Over the past year, we have seen the Decentralized Finance (DeFi) ecosystem rapidly expand in total value locked from $1B to over $40B. While a large portion of this value comes from native crypto-assets like Ether (ETH), an increasing percentage of DeFi value is now in the form of non-native crypto assets such as fiat-backed stablecoins (USDT), cross-chain tokens (WBTC), and tokenized real world assets (PAXG), all of which share the common trait of being backed by off-chain collateral.
By expanding the types of collateral available to users, DeFi applications are increasing their utility for users, which we can see reflected in the growth of value locked. However, there is a key issue regarding the use of off-chain assets within DeFi. On-chain tokens backed by off-chain collateral are only an IOU, a representation of the underlying asset, which is often held off-chain by a centralized custodian.
Because the collateral backing these non-native tokens exist outside of the blockchain, smart contracts are unable to determine the token’s true collateralization. This creates a significant risk that a malicious custodian could mint a large number of unbacked tokens and then use it within DeFi to siphon value from users. As an example, if a large amount of unbacked stablecoins are minted and deposited into an on-chain money market, the deposit would be treated the same as if fully-backed stablecoins were deposited (the smart contracts cannot tell the difference). This would allow the malicious custodian to borrow more assets on the market than their collateral is truly worth, leaving the protocol with an undercollateralized position, resulting in losses for other depositors.
Chainlink Proof of Reserve feeds have emerged as a promising solution to this off-chain auditability problem. These feeds use external oracles to provide smart contracts the data required to autonomously audit the reserves of tokens backed by off-chain assets. For stablecoins, this could be reporting the amount of USD in a bank account. For cross-chain tokens, this could be the amount of Bitcoin held by a specific address. And for tokenized assets, this could be the amount of gold in a vault. If the Proof of Reserve feed reports that there is a less than expected amount of collateral backing a token, such as only $10M USD backing 100M minted stablecoins, DeFi protocols could use this data to begin reverting transactions involving the token.
While Proof of Reserve does not prevent custodians from being malicious and stealing the underlying assets, it does allow DeFi protocols to minimize damages by locking down functionality. For a money market protocol, this could include disabling the deposits, withdrawals, borrows, and repayments that involve a token that has been reported by the Proof of Reserve feed to be undercollateralized. This protects the deposits of other assets on the market, reducing the risk of the platform overall.
On-chain Proof of Reserve feeds are a relatively new oracle function, and so there are various important questions around its value and implementation within DeFi:
Should Proof of Reserve for stablecoins fetch data from third-party auditing firms or connect directly to an API provided by the custodian’s bank?
How can Proof of Reserve be used to help audit non-fungible tokens backed by more exotic assets like artwork and physical collectibles?
What other DeFi applications can benefit from Proof of Reserve beyond money markets and collateralized loan platforms?
Can Proof of Reserve feeds provide additional utility beyond being a circuit breaker for DeFi applications?
As the amount of tokens backed by off-chain assets increases, I believe Proof of Reserve has the potential to become as common as Price Feeds within the DeFi ecosystem for maintaining end-to-end transparency of financial products. Eager to discuss how others are thinking about its application, as well as any other important considerations around ensuring the security and solvency of off-chain assets that interact with DeFi protocols.