Discussion Post: Proof of Reserves (PoR): A reliable method for centralized exchanges to achieve transparency?

[Ulysses]

TL;DR

• PoR is a method proposed for achieving transparency and ensuring the security of users’ funds on decentralized exchanges(DExs).
• There are several advantages of PoR that make it a good option for ensuring the security of funds, the privacy of users’ identities, and the transparency of operations and transactions. One of such advantages is the use of cryptographic proofs through Merkle trees.
• Major crypto industry players advocate for PoR as a solution to CExs transparency, but that doesn’t solve the problem completely. There are limitations to PoR that users should be aware of. However, these limitations are mostly not inherent features but shortcomings in the application and use of PoR.

At issue

Crypto-enthusiasts are clamoring for PoR audits on centralized exchanges, but it seems like much is not being said about the limitations and risks associated with both the method and its execution.

Related SCRF Posts

• A ZK-SNARK-based Proof of Assets Protocol for Bitcoin Exchanges by @B_Swaroopa_Reddy.
• Zero-Knowledge Proofs - An Ethics Perspective by @jasonanastas.

Discussion

• Before FTX, many other exchanges had failed due to a lack of transparency in transactions and managing users’ funds. And even then the idea of proof of reserve was already in existence but used by a few crypto exchanges. However, it was FTX’s failure that popularized the idea of proof of reserves.
• Traditional banks run on the fractional reserve banking system. Here, users’ funds are partly kept in the custody of central banks while part of it is lent out for value accrual in favor of the banks. But there is a problem with this system.
• What if one day something happens, probably a bank run, and all depositors need their funds? How will the bank pay back its depositors if the money had been lent out? This is one problem crypto and DeFi is trying to solve. Perhaps that is why Changpeng Zhao(CZ) of Binance advised against centralized exchanges running on fractional reserves.
• So if there are no central banks to help regulate crypto exchanges and, ideally, users’ funds should not be used for other purposes, how then do users ensure their funds are safe and not mismanaged by centralized exchanges? This is where PoR comes in.

What is proof of reserve and how does it work?

• PoR audit is a way of verifying that the amount of funds a crypto exchange claims to have in its custody is true. It is an independent exercise executed by a third-party blockchain account auditing service like Armanino that does not compromise users’ identity in the process.

This is basically how a PoR audit works:

• A third-party auditor takes a snapshot of all user’s balances in an exchange. This snapshot must be anonymized to ensure users’ privacy. Anonymity here is achieved using cryptographic hashing.

• These user balances represented as hashes are organized into merkle trees. The merkle tree possesses the merkle root that holds the aggregated balances of all users on the exchange.
  
  Pictorial representation of Merkle trees. Source: Kraken

• The next step is the verification of the crypto exchange wallet addresses. To achieve this, the third-party auditor produces a message requesting the crypto exchange to cryptographically sign using their private keys. Remember you can only sign from a wallet that you have its private keys.

• If the auditor compares the balance from the addresses producing the signature and the balance from the original Merkle root and they correspond, it shows that users’ funds are in the custody of the exchange.

Why PoR matters

• It is a way of earning users’ trust. If an exchange presents its PoR to users, it will increase the likelihood of them retaining old customers and attracting new ones.
• It ensures the sustainability of the industry as exchanges will be “forced” to keep user funds safe.

Limitations of PoR

• Generally, there is not yet a standard that exchanges are required to follow to achieve a comprehensive audit.

Below is a list of the major limitations of PoR:

• PoR is conducted by third-party services. This is not in line with the industry’s goal of decentralization. It creates room for possible manipulation of data.
• Present PoR lacks proof of liability which should be a prerequisite for users to keep their funds in a CEx. If an exchange cannot prove its solvency, it might probably be hiding something about its finances.
• A good number of present PoR are not available in real-time or done periodically. They are a sort of one-time audit. The problem with a one-time audit is that an exchange can borrow funds for an audit to return them after the audit. Crypto.com was accused of this but its CEO debunked it.
• Some exchanges just publish data on their website showing their assets without on-chain data backing it up.

Why do users prefer centralized exchanges?

