With the recent FTX exchange collapse that we mentioned in the last cryptocurrency training article, fear and uncertainty have returned once again. Lack of ethics on the part of the founder, Sam Bankman-Fried, led to a huge sell-off in the ecosystem, taking entities like Alameda Research, Block Fi, and many more with it. With this event, the use of the term “Proof of Reserves” has recently begun to stand out. If you don't know what we're talking about, let's dedicate this cryptocurrency training to analyzing what Proof of Reserves is and why it has recently become popular.
What is Proof of Reserves (PoR)?
The term “Proof of Reserves” (PoR or Proof of Reserves in Spanish) is an independent audit carried out by third parties that is carried out with the objective of guaranteeing that an entity maintains the assets that it claims to have in custody on behalf of its clients. This audit is performed by taking an anonymous snapshot (better known as a Snapshot in the crypto ecosystem) of all the balances you maintain and adding them to a Merkel tree.
Example of a Merkle tree. Source: Wikipedia.
How does booking testing work?⚙️
As we have commented in the previous paragraph, first an anonymous capture is made of all the balances it maintains and adds them to a Merkel tree. This tree is a (encapsulated) data structure that respects the privacy of all your customer data. From there, the auditor receives a Merkle root, that is; a cryptographic fingerprint that identifies the combination of these balances at the time the capture was made. The auditor then collects digital signatures produced by the entity, which demonstrate ownership over addresses on the blockchain with publicly verifiable balances.
Chainlink protocol reserve proof mechanism. Source: Chainlink.
Finally, the auditor compares and verifies that these balances exceed or match the client balances represented in the Merkle tree and, therefore, that the client assets are maintained with all reserves. Any client of such entities can independently verify that their balance has been included in the proof of reserves audit by comparing certain data with the Merkle root. Any change made to the rest of the data, no matter how small, will affect the root, allowing us to detect fund manipulations.
Why has reserve testing recently become popular?️
Why this term has become popular sounds obvious; After the huge collapse suffered by both the Terra protocol and the FTX exchange, everyone has panicked about which exchange or protocol could be the next to fall. As we have witnessed during these days, there are different events that have recently popularized this term, such as:
Alameda Research has had a great showing in the Solana ecosystem.
As seen last week, Alameda Research (an investment fund with close connections to FTX) had extensive exposure to the Solana ecosystem, where the native blockchain token (SOL) was its second largest holding. At the same time, they also held large amounts of tokens from the Solana ecosystem, such as MAPS and OXY.
SOL token drop of 10% on Monday, November 7. Source: CoinDesk.
Previously, the portal that uncovered the entire plot, CoinDesk, revealed that in Alameda's balance sheet document it could be seen that they had 292 million dollars in unlocked SOL tokens, 863 million dollars in locked SOL tokens and another 41 million dollars in SOL tokens placed as collateral. This has caused general distrust about what assets the defunct FTX exchange held in large quantities, given that we have already observed the price of Bitcoin with immediate effect. An event that was repeated six months ago when Terra got rid of nearly 80.000 BTC...
Wrapped token backups.
Speaking of backups, if we thought that Solana had already taken all the hits, we were very wrong... It turns out that with the recent uncertainty surrounding the Solana blockchain, it has been seen as the wrapped BTC and ETH tokens of the Solana blockchain ( soBTC and soETH respectively) lost the 1:1 parity until they fell to hell, specifically to $1223 and $269 respectively.
Chart of the wrapped BTC token in Solana (soBTC).Source: Coingecko.-
Chart of the wrapped ETH token on Solana (soETH).Source: Coingecko.
This happened when there were fears that the Solana blockchain's wrapped token backup could suffer a leak of the supporting assets, which will quickly spread the damage to the entire Solana ecosystem.
Other centralized exchanges splashed by controversy.⚠️
As we have learned in this cryptocurrency training, reserves are the star topic of these weeks. In order to verify and regulate whether they can withstand extreme conditions of volatility and be viable, exchanges must have well-distributed reserves so as not to harm the viability of the platform and, of course, the funds of their clients. If we see the collapse of FTX, the next exchange highlighted by the controversy is another of the greats; Crypto.com.
