What's the difference between an exchange's Proof of Reserves and a token's Proof of Reserves?

You should be hearing more and more about Proof of Reserves but can you explain the difference between a token’s Proof of Reserves and an exchange’s Proof of Reserves? Here’s our quick recap, in simple terms.

Exchange Proof of Reserves

This is the type of Proof of Reserves OKX and other crypto exchanges do. It’s a cryptographic proof that the assets customers deposit are matched 1:1 by our reserves. There are various types of exchange PoR, some use Merkle Trees, some also use Zero Knowledge Proofs. They can vary in quality and frequency, but they all aim to do the same thing: Proving without doubt that the custodian’s assets match its liabilities 1:1.

At OKX we believe offering strong PoR is the building block to build a trust-relationship with our customers so, if you’re curious, you can read more about how we do PoR ourselves. If you want to see if we walk the talk, you can also self-verify our solvency yourself, either using our open source tool or building you own if you really really don’t trust us!

Token Proof of Reserves

A lesser known but equally important type of PoR is what we’re calling here token PoR, namely a proof that a given crypto token is fully collateralized, i.e. that its units are matched 1:1 by reserves of the asset it’s meant to represent.

Among these, there are basically two kinds of PoR, which depend on what the token itself is meant to represent.

Fiat-collateralization

Asset issuers issuing stablecoins such as USDC peg its value to the US dollar or Euro, and are meant to hold customer funds 1:1 in ‘reserves’, off chain. These reserves are usually stored by banks or other financial custodians. Stablecoins such as USDC are called ‘fiat-collateralized’, because they are meant to be backed 1:1 by reserves of assets equivalent to the currency they are supposed to track. The 1:1 fiat is essentially held in these banks as collateral that protect depositors from the volatility of crypto assets, but provide them the benefit of liquidity for crypto trading by avoiding the wait of fiat onramps.

Because USDC’s reserves are kept off-chain, the asset issuer, Circle, is unable to attest to their reserves through a Merkle Tree like crypto exchanges do. Instead, they use traditional third-parties, like investment firm BlackRock to manually audit their reserves.

Like USDC’s 1:1 to it’s USD counterpart, the method for attestation is also 1:1 to traditional banks. Meaning, some stablecoin audits require placing trust in the auditor and their integrity, lacking transparency and happen typically on a monthly cadence rather than automatically, in real time like that of the Merkle Tree.

Notably, the March 2023 collapse of Silicon Valley Bank highlighted the fact that Circle (USDC) had 3.3 billion of its total 9.7 billion dollars deposited. Due to the briefly uncertain fate of those funds, USDC fell behind its USD counterpart from $1 to $.88 before rebounding just 2 days later once the US federal government assured funds would be fully reinstated.

That Circle did not lose $3.3 billion minus $250,00 of its funds completely was due to the fortuitous decision made by the Biden administration and US treasurer to hastily reinstate confidence in the US banking system, not because banks have reliable encoded safety levers in place.

Algorithmic-collateralization

While collateralization methods are determined by whether the institution holds their funds on or off-chain, some stablecoins are pegged to another cryptocurrency. For instance, Wrapped Bitcoin (WBTC) is not on the BTC blockchain, but actually an ERC-20 using an algorithmic-collateralization.

WBTC is pegged to the price of Bitcoin (BTC) amount using a smart contract encoded to a proprietary algorithm, primarily verified through math and incentive mechanisms.

Rather than using an underlying reserve asset like USDC does with fiat, WBTC is designed to regulate and stabilize their peg by using algorithms that control the supply or demand of its stablecoin.

WBTC’s PoR accomplishes this by using a reference contract via Chainlink oracle to programmatically require reserves to be greater than or equal to the supply being minted, checking the balances of BitGo’s WBTC custody wallets every ten minutes (the average time between Bitcoin blocks). This means that if the reserves don’t match the custody wallets, then new tokens won’t get minted until they match.

NOTHING IN THIS ARTICLE IS A SOLICITATION TO BUY OR SELL DIGITAL ASSETS. OKX DOES NOT ENDORSE ANY PARTICULAR DIGITAL ASSET OR STRATEGY. DIGITAL ASSETS HOLDINGS INVOLVE A HIGH DEGREE OF RISK, CAN FLUCTUATE GREATLY ON ANY GIVEN DAY, AND MAY EVEN BECOME WORTHLESS. YOU SHOULD CAREFULLY CONSIDER WHETHER TRADING OR HOLDING DIGITAL CURRENCIES IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. OKX DOES NOT PROVIDE LEGAL, TAX, INVESTMENT, OR OTHER ADVICE. PLEASE CONSULT YOUR LEGAL/TAX/INVESTMENT PROFESSIONAL FOR QUESTIONS ABOUT YOUR SPECIFIC CIRCUMSTANCES.