If 2022 has taught investors anything it’s that cryptocurrency liquidity must be substantiated. Crypto investors have endured life-changing disruptions over the last year because several blockchain products became illiquid. 2022 has given investors every reason to demand that an ample amount of reserve currency be held – and proven to be held – by the company.

What are proof-of-reserves?

Proof-of-reserves (PoR) is a key component of cryptocurrency and blockchain technology. It is an important security measure that helps protect users from fraud, as well as ensure the integrity of the network. PoR works by verifying that all funds are accounted for and stored securely in wallets, preventing double spending or other fraudulent activities. 

How does Proof-of-Reserves work?

In PoR, the proof is generated using cryptographic algorithms to prove that the amount of currency held in reserve matches the total amount supplied to customers. This proof is then shared with all participating nodes in the blockchain, allowing them to verify and authenticate it quickly. The proof also provides proof of ownership over coins—if someone attempts to send coins they do not own, the proof will be rejected.

An overdue necessity

While 2022 has been an unusual year given the number of bankruptcies and scams, as compared to other years, the need for PoR goes back several years. 

One example is Mt. Gox, which was once one of the largest Bitcoin exchanges in the world before its collapse in 2014 due to losses estimated at over $400 million. It's believed that proof-of-reserve systems could have helped prevent the disaster, as the company was able to operate for years without providing proof of its assets.

Another example is BitConnect, a cryptocurrency trading platform that shut down in 2018 after allegations of fraud and running an illegal Ponzi scheme. The platform had no proof-of-reserve system in place and was able to swindle investors out of their funds with impunity.

The most infamous example is of course FTX, a grifting enterprise that swindled billions from unwitting investors. The erstwhile second-largest crypto exchange in the world, behind Binance, and one of the most respected crypto companies, FTX is the kingpin when it comes to the need for PoR. Its downfall is the catalyst for the market’s demand for PoR as former CEO Sam Bankman-Fried was found to be mixing assets between his two largest firms to feign liquidity.

Why does cryptocurrency need PoR?

Proof-of-reserves is an important security measure that helps protect cryptocurrency users from fraud and ensures the integrity of the network. It also allows customers to have confidence in their transactions and investments, as their funds are accounted for accurately and securely. This proof also acts as a deterrent against double-spending and other fraudulent activities, helping to ensure a safe and secure environment for cryptocurrency trading.

Why proof-of-reserves are needed

1. Transparency

One of the primary benefits of proof-of-reserves is that it allows for greater transparency in the cryptocurrency space. Without PoR systems in place, there is no way to ensure that entities or individuals are holding onto their reserves or that they have already spent them elsewhere. 

By providing proof-of-reserves information publicly, everyone can see exactly how much money each entity has on hand, making it easier to identify suspicious activity and potential fraud.

2. Transaction protection

PoR is also important for protecting investors and businesses involved in cryptocurrency transactions. By having proof that reserves are available when needed, customers can be sure their funds will be safe even if something goes wrong during the transaction process. Businesses can use PoR information to provide added assurance to customers that they have access to the funds necessary to fulfill customer orders.

3. KYC

PoR helps ensure compliance with financial regulations. Cryptocurrency companies need to adhere to a wide range of regulations such as Anti-Money Laundering (AML) and Know Your Customer (KYC) guidelines or margin requirements. PoR provides regulators with the ability to audit and verify compliance with these regulations.

Preventing cryptocurrency scams

Proof-of-reserves serves as a last line of defense against the fraud that can occur in the cryptocurrency markets. Mt. Gox, BitConnect, TerraLUNA, FTX, and a host of other scarred crypto companies, have either lacked PoR outright or were not utilizing or sharing PoR with investors and stakeholders as they should have. 

PoR is key to building and maintaining a robust cryptocurrency market. Through PoR, customers can trust that their transactions will be secure, businesses can provide additional assurance to their customers, and regulators can ensure companies are compliant with financial regulations.