The recent collapse at FTX, one the largest cryptocurrency and DeFi exchanges, has shaken the space. The collapse of FTX, one of the largest exchanges in the world, has made it the talk and caused many to reconsider investing in cryptos. The crash caused by FTX’s lack of liquidity, its mismanagement of money and the questionable practices of its administrators led to it being taken down along with other exchanges, as well the value of important coins like Bitcoin and Ethereum. This significant incident has demonstrated once more the importance to verify liabilities for exchanges as well as custodial organizations.

It is essential to ensure checks and balances are in operation in the decentralized crypto environment. There were many instances of bankruptcies in traditional financial institutions before the FTX crashed. It is important to have a formalized procedure to verify liabilities. This can prove to be complicated and requires the services of a third party auditor to conduct a thorough assessment. The standard practice for assessing the checks and balances of DeFi platforms or exchanges is to conduct a Proof of Reserve Audit.

What is Proof-of-Reserve?

Proof of Reserve is a method that proves that an exchange platform holds the amount claimed. It is an auditing method that addresses the transparency concerns surrounding assets on exchanges. It is a vital inspection technique to ensure real assets are returned crypto in a decentralized area.

Proof of Reserve refers specifically to due diligence. Trusted third-party auditors examine the statements of crypto projects and present a clear picture of all reserves owned by the company. Proof of Reserve audit is an effective way to improve transparency and trust in the crypto market. It allows custodians to be held accountable by customers of exchanges and custodial services. It informs users about the status of their liabilities and how much crypto they have.

Why is Proof of Reserve so important?

Custodial platforms in the crypto world keep their users’ assets in a hot account, which can be used to fulfill withdrawal requests. A portion of the user’s deposits is kept in cold wallet storage. Customers can make deposits using a wallet address. They can move between the hot and cold wallets.

Custodial financial platforms don’t provide full custody of assets. Instead, they keep private keys that allow them to access these addresses. By tracing transactions that involve cold or hot wallets of custodial institutions, we can access the details about assets. But it must pinpoint individual users’ portions of the total assets. It shows only a total view of all assets on the custodial platforms. This lack of knowledge can cause distrust among users.

The proof of Reserve audit can be used in this scenario to do an in-depth investigation of the total assets of the institution, and determine what share of these assets each user owns.

Proof of Reserve is a combination of transparency in asset management as well as the privacy of customer assets. A platform that does not commit to 100% Proof of Reserve is at risk.

• There is a risk that the assets of the users could be misappropriated.
• Inefficiency or delay when cashing out assets.
• Inability of cashing out assets during crowded withdrawals
• Suffer assets losses or bankruptcy.

DeFi platforms need to regularly perform Proof of Reserve Audits in order for them to keep track of their checks and balances.

Let us now see how Proof of Reserve audits are done.

How does Proof of Reserve audit work?

Proof of Reserve auditing pairs the custodian and the exchange with a third person crypto auditor to check that the bank has sufficient assets to cover customer holdings. It helps ensure that customer holdings have been properly used and that the real assets returned cryptos. Because these reports are cryptographically reconciled by third parties, it provides security for the DeFi ecosystem.