• Someone would ask, " why not just use a decentralized wallet and forget about Centralized exchanges?"
• Some users are not good with keeping private keys. They prefer services run by a third party, that way they won’t bear the responsibility of safeguarding security keys.
• In the past, a good number of crypto users have lost their seed phrases and automatically lost all their funds. So you now understand why they decide to relinquish that duty to centralized exchanges.
• Secondly, CEXs have more features that users can easily navigate. For instance, people in areas where crypto is banned find it more comfortable using P2P services to convert crypto to cash.

Must haves for an ideal PoR

Having examined the downsides of PoR, these are the necessary data that every PoR audit should have to build high-level trust.

• Proof of liability to show the solvency level of crypto exchanges.
• Anonymized balances of users’ funds for deeper transparency.
• Periodic snapshots or real-time attestation to avoid manipulation of PoR.
• Publicly available verified wallet addresses owned by the custodial body to help users check activities on-chain.
• An option for users to verify their balances. This will help users confirm that their balances were part of a proof of reserve audit published by a CEX.
• Using Validiums to make centralized exchanges non-custodial as suggested by Vitalik Buterin. This will prevent CEXs from having access to users funds in the first place.

Bonus point: how to confirm an exchange’s proof of reserve.

• There are several ways to confirm if an exchange or any custodial entity has done its proof of reserves.

• We will focus on the simplest way to do this: Using CoinGecko.

• Visit CoinGecko’s crypto exchange page
  

  
  
  Image source: CoinGecko

• The link takes you to a page showing exchanges with the corresponding status of their proof of reserve. “Available” on the “reserve data” column shows that CoinGecko has the exchange’s proof of reserve data while “unavailable” shows they do not have it.

• To know the status of OKX proof of reserve, for instance, go to the “exchange” column and click OKX. It then takes you to a new page showing some headings. Click the heading “exchange reserve new”
  

  
  
  Image source: CoinGecko

• Once you have clicked that heading, it then shows you proof of reserve data for OKX from Defillama, Nansen, and from OKX itself.

Discussion questions

What are your thoughts on these proposed ideas?

• Proof of liability to show the solvency level of crypto exchanges.
• Anonymized balances of users’ funds for deeper transparency.
• Periodic snapshots or real-time attestation to avoid manipulation of PoR.
• Publicly available verified wallet addresses owned by the custodial body to help users check activities on the Blockchain.
• An option for users to verify their balances. This will help users confirm that their balances were part of a proof of reserve published by a CEX.

References

1. Agbo, J. (2022) What is Proof of Reserves, and Why is it Important? CoinGecko. Available at: What is Proof of Reserves (PoR)? | CoinGecko [Accessed 30th November 2022].

2. Binance (2022) what is proof of reserves and how it works on Binance. Binance blog. Available at: What Is Proof of Reserves and How it Works on Binance | Binance Academy [Accessed 30th November 2022].

3. Buterin, V. (2022) Having a safe CEX: proof of solvency and beyond. Available at: Having a safe CEX: proof of solvency and beyond [Accessed 30th November 2022].

4. Decker, C., Guthrie, J., Seidel, J., Wattenhofer, R. (2015). Making Bitcoin Exchanges Transparent. In: Pernul, G., Y A Ryan, P., Weippl, E. (eds) Computer Security – ESORICS 2015. ESORICS 2015. Lecture Notes in Computer Science(), vol 9327. Springer, Cham. Available at: Making Bitcoin Exchanges Transparent | SpringerLink [Accessed 30th November 2022].

5. Gilbert, J. (2022) What Is Proof of Reserves and Can It Build Back Trust? Blockworks. Available at: What Is Proof of Reserves and Can It Build Back Trust? - Blockworks [Accessed 30th November 2022].

