Proof of Reserves Are a Stupid Half Measure

Proof of reserves is a naive approach to trying to ensure exchanges are solvent. What people really want is regulation.

Proof of Reserves Are a Stupid Half Measure
Photo by Jason Pofahl / Unsplash

This week there has been a lot of buzz around the idea of Proof of Reserves being the solution to things like FTX’s sudden collapse. That is not correct.

Proof of Reserves is the idea that organizations holding any crypto assets should have to publish the addresses where they hold these reserves to prove they have the money they say they do. While that would be nice, it doesn’t actually improve the trustworthiness of the exchange, and it doesn’t actually increase the ability for us to properly assess a project’s risk.

The reason reserves aren't enough was clearly illustrated in the current FTX breakdown. FTX CEO Sam Bankman-Fried (SBF) recently sent a letter to FTX employees breaking down a rough timeline of assets and liabilities held by the exchange. At the peak, the company held $60B in collateral, which would have been seen in a fully transparent proof of reserve system, and $2B in liabilities, which would not be made apparent. These positions shifted over time to what he says the current state is: $9B in collateral and $8B in liabilities. Much of this shift came from large margin positions.

Now, SBF is a liar, so we shouldn’t trust what he says here, but it’s fair to say this is directionally correct. While seeing a collapse of collateral values on the exchange would be concerning, it would not be obvious that the liabilities ballooned 4x in value at the same time. Or when the liabilities potentially pass the collateral on the exchange. Would you pull out money when the exchange's reserves drop in value from $60B to $15B, but the CEO says they’re not in trouble? Or would you wait for $10B?

What people really want here is regulation, without government enforcement. That never works. People like SBF will lie about the health of the ecosystem, fake reserves, etc. and issues like this will continue to occur. Coinbase is trustworthy because of government enforcement, not in spite of it. What the ecosystem really needs to free itself from centralized actors fumbling their way to bankruptcy everytime Bitcoin drops 15% is regulation like banks have, which require a certain amount of reserves on hand at any given time, limitations on the risks they can take, etc.