Today’s crypto market is experiencing a boom in popularity, due to which electronic trading tools and related blockchain technologies are developing at the fast rate. On the other hand, there are more and more crypto companies providing various services related to crypto trading and which have certain obligations to all existing clients (traders and investors) due to the specifics of their work, the implementation of control over the execution of which the Proof of Solvency protocol is designed to solve.
This article will shed light on the Proof of Solvency protocol, the Proof of Reserves and Proof of Liabilities components, how they work, and what methods exist to implement the blockchain audit process. In the end, you’ll learn how the Proof of Solvency process impacts the crypto industry.
- Proof of Solvency is the result of combining the Proof of Reserves and Proof of Liabilities protocols.
- The Merkle Tree algorithm is used in each of the protocols to work with the dataset to verify data about users’ accounts.
- One way to ensure Proof of Solvency is a cryptographic approach that uses Zero-Knowledge technology for the purpose of proving that solvency is true.
What is Proof of Solvency?
Proof of Solvency is a rule that is used to assess the solvency of a crypto company that is obliged to pay funds to its customers in an amount sufficient to cover expenses in case of unforeseen circumstances. In other words, this rule is used to carry out verification of the exchange’s public wallets, combined with periodic checks by third-party auditors to confirm the results, followed by proof that the platform contains enough resources to maintain the liquidity of its assets.
Since the incredible popularity of crypto technologies was the impetus for the emergence and development of crypto payment systems, today many crypto traders and investors, as well as people distant from crypto trading, prefer to store their cryptocurrency assets on centralized exchanges. Such exchange wallets are easier to use and more convenient to access, and they eliminate the difficulty and risk of managing cryptographic keys on their own. This method is similar to online banking, where the banking institution assumes the obligation to manage customers’ assets and is responsible for their safety, which translates into full coverage of any losses in case of theft or hacking of the security systems responsible for servicing their accounts.
Over the past year, several terrible crashes happened in the crypto space, notably, the collapse of FTX, in which millions of investors got burned without the possibility of receiving compensation, because the company was unable to pay them their obligations as a result of insolvency.
The FTX cryptocurrency exchange collapsed in November 2022, and, according to court filings, FTX and its affiliates’ liabilities to the 50 largest creditors, including Coinbase, Coindesk, and Binance, reached $3.1 billion.
What are Proof of Reserves and Proof of Liabilities and How Do They Work?
Proof of Solvency is the result of both Proof of Reserves and Proof of Liabilities, with robust mechanisms to prove that the total amount of assets held by a crypto exchange or any other crypto entity is greater than the total amount of its liabilities. In addition, if a custodian holds reserves in cryptocurrencies, it must also prove ownership of the keys to the accounts that hold crypto funds. Let’s take a closer look at what the above-mentioned algorithms are and how they work.
Proof of Reserves
Proof of Reserves (PoR) is an innovative consensus protocol that provides an in-depth solvency analysis examining active cryptocurrency exchanges in the market to confirm sufficient liquidity at any given time to ensure that users (exchange account holders) can withdraw all available funds unhindered on demand. Ultimately, crypto exchanges, as well as other financial institutions in the crypto market, are audited to confirm the safety of user assets and to be able to continue to operate legally with the assurance that, in case of unforeseen circumstances, the company can meet its obligations to customers.
The Proof of Reserves method involves cryptographic verification to demonstrate ownership of digital assets. This consensus protocol is based on metrics that show the balance of digital assets (currently only BTC), which can be verified using online methods such as crypto wallet tracking. It is used by centralized exchanges to prove their solvency and assure customers that the exchange will be able to pay deposits during periods of market volatility.
Proof-of-Reserves verification converts the balance information of each account into a so-called Merkle tree, an algorithm used to determine information verification and file integrity, and allows for a single hash for multiple data fragments. A hash tree can be represented as a structure with branches diverging from its base to intermediate nodes. Leaves representing data fragments are placed at the ends of branches. The root hash (Merkle root) is at the base of the tree.
User balance data is hashed into a “leaf.” The “leaf” is then hashed to form a “branch,” and the “branch” group, in turn, is hashed to form the “root”. The auditor then verifies that the exchange owns the blockchain’s corresponding addresses (i.e., public keys).
Proof of Liabilities
In contrast to the proof-of-reserve protocol, proof-of-liabilities is a more complex concept. With PoL, the exchange publishes a list of all liabilities at a particular point in time (as with the PoR scheme). In theory, this list could include the account balance and the name of each creditor. Still, the exchange can always exclude certain obligations from the list, thus creating the appearance of solvency when it is in an insolvent state. To solve this problem, each creditor is encouraged to find himself or herself on the open list of liabilities. If at least one creditor claims to be not on the list, the exchange may be considered fraudulent.
This protocol is reliable because it gives users much more assurance regarding the exchange’s solvency than platforms that do not conduct this process. When using the method described above, user privacy suffers because each user’s name and account balance history is placed in the public domain. Previously, a combination of two techniques was used to improve user privacy: hiding the connection between published balances and personal user data, as well as the partial publication of user balances.
