Proof of Solvency will play a key role in the continuous adoption of centralized cryptocurrency exchanges
Proof of Solvency (POS) is crucial for centralized exchanges operating on chain, as they allow users to verify the financial health of the exchange and ensure that their assets are being held securely. Without these systems, users are at risk of losing their funds in the event of an exchange hack or bankruptcy.
Centralized Cryptocurrency Exchanges (CEXs)
Centralized crypto exchanges have come a long way since they first emerged in 2010, and are now the most widely accepted platforms used to buy and trade cryptocurrency safely and securely. By working with regulators, tightening security, and improving the user experience and product, centralized exchanges (CEXs) have played a large role in developing public and institutional trust in blockchain technologies and their underlying cryptocurrency assets.
Centralized exchanges are platforms which facilitate the buying and selling of cryptocurrency, either for fiat currencies, like the US dollar, or between digital assets, like BTC and ETH. They function as trusted intermediaries in trades, and often act as custodians by storing and protecting your funds. Leading exchanges facilitate every aspect of the digital asset trading experience: from security, to fair market pricing, to regulatory compliance, consumer protection, and access to various digital assets. As of September 2020, 95% of digital asset trades are executed through centralized exchanges, which represents approximately $228 billion USD a month.
However, the security and solvency of these exchanges are major concerns for users. There have been numerous incidents of exchanges being hacked or going bankrupt, resulting in significant losses for users. On November 2022, the spectacular collapse of FTX , once a $32 billion crypto exchange (in terms of valuation), brought to light the potential disadvantages of operating with centralized cryptocurrency exchanges. POS has been proposed as potential solutions to these problems.
Proof of Solvency (POS)
Transparency is key to financial stability and responsible conduct. Users should favor services that pledge to prove their solvency. Solvency has two sides: The total liabilities (user deposits) that a CEX has toward its customers on one side and the total assets it holds in reserve as collateral that may be redeemed by users.
Consequently, cryptographic schemes that enable transparent reporting by a CEX, exposing its solvency for scrutiny/audit, fall into two large categories:
- Exposing information/proof about liabilities for auditing and scrutiny, namely, the total deposit balances an entity maintains on behalf of its users. This is known as proof of liabilities (“PoL”). There are cryptographic schemes that can prove claims about the sum total of liabilities, without revealing individual items in the sum.
- Exposing information/proof that the entity reserves sufficient assets as collateral to back its liabilities, also known as proof of reserves. There are cryptographic schemes that can prove claims about the sum-total of CEX assets held on-chain or relayed from another chain, without revealing individual account addresses/balances.
It is important to note that neither of these schemes alone or jointly “prove” solvency in a legal or regulatory sense. For example, proof of liabilities doesn’t prove that a CEX has no other liabilities and their priority in case of a bankruptcy situation. Likewise, proof-of-reserves doesn’t prove that money held in the reserve is not doubly used as collateral for other liabilities.
Challenges in implementing Proof of Solvency (POS)
Not all exchanges currently utilize this method for a variety of reasons. One reason is the complexity involved in implementing POS. This method requires the creation of a transparent system for tracking deposits and withdrawals, as well as ensuring the security of all funds. This can be a time-consuming and expensive process that smaller exchanges may not have the resources to undertake.
Another reason why not all centralized cryptocurrency exchanges utilize POS is due to the lack of regulation. In some jurisdictions, POS may not be required by law. Therefore, some exchanges may not feel the need to implement it unless it is mandated by the regulator.
Overall, while POS can be a useful tool for exchanges to demonstrate their financial health, it may not be feasible or necessary for all exchanges to implement it.
Successful implementation by a few key players
By the end of 2022, a total of five centralized exchanges (CEXs) including Kraken, Bitmex, Coinfloor, Gate.io and HBTC have completed their proof-of-reserve audits while several other have announced their plans to do the same.
Most of these attestations were conducted via a PoR protocol that uses a Merkle Tree proof to integrate large amounts of data into a single hash and verify the integrity of the data set. Using cryptographic proofs, the PoR protocol verifies the validity of user balances and transactions.
Crypto exchanges publish Merkle Tree-based PoR attestations at regular intervals, including on a weekly, monthly, or quarterly basis, in the form of snapshots. Or alternatively, provide real-time attestations available on their website.
Going forward
While POS is a promising solution to avoid unfortunate situations when utilizing centralized cryptocurrency exchanges, there are several areas that need to be improved for mass adoption within the industry. Standardization, user interface, third-party auditing, transparency, and education are all important areas that exchanges need to address to increase adoption of POS and build trust with their users.
Knowing about POS is crucial for digitally literate individuals as it enables them to better comprehend the blockchain technology space. In case cryptographic payment methods attain widespread acceptance in the future, comprehension of these key concepts by leaders will be vital.