6. Jha P. (2022) Proof-of-reserves: Can reserve audits avoid another FTX-like moment? Cointelegraph. Available at: https://cointelegraph.com/news/proof-of-reserves-can-reserve-audits-avoid-another-ftx-like-moment/amp

7. Merkle, R.C. (1988). A Digital Signature Based on a Conventional Encryption Function. In: Pomerance, C. (eds) Advances in Cryptology — CRYPTO ’87. CRYPTO 1987. Lecture Notes in Computer Science, vol 293. Springer, Berlin, Heidelberg. A Digital Signature Based on a Conventional Encryption Function | SpringerLink

[Progrezz]

" Traditional banks run on the fractional reserve banking system. Here, users’ funds are partly kept in the custody of central banks while part of it is lent out for value accrual in favor of the banks. But there is a problem with this system."

This post is a recent trending issues in the crypto custody and exchange space. I want to know why can’t exchange run on fractional reserve as the traditional banking does. Are there clear reasons why Crypto exchanges cannot run on fractional reserve because both industries manage financial assets?

[Larry_Bates]

The main reason that crypto-exchanges shouldn’t be running on fractional reserves is that that specific issue was part of the reason that bitcoin was supposedly created. Fractional reserve banking intermixed with over-valued real estate investments was the crux of the 2007-8 financial meltdown. It’s not that exchange’s “can’t” do fractional reserve banking, they “shouldn’t” do fractional reserve banking. The main argument against Tether has been that USDT has claimed full-reserve banking while there are legitimate concerns as to whether or not they have been operating a fractional-reserve. Fractional-reserve banking can work until a liquidity crunch and then it quickly devolves into a full on liquidity crisis. FTX is a perfect example of the dangers of fractional-reserve banking being practiced in cryptocurrency and the most recent impetus to cause the move towards Proof of Reserves.

[Chrisarch]

PoR is important for different exchanges as it ensures trust, security and accountability, hence, reassures users’ commitment for continuous usage of the exchange protecting their funds.

The proposed ideas are diligent enough as it places many exchanges to embrace PoR after the fallout on FTX. The ideas are in line and would help curbing the limitations holding PoR’s full implementations.

Here are my thought on these ideas:

Without Proof of Liability, users may have false sense of security. Some exchanges could use their PoR to disguise as a self regulating and transparent participant without disclosing their actual solvency risk. An exchange cannot have good PoR without looking at its proof of liability.

Since PoR auditing is done by a third party, to avoid manipulation, real-time attestation would help provide insights that are updated several times daily. As you know, the address containing the reserves are not always publicly disclosed, hence, making one unable to verify that the funds are still there after auditing is completed. Even if the address is publicly known, there is no way to verify account ownership in the audit.
Real-time attestation would be able to deal with the account balances of the user and the exchange, liabilities’ disclosures and verifiable wallet address since snapshots only includes liabilities at some specific time, published addresses cannot be used to verify solvency at real time.

The use of cryptographic approach aids users to verify that their account balance is included in the part of PoR published by an auditor. Every user can be able to verify if their account balance was included in the Merkle tree by hashing their account balance and unique ID, and searching it on the Merkle tree. However, one may ask, can every user be able to hash and verify their account?

@Ulysses, this is an insightful post detailing PoR and its implications. It is well detailed and a good read.

[Yeoriton56]

@Ulysses

Proof of liability to show the solvency level of crypto exchanges.

Nice thoughts @ulysses. This area you talked about proof of liability, can you explain further? It doesn’t seem to be very clear to me.

[Ulysses]

I can see that Larry has given a comprehensive response to this question. I agree with that.

The crux of the matter here is the liquidity crisis. Being that cryptocurrencies are very volatile, centralized exchanges have to make provisions as a factor of safety for periods of crises. And, having a robust reserve is one way to do that.

[Ulysses]

Wonderuful input @Chrisarch!

If Merkle tree method was used for the proof of reserve audit, every willing user can verify that there balances were added to the proof of reserve audit.

This article by Binance details how a Binance user can verify that their account was considered on the Binance proof of reserve audit.

[Ulysses]

A complete proof of reserve should have proof of assets and proof of liabilities.

A Proof of assets shows what the balance of an Exchange is at any time and the wallets where the funds are stored.

Proof of liabilities on the other hand shows the deposits of users which sum up to the asset the exchanges hold.

If an exchange shows the balance only without the deposits, users cannot say for certain that their fund wasn’t mismanaged.