The principle of this protocol is similar to the above-described PoR, which uses a Merkle tree. Below is an example of such a tree for an exchange with several accounts. To ensure that Alice’s balance of 20 ETH is included in the total balance of the exchange’s liabilities of 1480 ETH, only the information inside the area highlighted in red is needed.
Methods to Provide a Proof of Solvency
As part of the development of the Proof of Solvency protocol, in order to verify the solvency of a financial institution working in the field of crypto, there are two methods that help to perform a comprehensive assessment of indicators demonstrating its ability to pay its obligations to customers. Let’s consider them below.
The traditional method of proving the solvency of a crypto exchange involves engaging a third party auditing company to study all the components of the ecosystem of the company that gives access to crypto assets trading. Such components include customer accounts and their contents (the exact number of crypto assets), headcount and other confidential information of the organization in order to report on its solvency.
In the process of such an audit, auditors check the extent to which the exchange’s obligations to customers are met. To calculate liabilities, auditors use the amount of all funds in customer accounts, then compare it to the total amount of reserves on the platform. Commitment verification involves steps like the Merkle tree described above, using a cryptographic hash of the customer’s ID.
Using this method, auditors do not need to analyze the entire blockchain because the aggregated data available to the public is used. During verification, all balances on crypto addresses are aggregated. The exchange can prove that it owns them by providing the public key associated with the address and signing it with the private key.
It is also worth noting that today some crypto platforms provide users with the ability to check their own assets in their personal account and verify with the Merkle Tree that they are indeed secured by cryptocurrency on the exchange. The verification includes a full analysis of the state of crypto addresses related to each specific crypto asset, its volume, value assessment, and a graphical visualization of the dynamics of the volume of funds to secure each crypto address for each user.
The cryptographic way goes by using an innovative technology called Zero-Knowledge. With this method, an organization can create a cryptographic proof (zk-proof) by which one party can prove to a third party that its statement of solvency is true without revealing any additional information.
The three main characteristics of ZK Proof are integrity, accuracy, and zero disclosure. Looking at the technology in general terms, we can say that zero-disclosure proof is a method that allows you to verify the accuracy of the claim without disclosing any additional information about the claim itself. As part of the protocol, the proving party demonstrates the assertion’s validity to the verifier without providing any additional data.
Zero-Knowledge proof can be interactive, where the prover convinces a particular verifier but must repeat this process for each verifier, or non-interactive, where the prover creates a proof that can be verified by anyone using the same proof. There are several implementations of zero-knowledge proofs, including zk-Snarks and zk-Starks, each with a different size of proof assertion, proof checking time, and more, working with various mechanisms in their systems.
Impact Proof of Solvency Has on the Crypto Industry
In terms of financial reporting, auditing cryptocurrencies is quite complicated. Cryptocurrencies have various complex characteristics and price movements tend to be volatile. Despite their name, it would be a mistake to assume that cryptocurrencies should be accounted for as cash. This is because the standard outlined in IAS 7 and IAS 32 implies that cryptocurrencies are not equivalent to cash, especially since cryptocurrency is still far from being fully distributed in global trade. At the same time, the basic principles for evaluating digital assets remain the same and are gradually being implemented globally to allow for an accurate solvency check of each financial institution within the crypto market.
In 2019, the IASB concluded that a cryptocurrency meets the definition of an intangible asset in IAS 38. If it is held for sale in the ordinary course of business, it falls within the scope of IAS 2, Inventories. The IASB and the Financial Accounting Standards Board (FASB), which governs mainly accepted accounting standards in the United States, agreed that there is no clear path to universally address this issue. Instead, accountants need to consider digital assets’ nature and financial impact to determine how to account for them.
On the other hand, today, it’s possible to observe opponents of the cryptocurrency audit who consider it pointless. Thus, the former hedge fund manager and legendary investor, who was one of the first to predict the subprime crisis, Michael Burry, published a post on his Twitter in which he explained the actions of the French auditing firm Mazars Group, which suspended the service of crypto exchanges due to the increased media attention. He noted that not all investors are satisfied with the reports confirming the reserves compiled for crypto exchanges such as Binance, KuCoin, and Crypto.com. Many influential crypto community members have openly criticized such documents, agreeing with Burry’s statement.
With a high degree of probability, the Proof of Solvency protocol will make a significant contribution to the development of audit standards for crypto organizations, including within the legislative framework of many countries, to prevent negative consequences resulting from fraudulent actions of a crypto company, which are expressed in the loss of capital on the part of investors, as well as to create conditions that help ensure the full solvency of the exchange or any other crypto-financial organization in case of unforeseen circumstances associated with turbulent situations on the crypto market.
After several severe incidents in the history of the cryptocurrency space, the emergence of new methods of auditing cryptocurrency exchanges will be a new round of development of security systems for all entities involved in crypto trading, which will not only help to avoid the negative consequences caused by fraudulent actions but also create a solid foundation for the development of verification and verification systems of complex organizations outside the crypto sphere.