Transparency has been, and always will be, an essential pillar of cryptocurrency and blockchain technology. Without it, ledgers on the blockchain would not be public and there would be no understanding of how much liquidity is being held or traded by large entities. 

To combat the rising risk of Ponzi schemes shown by FTX, Chainlink has taken the time to remind everyone of their Proof-of-Reserve system which was first launched in 2022 to help provide necessary information to investors and prevent them from placing their funds in risky locations. 

What is proof of reserve

Proof-of-Reserve is an automated auditing system that monitors reserve assets, providing clarity to traders and investors so that they know how much reserve fiat and cryptocurrency are held by an entity. 

This is especially helpful in certain situations, such as FTX, when a web3 business is backed by its own cryptocurrency which inflates the price and essentially means they are backed by nothing because the native token is not pegged to any real form of value. 

Why is it necessary

With major collapses by TerraLuna and FTX causing billions of dollars to suddenly vanish, it has become increasingly important for investors to be reminded about the necessity for proof of reserve auditing. 

Massive issues arise when liquidity reserves are not transparent once native tokens are used as collateral to loan against. The major risk here is that if the valuation of these native tokens drops, then there is no way of repaying back any loans taken out against the tokens.

Without full transparency, bankruns become the key moment when many investors find out that a web3 business has been propped up by tokens which mirror Ponzi schemes and can cause massive ripples across the ecosystem. 

How it works

In order for Proof-of-Reserve to work, Chainlink first uses its program to audit vaults that are stored off-chain. This is necessary for funds that are held in fiat as a form of backing. 

The information is then sent to the Chainlink network oracle where it is then redirected into a smart contract and put on-chain where that transparency of the asset vault is permanently recorded and available to the public. 

Chainlink can also do similar auditing with vaults that are stored on-chain through cross-chain technology so that reserves that hold popular tokens from a variety of different networks, such as Ethereum and Solana, can also be accounted for. 

Who is using it

As more protocols and companies in web3 collapse, the need for on-chain transparency is reaching an all-time high. Stablecoins, DeFi protocols, and DeFi are examples of different business types in web3 that need to begin taking their reserve funds more seriously because it is clear that, without proper verification of liquidity, there is simply not enough confidence for investors anymore in the cryptocurrency ecosystem.

Projects like TrueUSD and Poundtoken have already begun using the automated auditing solution to provide full disclosure to their user base realizing the need for transparency in web3. 

As we move forward, it’s likely that the cryptocurrency community will begin avoiding popular exchanges and DeFi protocols that don’t provide enough information about their liquidity following the fallout of FTX and TerraLUNA which would be a good thing for the space and help to mitigate these massive types of collapses from happening again in the future.