Digital Assets Needs Proof, Not Promises
Last week featured more developments on the FTX collapse, including an interview with SBF to try and better understand exactly what happened so suddenly in the month of November.
This post evaluates Proof of Reserves as a concept and technology that can potentially be a piece of the puzzle to solving the issues of recent past to include CeFi failures like Celsius, Terra (LUNA), 3 Arrows Capital, Voyager, BlockFi and FTX.
This of course must be accompanied with proper regulatory guard rails, CeFi governance and risk management, and additional transparency on complete audited financials such as liabilities… however, proving assets in an automated, real-time, and less labor intensive manner than traditional methods can be a huge unlock for the future and trust in Digital Assets.
What is the problem that needs to be solved for?
Look at most of the most recent bankruptcies, liquidity events, and other failures in this recent crypto winter.
Celsius. Terra (LUNA). 3 Arrows Capital (3AC). Voyager. BlockFi … and now FTX.
What do they all have in common?
CeFi.
The vast majority of the crypto winter’s meltdowns, loss of customer funds, and unethical or illegal activities have come from trust-based CeFi organizations that do not have to abide by the same regulatory guidelines as TradFi, and also are not completely trustless and transparent as most DeFi protocols and projects. There are solutions detailed below for how each of TradFi, CeFi, and DeFi can learn and evolve from this, but also consider this article from Bankless suggesting that we need more DeFi, not less, as the solution. Bankless also submits a hypothesis that this could be the crypto bottom. Read more here to explore the recent collapses in CeFi.
One of the key differences between CeFi and DeFi is that CeFi and CEX demand trust, versus the promise of DeFi’s trustless constructs like Layer 1 blockchains and smart contracts.
Think of a CeFi institution much like a TradFi of today, such as a Bank or a stock exchange, that operates largely in a centralized manner but without the same regulatory guardrails, governance, or risk management practices.
However, some CeFi’s operate in a highly transparent, regulated, and asset backed manner in the face of regulatory ambiguity, such as Coinbase, which already proves proof of reserves via traditional audited financial statements as a publicly traded company, and others clearly have not, to include FTX. However, more Web3 and crypto-native methods are required if digital assets platforms will survive in the future and maintain customer trust.
What is proof of reserves as a concept, and how can it help CeFi?
Proof of Reserves generally refers to a Web3 or crypto-native model of “on chain accounting” to verify that a platform or exchange actually holds enough assets to match its users’ deposits. It is a reliable, timely method of monitoring reserve assets with automated audits that are based on blockchain principles like cryptographic truth.
Proof of Reserve (PoR) can help reduce insolvency risk, enhance transparency, and prevent systemic failures in Web3 and DeFi by providing proof, not promises. This brings confidence to the Web3 ecosystem and individual customers that they can store or withdraw their assets from the platform at any time without failure of the institution.
Method 1 - Traditional Accounting Methods with Crypto Supplementation.
The first method of approach (categorically), is the traditional method that Coinbase has established. Traditional financial statements and third party auditing are also extended with cryptographic proofs to supplement the filings, with random sampling of addresses of cold storage reserves to demonstrate ownership of assets. Additionally, with SAB 121, Coinbase is required to account for crypto assets held for its customers as liabilities and assets explicitly on the balance sheet. Other traditional methods can include government licenses, auditors and examining the corporate governance and the backgrounds of the individuals running the exchange.
The problem with the traditional method is that it is highly manual, the processes are centralized, it is highly labor intensive, and the updates come on a relatively infrequent basis and only provide a snapshot of data at a given moment in time.
Some great resources here include the approach by Coinbase as well as the reporting initiated earlier this year by Circle for its USDC stablecoin with a full breakdown of its USDC reserve assets, which are solely held in cash and 3-month U.S. Treasuries.
Method 2 - Digital Asset Native Approach.
