Proof of reserves and zero-knowledge proof are essential for restoring credibility to the cryptocurrency, NFT and blockchain industry.

Unfortunately, recent failures like the FTX exchange and numerous NFT-related scams have eroded trust in blockchain technology among the mainstream audience. The issue is not with the technology itself, but rather with the actions of bad actors within the industry.

It's worth remembering that as with any new and still-evolving technology, failures in its early stages are almost inevitable. While blockchain and cryptocurrencies have been around for years, they are still in their early stages of development as far as the general public is concerned. Some may even compare the current situation to the early days of the internet, when many declared its end after the first dot-com crash in 2000-2001.

The blockchain industry is experiencing a settling down similar to what happened 20 years ago with the first Web2 companies. However, cryptocurrencies and blockchain technology have a promising future. Unfortunately, fraudsters and speculators are always ready to prey on new opportunities. As the industry matures, government regulations and increased public awareness can help prevent it from being inflated by speculators. While consumer protection from fraudulent practices is essential to restore lost trust, regulation could potentially undermine the decentralization principles associated with blockchain technology. To avoid government intervention, the industry is attempting to self-regulate by adopting "proof of reserves" mechanisms. This can help restore customer confidence by demonstrating that institutions possess the assets they claim to hold and are not engaged in fraudulent behavior such as "exit scams."

Proof of reserves and zero-knoledge proof

Cryptocurrency exchanges and institutions can provide proof of reserves in several ways, such as using an independent auditor, publishing a list of assets along with proof of ownership, or utilizing the cryptographic technique of zero-knowledge proof. While zero-knowledge proof is the safest from manipulation, it's also the most difficult to explain to the general public, raising the question of how trust can be regained if evidence is not easily understandable. The answer to this question will determine the success or failure of the self-regulatory strategy.

Zero-knowledge proof allows a prover to prove a statement's truth to a verifier without revealing any information about the statement itself, which is useful for a cryptocurrency exchange that wants to prove ownership of assets without revealing specific assets or addresses. Zero-knowledge evidence has three properties: completeness, soundness, and zero-knowledge, ensuring the verifier is convinced of the statement's truth, the prover cannot convince the verifier of a false statement, and no information about the statement is revealed to the verifier.

Cryptocurrency exchanges and institutions can provide proof of reserves through various means. One way is by having an independent auditor certify that the assets they claim to hold are indeed in their possession. Another way is by publishing a list of their assets, along with evidence proving that the assets are under their control. However, the most secure method is through a cryptographic technique called zero-knowledge proof, which can prove asset ownership without revealing specific information about the assets themselves. This method can be particularly useful for cryptocurrency exchanges that want to demonstrate to customers that they hold a certain amount of assets in reserve, without disclosing details about the specific assets or transactions.

For example, let's say Alice owns a cryptocurrency exchange and wants to prove to her customers that she holds a certain amount of Bitcoin in reserve. She can do this by creating a cryptographic commitment that ensures the Bitcoins in her reserve match the Bitcoin blockchain, thereby verifying that her reserves are genuine and not fraudulent. Alice can publish this evidence for her customers to verify and confirm that she has the Bitcoins she claims to have. Customers can perform this verification manually, through the use of online services, or directly through their own cryptocurrency wallet on their exchange, if supported.

If you're still unsure about how zero-knowledge proof works, you might find this video by Professor Amit Sahai helpful. In the video, he explains the concept to people with different levels of understanding, including a child, a teenager, a college student, a graduate student, and an expert. The video has over 5 million views and is accessible to everyone.

The foundation of a "healthy" blockchain that can self-regulate and exclude fraudulent operations, while providing enormous benefits to the general public, is built on the concepts discussed above. Although these concepts may still be unfamiliar to many, their mastery is essential to the success of blockchain technology. The inevitability of regulations looms on the horizon, and their flexibility or rigidity will depend on the progress made in the blockchain world in the meantime.

...

We are Ex Machina. Driving innovation in software development with our team of expert Java developers, software engineers, and blockchain specialists. We serve global companies and public agencies with cutting-edge, complex applications in Lugano, Ticino, Switzerland, and beyond.