[Angle]

As someone working on launching a derivatives exchange, I have a mix of thoughts and opinions on what an exchange “should and shouldn’t” do that might be an interesting perspective for y’all to hear.

First I want to clarify how I define an exchange. In my eyes, exchanges at the core should be in the business of making markets. Connecting buyers and sellers. Nothing else. This is what an exchange is to me, no questions about it.
The problem comes from this initial business (an exchange) expanding to be more of a broker than an exchange. When you start interacting directly with your clients, you move beyond being a “crypto exchange” and become something else.
So no, an exchange should NOT be fractionalizing their reserves engaging in rehypothecation because it is not within the scope of their business. All the popular crypto marketplaces have become something more through their lending, borrowing, staking, etc…

Most brokers will disclose what they are doing with customer funds in their terms of service agreements, so frankly anyone using these crypto brokers should understand the risks of depositing their money into these platforms. That is their responsibility (more on this later).
However, I see some issues:

1. These companies/platforms market themselves in a particular way that obscures an apparent truth from people.
2. People don’t even know what a broker does for any number of reasons.

Let’s say you do understand what a broker is, that these platforms are them, and even read the ToS…
The problem with FTX is that they explicitly said funds would not be loaned out for trading.
So now it’s a problem of transparency.
This is where this summary comes into play with Proof of Reserves and its ability to be spoofed.

You are basically choosing to accept the possibility of your funds being compromised the instant you deposit. Even with a PoR, there is no way to TRULY know that these companies are being truthful and transparent…

Unless you use a DEX. The points on why people choose CEXes are valid, but people don’t always understand the inherent risks of using a CEX. CEXes tend to not make these apparent. Here lies the problem.
Whatever the reason someone chooses to use CEX > DEX, I feel that their base information is not always complete and PoR is not the actual information that is needed to complete it.
Whether or not you choose to take on responsibility

So I guess my point here is that there is a lack of transparency of information that comes even before PoR. While it ~can be an effective method, it has to assume honest actors in the space. I think the saying “don’t trust, verify” is very applicable here. You either accept liability for your funds or you throw them into a black box and hope the company is honest.

I’d love to hear what folks think about my opinion here.

[Mansion]

Thank you @Ulysses
for this fantastic work.

Welll, public transparency blocks a crypto exchange from making any secretive financial transactions, such as for example, loaning out more money than the collateral it holds and risking insolvency. Its likely seemed to be a step toward a more transparent crypto ecosystem.

By providing Proof-of-Reserve audits, It help users make more informed decisions by providing an unbiased and completely honest picture of their funds.

[Ulysses]

Hi @Angle, you have made substantial points here.

I, very much, agree with your perspective on what an exchange should be— a connector. This is the first step to avoiding problems of fund mismanagement. I hope you apply this model in your forthcoming derivatives exchange!

Although PoR might not be efficient, it is a step ahead on the quest for establishing a standard for transparency on centralized exchanges.

A centralized exchange is community backed and its stronghold is the community’s trust. The secondary reason FTX collapsed was for a failure in trust from its community.

My point is this: if standards are set formally or informally as in PoR, your definition of what an exchange should be, etc, most centralized exchanges will try to adapt to it, unless they run the risk of losing their community’s trust.

And, once an exchange loses its community’s trust, it will be out of business. No one wants to be out of business.

I’m optimistic that PoR will be the first piece of domino to trigger other dominoes in order to ensure transparency and proper fund management by CEXs.

[WaterLily]

PoR is crucial across various trades since it guarantees confidence, confidentiality, and integrity, guaranteeing clients’ devotion to ongoing use of the trade while safeguarding their investments.

The suggested solutions are comprehensive that much because they encourage numerous trades to adopt PoR in the wake of FTX’s failure. The concepts are sound and would aid in reducing the restrictions preventing complete PoR deployment.

However, people might feel insecure if there is no Proof-of-Reserve. Most trades might conceal their true solvency risk by using their PoR to pass themselves off as an ego and honest user. Without considering its substantiation of obligation, no exchange can have a solid PoR.