57% drop in 5 days of the CRO token. Source: Tradingview.
The Singapore-based exchange harbors many structural similarities to the bankrupt FTX; utility token (CRO), sponsorships in well-known sporting events (F1, UFC or NBA) and additionally, its own blockchain (Cronos Chain; FTX did not have it). The question we can ask ourselves is why this exchange has caused the FTX problem.
These similarities may make us doubt this exchange, but Crypto.com announced that it was in the process of conducting an audited reserve test. At the moment, it was seen in that Twitter thread that a proof of reservation document in Nansen Portfolio to show the community its commitment to transparency. But it seems that they were not well received at all...
The Shiba meme isn't funny anymore.
Indeed, when it was observed that Crypto.com exchange reserves were heavily exposed to the Shiba dog meme token, the jokes stopped. Seeing the SHIB token as the second largest asset in custody with 21,29% of all reserves (equivalent to $525 million), doubts began to arise. It is true that these reserves also constitute the assets of its clients, but it is surprising that almost a quarter of all assets are in a purely speculative token.
Crypto.com PoR portfolio reserves, where BTC (31%), SHIB (21%) and ETH (15%) top the list. Source: Crypto.com Reserves Portfolio at Nansen Portfolio.
Not to mention that Crypto.com's stablecoin reserves quadrupled 4 days before Chris Marszalek published the tweet we mentioned above. But that was not what completely alarmed the entire community...
Crypto.com exchange stablecoin reserves during the month of November. Source: CryptoQuant.
“Wrong” transfers between centralized exchanges.
The straw that broke the camel's back (rather, the end of trust) has been the controversy surrounding the aforementioned Crypto.com exchange and another of the ecosystem's biggest players. It turns out that “mistakenly” on October 21, Crypto.com made some transfers, including one of 324.000 ETH worth $421 million. These funds were sent to the Gate.io exchange, which were investigated in the aforementioned exchange's proof of reserves audit.
Transfer of 324k ETHs from Crypto.com to Gate.io. Source: CryptoQuant.
Crypto.com ETH reserves drop from 401k to 80k.
Increased ETH reserves on Gate.io from 251k to 568k.
The CEO of Crypto.com explained that it was an “erroneous” transfer that was made to take those funds to a cold wallet, but it is obvious that said funds were returned after Gate.io's audit. This is when the supposed “transparency” that Marszalek wanted to show is questioned, for “by mistake” transferring more than 324.000 ETH and that coincidentally those funds are destined for an exchange that is in the middle of an audit of reserves at the time of that event. .
Hash of the “erroneous” transfer of 320k units of ETH from Crypto.com to Gate.io. Source: Etherscan.
Conclusions from this cryptocurrency training on proof of reserves.
We have already finished this cryptocurrency training on reserve testing. As we have seen throughout the article, proof of reserve audits are very necessary within the cryptocurrency ecosystem. After the failures in FTX's support and the suspicious maneuvers carried out by different large-caliber exchanges, it has been demonstrated that regulation is necessary to protect investors in these situations. Of course, without compromising the principles of real decentralization. As a reflection of this entire topic, we can see two facts that have totally defined this situation that we are currently experiencing. First, the lack of transparency ends up sinking the reputation and trust that users place in the exchanges (along with their crypto assets, of course...). This causes volumes of outflows from exchanges to personal custody wallets in centralized exchanges, accumulating a negative balance during this month of November.
Netflow of stablecoins from all exchanges. Source: Cryptoquant.
In turn, distrust of centralized entities has led to a growing use of decentralized personal custody alternatives, such as Trust Wallet Token, the decentralized wallet that CZ already recommended this week in light of the current situation. Its governance token, the Trust Wallet token (TWT), has appreciated 165% in just 5 days. Notably, it has also launched a browser integration for its wallet.
With the distrust of the community and the help of CZ, the TWT token has jumped 165% in 5 days. Source: Tradingview.
We conclude the cryptocurrency training by remembering the importance of keeping our assets safe. And remember that, if you have funds in centralized exchanges, you can access the reserve test audit reports on the page of each exchange that carries them out. As we have available on the exchange Gate.io... 2
Tab to verify the Gate.io exchange proof of reserves audit. Source: Gate.io.