The Emergence of an Alternative: Proof of Reserves

Our modern world is highly dependent on the digital sphere, so it is only natural that currency has also found its digital counterpart in the form of crypto. That said, the year 2022 has been the bane of multiple reputable cryptocurrency titans such as FTX, Terra Luna, and Genisis/Gemini have all met their ends, which only reinforces the FUD that the crypto community is enduring due to a harsh bear season in the market. The volatility in the cryptocurrency sector begs the question; is the financial system adopted sound?????

Token Economy?

?First and foremost, a token is defined as a representation of value. Whether the value is physical or otherwise, a token can be attributed to it so that its value can be carried and traded.??

Most currently available cryptocurrencies follow the token model, and the labor required to mine, or validate in the case of PoS, new coins is represented by a token. Similarly, the real world uses fiat currency, and it is also a token whose worth is rooted in the promises, mainly of development and economic prosperity, that a government gives to its people, as well as some other socio-political factors. Also, fiat currency is fairly recent as prior to the year 1970s, the gold standard was the most widely used measure of worth for a currency, whereas the value of the currency would be pegged to that of the gold.??

Both fiat and cryptocurrencies are examples of token economy. Another example of token economy is the credit system, which is dominant in the modern banking system. In a nutshell, banks loan out freshly printed money to borrowers who prove that they’re investing in development projects and are able to return the money over time with an additional interest fee. As such, the borrowed money itself is the token, and the value is the promise of returning the debt.??

Further, in order to increase the supply of money and allow more investments to be made, a system known as leverage banking is also employed. Effectively, banks are allowed to loan out more money than they hold in their vaults as they have access to several sources of money such as window lending, government bonds, or other financial institutions. For example, some banks employ the 1 to 10 ratio whereas, for each 1$ that they hold, they can lend up to 10$.??

Most crypto exchanges that have recently faced their doom operated through token economy whose fatal flaw is “bank runs,” or when people rush to withdraw their assets from banks or exchanges in the masses. If banks or exchanges do not have the funds to cover the withdrawals, this would inevitably lead them to lock their customers’ money, and ultimately, bankruptcy could ensue.??

Proof of Reserves?

In the realm of cryptocurrency, there exists a technique that can be employed to prove to customers that their assets are safe and sound, locked in the vaults of a given exchange until they decide to withdraw them. Kraken championed this concept, and it is known as Proof of Reserves. The real-world equivalent would be the vault system that banks adhere to. That said, banks do not hold all their clients’ deposits, and the amount placed in these vaults varies in accordance with local jurisdictions. Proof of Reserves on the other hand does just that. It operates on a 1-to-1 ratio, meaning that the depositor’s assets are always safe and can be withdrawn whenever. This effectively protects against catastrophic events such as “bank runs” where people rush to withdraw all their money at once due to a certain event, leaving the bank unable to cover the amount requested and thus collapsing.??

It is worth noting that an early form of proof of reserves came in the form of stablecoins whose value was pegged to physical commodities, other cryptocurrencies, or fiat money. Tether (USDT) is an example of a stablecoin whose value is pegged to the US dollar, and it regularly releases audit reports for the sake of transparency, showcasing that they do indeed hold the money in their vaults.??

Bottom Line?

The world has gone through several economic systems, but it seems that none can truly remediate all the problems that arise.??

Back when currency was pegged to gold, supply was scarce, and governments could not answer the needs of a growing economy. Also, mining gold is a difficult process that can be hazardous to the environment, not to mention the fact that the price of the currency fluctuated according to the demand and supply curve of gold. With the credit system, inflation is always lurking around the corner, and fluctuation can become quite extreme because the value would depend on the supply and demand curve of the currency itself.??

It is difficult to say whether adopting proof of reserve for all crypto exchanges would yield positive results as it did not work for the traditional financial sector, but it can definitely protect users’ assets from large-scale collapses that could leave them with nothing.??

Conclusion?

All in all, proof of reserves can potentially bring stability to the highly unstable and volatile cryptocurrency. Both the credit and the vault systems have been tested in the real world, and it has been shown that the latter is low risk but with low return, and the former is a higher risk but with much more expansion opportunities.?