Legit authentication may aid to offer ideas which are modified multiple instances everyday because PoR auditing is performed by a private entity, preventing fraud.T the location storing the assets is not always disseminated, making it impossible to confirm that the money is still present once the audit is over. There is no method for the audit to confirm client membership, so if the location is widely recognized.

By giving consumers a fair and honest representation of their finances, Proof-of-Reserve audits aid users in making better rational choices.

[Cashkid18]

I believe that it might be difficult for someone to have faith in the security of their assets in light of the recent FTX fiasco. A foundation based on increased confidence, credibility, security, and credence is what the cryptoverse is looking for, which is why more and more exchanges are moving toward a Proof-of-Reserves system.Several cryptocurrency companies are using the Proof-of-Reserves system, a technique that ensures transparency to centralised crypto reserves, in response to the havoc produced by the FTX fiasco. The PoR method, often referred to as Proof-of-Reserves, is a verifiable auditing process that answers concerns about the transparency of assets kept on exchanges… this means that Proof-of-Reserves is a method of confirming that a company, such as a crypto exchange, has enough reserves to back all of its customers’ balances.
This process assures that the cryptocurrency is backed by actual assets and answers concerns about asset transparency on exchanges.
The Proof-of-Reserves is significant in light of the current issue brought on by the FTX crash because it:
benefits both users and customers.
provides clients with information that is clear regarding the availability and support of money.
the ability for clients to independently and cryptographically verify that their account balances are included in the stated system is increased due to increased customer trust.
Furthermore, it safeguards underages from hazardous players and minimizes security threats to keep them safe.
encourages companies to adhere to transparency requirements, which makes it more challenging for them to engage in shady or unlawful financial behavior.

In conclusion,
Many experts do not view the PoR approach as a flawless system, despite the fact that it guarantees that a cryptocurrency corporation has the assets necessary to cover its liabilities.
They contend that the approach simply represents a single moment in time and does not provide a continuous accounting of balances. Furthermore, it does not trace where the assets originate and merely represents the custodian’s on-chain holdings.
In a word, Proof-of-Reserves is a positive development for any cryptocurrency business. Any cryptocurrency exchange or company that acts as a custodian on behalf of its customers would gain from this strategy as nations all over the world strive for stricter bitcoin rules. Despite its drawbacks,I still believe that the method can give customers assurance and boost their confidence.

[Raphking]

There’s one thing we can all agree on, it’s that 2022 has been a rough year for everyone in the crypto industry — traders and exchanges alike. Unfortunately, the bearish streak doesn’t look to be ending any time soon. Following the FTX saga, which culminated in a bankruptcy announcement. Proof of reserves, or PoR, which refers to a background check (or an independent audit) conducted on crypto exchanges by a third-party auditor has been thrust into the spotlight.

Furthermore, these proposed ideas are fantastic as they will improve transparency between CEX and users.

@Ulysses

What are your thoughts on these proposed ideas?

• Proof of liability to show the solvency level of crypto exchanges.
• Anonymized balances of users’ funds for deeper transparency.
• Periodic snapshots or real-time attestation to avoid manipulation of PoR.
• Publicly available verified wallet addresses owned by the custodial body to help users check activities on the Blockchain.
• An option for users to verify their balances. This will help users confirm that their balances were part of a proof of reserve published by a CEX.

Conclusively, the security of a system can almost every time be compromised if exposed to a third-party system or application especially when they have access to certain information about clients in the system.

I’m just wondering about the possibility of achieving PoR by an internal body of a CEX using a different algorithm-like application of AI that would enable the user’s see the analysis by comparison in like incase of P2P.

[Ulysses]

Hi @Raphking thanks for adding your thought to the discussion.

You are concerned about the safety of users’ data in the PoR process. The pocesss uses zero knowledge proofs (ZKPs). ZKPs proves that something is true without actually revealing that data.

Another concern you raised is the idea of centralized third-party in PoR audits. I briefly talked about it. It’s a real issue which is why Vitalik Buterin suggested the use of Validiums.

@Ulysses

Using Validiums to make centralized exchanges non-custodial as suggested by Vitalik Buterin. This will prevent CEXs from having access to users funds in the first place.

[Ulysses]

Hey @Cashkid18, thanks for your inputs!

