Proof of Reserves is a start, but you need Proof of Solvency
Proof of Reserves proves only one side of the balance sheet.
Proof of Reserves (PoR) is the notion that blockchain technology allows a fund or any other entity to cryptographically prove its reserves, or, roughly, its assets. Had FTX done a PoR, maybe it would have never crashed and burned. The logic is pretty simple and straightforward, and appealing. But it’s missing something: the other side of the balance sheet.
Let’s provide some context here. The reason that FTX couldn’t raise emergency capital to shore up its operations, and so facilitate client withdrawals, was because it was insolvent. It had fewer assets (reserves) than it had liabilities. Binance, and presumably others, were given its balance sheet, they saw that FTX was insolvent, and they walked. The reasons why FTX is insolvent are at present somewhat unclear, and are beyond the scope of this post.
So, back to PoR. Here’s Nic Carter advocating for PoR:
Proofs of Reserve harmonize the innate transparency of blockchains with the convenience of centralized custodians. The procedure generally refers to a demonstration undertaken by exchanges proving that they possess client assets to match outstanding liabilities. There was a minor wave of PoR enthusiasm post-Gox, which immediately fizzled out, and a slight renaissance starting summer 2021 with BitMEX’s proof of reserves and liabilities, followed by Kraken’s effort in Feb. 2022.
And BitMEX’s proof of reserves AND liabilities is precisely what’s needed. An exchange ought to be required to prove its solvency, and the way that you do this is by proving that PoR > PoL. Prove that your reserves are greater than your liabilities.
Emin further notes that (2) is harder than (1). Liabilities could be hidden off balance sheet, as with Enron and its special purpose entities.
In any event, PoR by itself doesn’t do much to reassure the public. Proving that PoR > PoL is the ideal. But it has to be in a way such that Emin’s second point is addressed.