Understanding Proof of Reserves
Updated June 6, 2022.
The global financial system commonly operates in an undercollateralized and highly opaque manner, creating systemic risks that can result in boom and bust cycles and market-wide failures. Decentralized finance (DeFi) provides an alternative by offering highly transparent, trust-minimized financial products that are powered by deterministic smart contracts and cryptographic truth. With the growth of DeFi comes an increasing demand for new collateral types that extend beyond native on-chain assets, including cross-chain tokens, fiat-backed stablecoins, tokenized real-world assets, and more.
In this article, we’ll break down what Chainlink Proof of Reserve (PoR) is and how it helps provide stronger security guarantees and more transparency in the cryptocurrency ecosystem. In addition, we’ll also explore the PoR reference feeds already implemented by top DeFi teams and provide context for future use cases and implementations.
What Is Proof of Reserve?
Proof of Reserve traditionally refers to businesses that hold cryptocurrency creating public attestations regarding their reserves to prove their solvency to their depositors via an independent audit. As these audits are commonly done by a centralized third party, they can be lengthy, time-consuming, and require manual processes.
As developers continue to build increasingly sophisticated financial products in the digital asset ecosystem, a reliable, transparent, and decentralized standard is required to enable reserves to be audited using an automated process leveraging the superior transparency of blockchains, smart contracts, and oracles—enter Chainlink PoR.
Chainlink Proof of Reserve (PoR)
Chainlink Proof of Reserve provides smart contracts with the data needed to calculate the true collateralization of any on-chain asset backed by off-chain or cross-chain reserves. Operated by a decentralized network of oracles, Chainlink Proof of Reserve enables the autonomous auditing of collateral in real-time, helping ensure user funds are protected from unforeseen fractional reserve practices and other fraudulent activity from off-chain custodians. Rather than forcing users to trust paper guarantees made by custodians, Chainlink PoR can be deployed for automated on-chain audits that give users a superior guarantee of an asset’s underlying collateralization and generate a higher degree of transparency for the crypto asset ecosystem around asset collateralization.
Furthermore, Chainlink PoR is also increasingly being used to help secure the minting, redeeming, and burning of wrapped assets. Once Chainlink PoR determines that wrapped tokens are undercollateralized, Chainlink Keepers can be used to halt the minting, redeeming, and burning of wrapped tokens.
Proof of Reserve for Cross-Chain Assets
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 unlocking cross-chain liquidity. As Chainlink is blockchain-agnostic, Chainlink PoR feeds can be constructed to provide collateralization data on any cross-chain asset settled on any smart contract-enabled blockchain.
Proof of Reserve for Bitcoin
Tokenized Bitcoin on Ethereum represents a significant portion of collateral used within DeFi. Chainlink PoR reference feeds provide DeFi applications with the data required to audit the reserves of BitGo’s WBTC and Ren Protocol’s renBTC, which collectively represent a majority 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, i.e., when there is less than the 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.
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 that are seeking to securely generate yield in the decentralized finance ecosystem.
Beyond USD-backed stablecoins—which are the most popular pegged assets within the DeFi ecosystem—Chainlink Proof of Reserve feeds can also be constructed to provide collateralization data regarding any type of pegged asset. These can include fiat currencies such as GBP or commodities like gold, increasing the transparency of an entire category of building blocks within DeFi. For example, Paxos is using Chainlink PoR feeds to enable DeFi applications to quickly verify on-chain that its PAX Gold (PAXG) tokens are fully backed by gold bars held off-chain in Paxos’ custody.
Proof of Reserve in Traditional Markets
While current implementations provide transparency on the collateralization of tokens that are currently used within the cryptocurrency ecosystem, 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 Reserve to provide the transparency required for user adoption.
Chainlink PoR 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 property and its cash flow, with collateralization verified by a decentralized network of Chainlink oracles.
Furthermore, Proof of Reserve feeds can be used beyond the world of DeFi and smart contract applications. For example, they can provide traditional financial institutions with a way to increase trust with customers and counterparties by using Chainlink oracles to publish their audit reports on-chain as an immutable and tamper-proof 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 regarding 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 Reserve provides both the growing DeFi ecosystem and the traditional financial system with a way to boost the transparency of their operations through definitive on-chain proof of any asset’s true collateralization. As the smart contract ecosystem grows, it is critical to ensure market failures caused by opaque operational processes and toxic collateral are consigned to history. With Chainlink Proof of Reserve, the DeFi ecosystem is well-positioned to scale and help secure the next generation of trust-minimized financial products.
If you want to know more about Chainlink Proof of Reserve, visit the PoR product page. If you’re a developer and want to integrate Chainlink Proof of Reserve into your smart contract applications, check out the developer documentation or reach out to an expert.