@Cashkid18

They contend that the approach simply represents a single moment in time and does not provide a continuous accounting of balances. Furthermore, it does not trace where the assets originate and merely represents the custodian’s on-chain holdings.

This was exactly why this post suggested the use of a real time audit, and the use of proof of liabilities to solve the two challenges you highlighted.

[Raphking]

@Ulysses Thanks a lot for the reference and explanation

However, Validiums are scaling solutions that use off-chain data availability and computation designed to improve throughput by processing transactions off the Ethereum Mainnet. Like zero-knowledge rollups (ZK-rollups), validiums publish zero-knowledge proofs to verify off-chain transactions on Ethereum. This prevents invalid state transitions and enhances the security guarantees of a validium chain.

I think validiums is just another software, do you think using validiums would be an effective solution as suggested above because’s core design is based on the Ethereum network?

[Humphery]

Hello, your research is a fine piece @Ulysses but In general, I believe that the proposed ideas you mentioned could potentially enhance the transparency and security of crypto exchanges.

Proof of liability can be a useful tool for demonstrating the solvency of a crypto exchange and helping users to assess the risk of losing their funds. By disclosing information about the assets and liabilities of the exchange, users can get a better understanding of the financial health of the exchange and make informed decisions about whether to use it.

Anonymized balances of users’ funds can also help to increase transparency by disclosing information about the overall financial health of the exchange without revealing the specific balances of individual users. This can help to protect the privacy of users while still providing valuable information to the public.

Periodic snapshots or real-time attestation can help to prevent manipulation of proof of reserve (PoR) by crypto exchanges, which can increase the credibility and trustworthiness of the information disclosed by the exchange.

Making publicly available verified wallet addresses owned by the custodial body can help users to check activities on the blockchain and verify that their funds are being held securely.

An option for users to verify their balances can also increase transparency and accountability by giving users a way to confirm that their balances were included in a proof of reserve published by the exchange. This can help to build trust and confidence in the security of the exchange.

Overall, these proposed ideas could contribute to a more transparent and secure crypto exchange ecosystem, which would benefit both users and the industry as a whole.

There are a few additional points that could be considered when discussing the proposed ideas for increasing transparency and security in the crypto exchange industry:

1. The importance of regulation: While the proposed ideas could help to increase transparency and security in the crypto exchange industry, they may be more effective when implemented as part of a broader regulatory framework. This could include regulations around the disclosure of financial information by crypto exchanges, as well as requirements for third-party audits and other forms of oversight.

2. The role of industry standards: In addition to regulatory measures, industry standards and best practices can also play a role in promoting transparency and security in the crypto exchange industry. This could include guidelines for how exchanges should disclose financial information, as well as recommendations for security practices and risk management.

3. The potential for technological solutions: There are also a number of technological solutions that could be used to enhance transparency and security in the crypto exchange industry. For example, the use of blockchain technology and smart contracts could help to automate the process of disclosing financial information and verifying the solvency of exchanges.

4. The need for user education: Finally, it is important to consider the role of user education in promoting transparency and security in the crypto exchange industry. Users need to understand the risks and benefits of using crypto exchanges, as well as how to protect their own interests when using these platforms. Providing users with the knowledge and tools to make informed decisions can help to promote a more transparent and secure crypto exchange ecosystem.

Understanding the Research question I would add that Proof of reserves (PoR) is a method that centralized crypto exchanges can use to demonstrate their solvency and provide transparency to their users. The idea is that the exchange publishes information about the assets it holds and the liabilities it owes to customers, such as the total value of cryptocurrencies and fiat currencies held by the exchange and the total amount of outstanding deposits and withdrawals. This information can help users to assess the financial health of the exchange and the risk of losing their funds.

There are several potential benefits to using PoR as a method for achieving transparency in centralized crypto exchanges:

1. Increased confidence: By disclosing information about their assets and liabilities, exchanges can build trust and confidence among their users. This can be particularly important for exchanges that hold significant amounts of user funds and may be at risk of financial failure or bankruptcy.

