited by respected, independent third parties. Garbage in, garbage out!” said Niemerg.

Part of the challenge of providing transparent services is cultural. Tradition finance has “benefit of living in 2022, where we have almost 100 years of highly regulated capital markets,” Schwenk said.

The DAR seeks to “apply the same rigors as regulators” for “the kind of firms that are used to having a high degree of confidence in their counterparty.” Nonetheless, “It is impossible to get perfect information about any of these counterparties today, because many of them are still getting through some maturity questions and they struggle to be as buttoned up as you see in traditional finance,” Schwenk said.

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Bank of India report calls for regulatory coordination on crypto market challenges

The RBI’s latest financial stability report accentuated the negative about cryptocurrency and reminds the world that India is looking for global action on crypto regulation.

The Reserve Bank of India (RBI) has again expressed concerns about the burgeoning crypto ecosystem and suggested parts of it could be banned. In its latest financial stability report, released Dec. 29, the central bank said it would use its rotating presidency of the G20 group of the world’s largest economies to call for the development of a global regulatory framework of crypto assets.

The report was generally upbeat about current conditions in the country, despite “strong global headwinds,” saying, “the Indian economy and domestic financial system remain resilient.” The tone changed drastically in its discussion of crypto, however, as it highlighted a familiar laundry list of crises that struck the cryptoverse in 2022. It noted crypto’s volatility, high correlation with equities and its inadequacy as a hedge against inflation, as well as issues with governance, and added:

“Leverage is a constant theme running across the crypto ecosystem, making failures rapid and losses huge and sudden.”

Be that as it may, rising prices in that ecosystem drive crypto’s popularity, especially in the “younger segment of the population.” The report concluded:

“To address potential future financial stability risks and to protect consumers and investors, it is important to arrive at a common approach to crypto assets.”

The report saw three options for crypto regulation. The first was “the same-risk-same-regulatory-outcome principle.” Second, it suggested the possibility of a prohibition of crypto assets “since their real-life use cases are next to negligible.” This option would be complicated by “different legal systems and individual rights vis-à-vis state powers” globally. A third option, “let it implode” without regulatory action, was considered too risky for mainstream finance to pursue. The report noted that:

“Under India’s G20 presidency, one of the priorities is to develop a framework for global regulation, including the possibility of prohibition, of unbacked crypto assets, stablecoins and DeFi.”

Related: Crypto could spark the next financial crisis, says India’s RBI head

Crypto regulation was a G20 priority for India from the beginning of its presidency. Despite the government’s generally negative position on cryptocurrency, there are an estimated 115 million users in India. The RBI is more bullish on central bank digital currency. India also has one of the world’s largest Web 3 workforces.

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Turkey’s central bank completes first CBDC test with more to come in 2023

After recently completing its first payment transactions using a central bank digital currency, the Turkish central bank is pushing ahead with more tests over 2023.

The Central Bank of the Republic of Turkey (CBRT) has completed the first trial of its central bank digital currency (CBDC), the Digital Turkish Lira, and has signaled plans to continue testing throughout 2023. 

According to a statement released by the CBRT on Dec. 29, the central bank authority said it successfully executed its “first payment transactions” using the digital lira.

It said it will continue to run limited, closed circuit pilot tests with technology stakeholders in the first quarter of 2023, before expanding it to include selected banks and financial technology companies in the rest of the year.

It said the results of these tests will be shared with the public through a “comprehensive evaluation report,” before unveiling more the next phases of the study which will further widen participation.

The Turkish central bank first announced it was looking into the benefits of introducing a digital Turkish Lira in September 2021 in a research project called “Central Bank Digital Turkish Lira Research and Development.”

At the time, the government made no commitment to the ultimate digitalization of the country’s currency, noting it had “made no final decision regarding the issuance of the digital Turkish lira.”

In its most recent statement, the CBRT said it will continue testing the use of distributed ledger technologies in payment systems and their “integration” with instant payment systems.

It will also prioritize studying the legal aspects around the digital Turkish Lira, such as the “economic” and “legal framework” around digital identification, along with its technological requirements.

Related: CBDCs are no threat to crypto — Binance CEO

Several countries, including the United Kingdom and Kazakhstan, have recently begun piloting central bank digital currencies.

The Bank of England has opened applications for a proof of concept for a CBDC wallet, while the Kazakhstan central bank has recommended the introduction of an in-house CBDC as early as 2023 with a phased implementation over three years.

The Reserve Bank of Australia (RBA) recently expressed hesitation about its own CBDC plans, with assistant governor Brad Jones warning in a speech on Dec. 8 that a CBDC could displace the Australian dollar and lead to people avoiding commercial banks entirely.

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