Over the centuries, financial markets have maximized the value humans have been able to create. However, the global financial system of today commonly operates in an undercollateralized and highly opaque manner, creating systemic risks that can result in market-wide failures. Decentralized Finance (DeFi) provides an alternative by offering highly transparent smart contract-powered financial products that provide superior security guarantees through overcollateralization. With the growth of DeFi comes an increasing demand for new collateral types that extend beyond native on-chain assets to include cross-chain tokens, fiat-backed stablecoins, tokenized real-world assets, and more.
To ensure the end-to-end transparency of the DeFi ecosystem, we have developed Chainlink Proof of Reserve, on-chain reference feeds that provide smart contracts with the data needed to calculate the true collateralization of any on-chain asset backed by off-chain reserves. Operated by a decentralized network of oracles, Chainlink Proof of Reserve enables the autonomous auditing of collateral used within DeFi in real-time, ensuring users’ funds are protected from unforeseen fractional reserve practices and other fraudulent activity from off-chain custodians.
Chainlink Proof of Reserve generates a higher degree of transparency for the DeFi ecosystem around asset collateralization, giving users proof they own what they think they own and increasing their trust in financial products. To bring to light the importance of such a mechanism, we will explore the Proof of Reserve reference feeds already implemented by top DeFi teams, as well as provide context for future use cases and implementations.
Verifying the Reserves of Tokenized Bitcoin and Cross-Chain Assets
With now over $2B of Bitcoin tokenized and bridged onto the Ethereum blockchain, the demand for cross-chain tokens within DeFi is ever growing, representing an increasing percentage of collateral actively used within DeFi. However, as cross-chain tokens are tokenized representations of cryptocurrency held by off-chain custodians, risk is increased as smart contracts on the receiving chain are unable to natively determine the cross-chain token’s true underlying collateralization.
To bridge this gap, Chainlink Proof of Reserve reference feeds provide DeFi applications the data required to audit the reserves of BitGo’s WBTC as well as Ren Protocol’s renBTC, representing over 90% of all wrapped Bitcoin on the Ethereum blockchain. These Proof of Reserve feeds are supported by a network of Chainlink oracles that check the BTC balance of the custodian’s address on the Bitcoin blockchain every ten minutes. Whenever a deviation is detected beyond a predefined threshold from the previous balance stored on-chain, the on-chain Proof of Reserve reference feeds are updated with the new balance data.
By making this reserve data available on-chain, smart contract-based DeFi applications are able to employ customized logic to automatically protect user funds during an undercollateralization event when there is a less than expected amount of Bitcoin backing the cross-chain tokens. Such a feature is particularly beneficial for applications using tokenized Bitcoin as collateral to secure the borrowing of other digital assets.
Proof of Reserve reference feeds for tokenized Bitcoin also unlock new financial products such as Credit Default Swaps that enable users to hedge against fractional reserve activities and/or speculate on the collateralization health of a particular tokenized Bitcoin implementation. Hedging risk exposure to tokenized Bitcoin within DeFi allows for an increase in economic activity due to the additional security and transparency provided.
While tokenized Bitcoin is currently the most popular form of cross-chain assets, Chainlink Proof of Reserve reference feeds can be constructed to provide collateralization data on any cross-chain asset settled on any smart contract-enabled blockchain (e.g. tokenized ETH on Polkadot, tokenized XTZ on Cosmos, etc). As a highly flexible and transparent oracle network model, Proof of Reserve helps accelerate the growth of DeFi by providing collateralization data on a wide array of assets and enabling new cross-chain diversification opportunities.
Verifying Off-Chain Custody of Fiat-Backed Stablecoins
Stablecoins are a key building block within the DeFi ecosystem, providing users the ability to transact and earn yield in a stable value currency, while still benefiting from the permissionless and censorship resistant nature of blockchain-based smart contracts. In particular, stablecoins on average generate the highest yields in DeFi, making them an increasingly popular collateral choice and fundamental to scaling up the adoption of DeFi financial products. With over $20B in US dollar-backed stablecoins on the Ethereum blockchain alone, it is now more important than ever to provide smart contracts definitive proof that each stablecoin is fully backed by an equal amount of dollars in an off-chain escrow bank account.
By leveraging data generated from professional trusted auditors, Chainlink Proof of Reserve provides smart contract applications with collateralization data regarding the off-chain reserves of fiat-backed stablecoins. As a prime example, the TUSD Proof of Reserve and Proof of Supply reference feeds provide DeFi applications definitive proof regarding the amount of US dollars held in TrustToken’s escrowed bank account backing TUSD tokens, as well as the number of TUSD tokens minted across multiple blockchains.
To power the TUSD Proof of Reserve reference feed, Chainlink oracles fetch data from Armanino, a top 25 US accounting firm, which performs regular reviews on TrustToken’s escrowed bank accounts. When the amount of US dollars held in TrustToken’s reserves deviates beyond a predefined threshold, an update is pushed on-chain to the Proof of Reserve reference feed. DeFi applications can then utilize this data to audit the reserves of TUSD tokens on-demand.
The TUSD Proof of Reserve feed operates independently from TrustToken, providing a degree of separation and increased trust in the data provided. Following this model, Proof of Reserve reference feeds can be deployed to track the collateralization of any stablecoin backed by off-chain fiat reserves. Through this data, the economic activity of stablecoins can accelerate within DeFi not only from retail users, but also from traditional institutions who are seeking yield in a trustworthy and secure manner.
Beyond USD-backed stablecoins, which are the most popular pegged assets within the DeFi ecosystem, Chainlink Proof of Reserve can also be constructed to provide collateralization data regarding any type of pegged asset, including alternative fiat currencies such as GBP or commodities like gold, increasing the transparency of an entire category of building blocks within DeFi.
Integrating Proof of Reserve into Traditional Markets
While current implementations provide transparency on the collateralization of tokens that are currently used within DeFi, the Chainlink Proof of Reserve model is much broader in scope and can be utilized to bring transparency to any asset that has been tokenized and brought on-chain. Tokenized assets that previously required an impractical level of trust in the issuer are now able to utilize Proof of Reserves to provide the transparency required for user adoption.
Chainlink Proof of Reserve feeds can be used for a wide range of tokenized real-world assets such as real estate properties that generate verifiable cash flows. Both the ownership of the property and the escrowed bank account holding the USD cash flows generated are able to be audited and brought on-chain, enabling smart contracts to mint trust-minimized tokenized representations of both the real estate properties and its cash flows, with collateralization verified by a decentralized network of Chainlink oracles.
Additionally, Proof of Reserves feeds can be used beyond the world of DeFi and smart contract applications. For example, they can provide traditional financial institutions a way to increase trust with customers and counterparties by using Chainlink oracles to publish their audit reports on-chain as an immutable and untamperable record. By leveraging blockchain technology without any modifications to their business model or backend enterprise systems, institutions can provide a definitive and immutable source of truth of their assets, creating an unprecedented level of transparency. Additionally, DeFi products can be constructed around this data allowing users to hedge against the fractional reserve activities of traditional off-chain institutions.
Chainlink Proof of Reserves provides both the growing DeFi ecosystem and the traditional financial system a way to boost transparency of operations with definitive on-chain proof of any asset’s true collateralization, bringing a high degree of trust to a traditionally opaque and low-trust industry. As the smart contract ecosystem grows, it is critical that trust is maintained end-to-end without gaps, ensuring market failures caused by opaque and toxic collateral become history. With Chainlink Proof of Reserve, the DeFi ecosystem will be well-positioned to scale up and secure the next generation of innovative financial products.