DeFi and crypto markets are rapidly growing, bringing along new protocols and applications to safeguard customers’ assets. The industry must flourish if customers believe protocols and institutions hold the assets they claim, and it is a requirement that they provide proof of reserves.
You may wonder how Proof of Reserves Audits work. It is a system that proves that centralized and partially decentralized custodians have sufficient assets to back digital assets, such as currency-backed stablecoins and wrapped tokens.
While most decentralized DeFi protocols are self-custodial, allowing funds to be locked into smart contracts and guaranteeing that assets are represented correctly and safely, proof of reserve is still required.
A “break test” of DeFi protocols and exchanges
Audits can include “breaking” contracts or simulating attacks on them to see if cybercriminals can exploit them to drain money. Thus, DeFi protocols ensure that the contracts they use work as intended and can’t be manipulated by outside actors or the protocol itself. Proof of reserve doesn’t work like this but ensures the protocol’s contracts are stable.
Still, proof of reserve is the most important part of centralized crypto exchanges. As more banks, asset managers, and other centralized organizations start holding digital assets for clients, proof of reserve will become more critical.
Keeping CeFi applications out of insolvency
Proofs of reserve audits are a great way to protect custody protocols from insolvency. Whenever it offers other services, like crypto lending and yield farming, it audits the reserves of coins or tokens used as collateral.
Currently, most centralized exchanges and CeFi crypto platforms keep collateralization and asset data in their databases. Moreover, different customers’ funds can be held in the same wallet when trading or lending.
Proof of reserve ensures protocols lend only what they have on reserve in anticipation that borrowers will withdraw their assets soon. If this happens, the protocol may experience a “run” like a “bank run.”
Fractional reserve banking isn’t completely against the Federal Reserve, but it warns that digital assets pose new risks, even when the protocol has insurance and strict reserve ratios are followed.
The FDIC doesn’t insure crypto exchange accounts or other protocols that hold digital assets, unlike U.S. bank accounts, which the FDIC generally insures up to $250,000. If the protocol fails or closes, digital assets held by a centralized exchange or traditional bank aren’t guaranteed safe.
State regulators require digital asset platforms in the U.S. to submit audited financial statements from a CPA to keep their money transmission licenses, but this information is usually private.
Stablecoins Need Proof of Reserve
Cryptocurrencies that hold steady values, often linked to real-world currencies like the dollar, are known as stablecoins. A wide variety of stablecoin options are available on the market, with Tether (USDT) being the most popular. Questions about the reserves held by Tether have caused much controversy.
UDST was initially claimed to be fully exchangeable for real U.S. dollars by Tether since it was held in dollar reserves. The company’s story has changed repeatedly, with the company now claiming to hold a substantial amount of its reserves in commercial paper (short-term loans).
It needs to be clarified what assets Tether holds to back its stablecoin. According to some regulators, a “run” on Tether, which has a market cap of over $70 billion, could result in a crypto market crash, further destabilizing financial markets.
Using a proof of reserve would assure regulators and the general public that stablecoins like Tether are as stable as the assets they claim to back.
A proof of reserve can also help asset-backed tokens
Proof of reserve audits can also be helpful for wrapped tokens, like gold tokens on digital commodities exchanges.
It’s different from synthetic gold tokens in that wrapped gold token issuers claim to hold 100% real, physical gold reserves or, at the very least, gold receipts or gold ETFs.
Wrapped Bitcoin tokens are a popular token class that benefits from proof of reserve. If these tokens aren’t backed by Bitcoin, the value of these tokens could crash, causing investors to lose a lot of money.
Collateralization claims are easier to verify with an audit. If wrapped assets were audited for proof of reserve, potential investors would sleep better at night.
Tokens wrapped or backed by assets and commodities can use proof of reserve. Tokenized assets like cross-chain, liquidity pool, and interest-accruing tokens can also benefit from it.