Many cryptocurrency exchanges have adopted Proof-of-Reserves (PoR) to demonstrate transparency and reassure concerned users about the safety of their assets.
Crypto analyst Martin Hiesboeck, however, maintains that PoR can be easily manipulated or misrepresented.
He argued that PoRs are insufficient for verifying an exchange’s reserves because they do not “account for liabilities and off-chain assets at all.”
Increased PoR Adoption After the FTX Collapse
Following the November FTX collapse, users’ trust in centralized exchanges waned, resulting in a mass exodus of assets from these platforms. As a result, cryptocurrency exchanges were quick to show their Proof-of-Reserves in a desperate attempt to stem the mass exits.
PoR Merkle trees, created in response to the trust crisis caused by the FTX crash, now appear to be the universally accepted standard for assessing a cryptocurrency exchange’s implied transparency.
Proponents of Proof-of-Reserves audits argue that they give users confidence that their funds are safe on a cryptocurrency exchange.
PoR Audits Not Enough To Assess Exchanges
While Proof-of-Reserve audits appear to be widely accepted in the crypto space, this does not necessarily mean they are sufficient to ensure an exchange is not mishandling customer funds.
The PoR audit is not foolproof; for example, cryptocurrency exchanges may trick users by lending money to each other right before an audit, then returning the money right after a Proof-of-Reserve is presented.
Since PoRs do not “account for liabilities and off-chain assets at all,” critics like Martin Hiesboeck, the Head of Blockchain and Crypto Research at Uphold, argue that they are not suitable tools for proving the status of an exchange’s reserves. Since this is the case, Hiesboeck claims that PORs are “at best incomplete and at worst misleading and deceptive.”
PoRs Can Be Manipulated
To back up his position, Hiesboeck cited two flaws in PoR that allow for manipulation or misrepresentation.
First is the Merkle Tree model’s “inherent opaqueness,” which was specifically designed to allow the verification of specific data without revealing its contents. This model enables auditors of centralized exchanges to issue a “legitimate report” on a cryptocurrency exchange’s reserves.
Another reason Hiesboeck believes PoRs aren’t an excellent method for evaluating the financial health of a crypto exchange is that they exclude the exchange’s outstanding liabilities.
Hiesboeck contended that more than a presentation or publication of a cryptocurrency exchange’s assets is needed to provide a complete picture of its financial health.
The Alternative to PoR Audits
According to Hiesboeck, the only reliable alternative to PoR audits is a system that combines both reserves and liabilities. The attestation must be analyzed by an external auditing firm, and there must be proof that the operating entities are in the right places.
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