2. Improved accountability: PoR can also help to increase accountability by giving users a way to verify the information disclosed by the exchange. This can help to prevent fraud and other forms of deception, and encourage exchanges to be more transparent and honest about their financial situation.

3. Enhanced security: PoR can also help to improve the security of user funds by providing a way for users to verify that their funds are being held securely by the exchange. This can help to reduce the risk of losses due to fraud, hacking, or other security breaches.

There are, however, some potential limitations to the use of PoR as a method for achieving transparency:

1. Dependence on the exchange: PoR relies on the exchange publishing accurate and truthful information about its assets and liabilities. If the exchange is not honest or transparent, PoR may not provide a reliable indicator of the exchange’s solvency.

2. Limited scope: PoR only provides information about the assets and liabilities of the exchange. It does not necessarily provide insight into other aspects of the exchange’s operations, such as its business model, management practices, or financial performance.

3. Complexity: The information disclosed through PoR may be complex and difficult for users to understand, particularly if the exchange holds a wide range of assets or has complex liabilities. This could make it difficult for users to assess the financial health of the exchange based on PoR alone.

4. Vulnerability to manipulation: PoR is vulnerable to manipulation by the exchange, either intentionally or unintentionally. For example, the exchange could underreport its liabilities or overreport its assets in order to present a more favorable financial picture. Alternatively, the exchange could simply make errors in reporting its financial information, which could lead to a misleading portrayal of its solvency.

Overall, while PoR can be a useful tool for increasing transparency in centralized crypto exchanges, it is not a foolproof method and should be used in conjunction with other measures to ensure the security and integrity of user funds.

[Zionitegem]

Thank you for sharing your thoughts on exchanges and their role in connecting buyers and sellers. You make a good point about exchanges expanding beyond their core function of making markets and becoming more like brokers, which can create risks and challenges for users. It is important for exchanges to be transparent about their operations and the use of customer funds, particularly when they offer additional services such as lending, borrowing, staking, etc.

I agree that there is a lack of transparency in the crypto industry, and that it can be difficult for users to fully understand the risks and responsibilities associated with using different types of exchanges. It is important for exchanges to clearly communicate the terms of service and any potential risks to users, and for users to be proactive in understanding the nature of the platform they are using and the potential risks involved.

You also bring up the issue of Proof of Reserves (PoR) and its potential to be spoofed. PoR is a mechanism used by some exchanges to demonstrate the solvency of their operations, but as you pointed out, it relies on the assumption of honest actors. Therefore, it is important for users to be aware of the limitations of PoR and to consider other factors when evaluating the security and trustworthiness of an exchange.

Overall, I think it is important for both exchanges and users to be transparent and proactive in understanding the risks and responsibilities involved in the use of these platforms. This can help to promote trust and confidence in the crypto industry and ensure that it continues to evolve and mature in a responsible and sustainable way.

[Zionitegem]

@Progrezz in response to your concern “I want to know why can’t exchange run on fractional reserve as the traditional banking does. Are there clear reasons why Crypto exchanges cannot run on fractional reserve because both industries manage financial assets?”

There are a few key differences between traditional banks and crypto exchanges that may explain why crypto exchanges cannot run on the fractional reserve system.

First, traditional banks are regulated by central authorities, such as central banks, which oversee their operations and ensure that they are adhering to certain standards and practices. This is not the case for crypto exchanges, which are largely unregulated and operate in a largely decentralized manner. This lack of regulation may make it more difficult for crypto exchanges to implement a fractional reserve system, as it would require them to be more transparent about their operations and potentially subject to external oversight.

Second, traditional banks have a long history of operating within the fractional reserve system, and the public has generally come to trust and rely on this system. In contrast, crypto exchanges are relatively new and still building trust with the public. Implementing a fractional reserve system could potentially damage this trust, as it may be seen as a risky or untested practice.

Finally, the nature of the assets being managed by traditional banks and crypto exchanges is fundamentally different. Traditional banks manage fiat currencies, which are backed by governments and central banks, whereas crypto exchanges manage digital assets, which are not backed by any central authority and can be more volatile in value. This difference in the nature of the assets being managed may make it more difficult for crypto exchanges to implement a fractional reserve system without exposing users to additional risks.