The second method is establishing true Web3 and crypto-native models for CeFi organizations, and potentially even DeFi), and any digital assets organization that acts as a custodian, asset issuer, or even a DeFi protocol. We need to create a hybrid of distributed, trustless systems that still require some aspects of trust and transparency (e.g. retail investors storing funds in custodial wallets and exchanges). Enabling this transparency trust into all digital assets and their underlying platforms is critical for retail and institutional investors to use these products and services in a meaningful way. Read more here from Vitalik Buterin on permutations of this method to include “old school” proof of solvency and proof of assets.
The upside of this method vs. traditional is that it is automatic, decentralized in nature, significantly less expensive and labor intensive, and the results are real-time or close to real-time (based on the availability of the data source).
One downside of this approach that is key to note is that on-chain reporting methods only prove assets, and do not necessarily prove liabilities (or that they are in aggregate less than total assets), so there may still be some additional data collection and reporting required to give a complete picture of an institution.
A great digital assets native solution that also maintains its independence from the custodian includes Chainlink’s Proof of Reserves, which helps to bring end-to-end transparency of both on-chain and off-chain reserves for industry leaders. Using Chainlink’s blockchain oracle technology is a great use case for validating assets in a third party manner that is also decentralized, automated and near real-time.
… as you can see in the figures above, Chainlink provides methods for on-chain, off-chain and cross-chain reserves to publish to a Proof of Reserve Contract that can assure customers that assets are present in any given ecosystem. Chainlink serves as a completely independent validator, as opposed to custodian self reporting or a traditional auditor.
Node operators that are independent of Chainlink and act as validators across blockchains can provide feeds of Proof of Reserve (much the same way Chainlink provides other feeds for things like pricing data of assets). Effectively, Chainlink Proof of Reserves works in a very similar fashion to all other use cases of blockchain oracles by providing a smart contract (e.g. a Proof of Reserve contract) with the authoritative data it needs from an on or off-chain source for secure, automated execution.
Native and wrapped tokens and digital assets can be sourced and validated at any time as they generally live on or cross-chain. On-chain assets are typically real-time. Check out some of the active feeds here which include Paxos.
However, real world assets that are off-chain (e.g. tokenized real world assets like real estate, fiat backed stablecoins, real estate, synthetics) also must be addressed. Off-chain assets are typically subject to the availability of the data source in order to validate and report on.
Method 3 - Pure Play DeFi.
The third method is pure play DeFi, where users own their own identities, private keys, and non-custodial wallet. In this model, it completely takes the need for Proof of Reserves out of the equation as there is no custodian other than the user.
While the purist definition of Web3 and DeFi suggests a model of decentralization, democratization, and repatriation of your identity, data and assets, many existing TradFi users want a simple, no hassle model of engagement for mainstream adoption.
Is proof of solvency and reserves a viable solution to prevent future collapses?
There a few hurdles that this technology needs to address:
Maturity of the technology: first and foremost, we need mature, viable technology that is easy to integrate in existing custodial and other Digital Assets platforms and environments that is high fidelity, secure, and authoritative. If you read Vitalik Buterin’s post, you can get a sense for how long of a way there is to go here
Ubiquitous adoption: there needs to be a standard set that is adopted across all Proof of Reserve “services”, otherwise we may end up in a patchwork quilt of services that are neither authoritative and trusted, and potentially not fully adopted
Painting the full picture: as discussed earlier, even if we achieve ecosystem-wide adoption of Proof of Reserves, this can create a false sense of security as it doesn’t necessarily tell the whole story. As evidenced in the FTX collapse, CeFi’s can still rely on highly volatile assets (e.g. FTT), be extremely over leveraged, or otherwise not tell the full story on their liabilities profile. Having Proof of Reserves does not automatically equate to a healthy business.
For reading more generally on proof of reserves, consider the following resources:
Vitalik Buterin on proof of solvency and beyond for CEX’s
Chainlink: The Hitchhiker’s Guide to Chainlink Proof of Reserve
Blockworks: What Is Proof of Reserves and Can It Build Back Trust?
