Following FTX’s unexpected collapse, which raised concerns about its reserves composition and liquidity, several crypto exchange have released financial reserve data in an effort to restore trust and increase transparency.
Proof of Reserves (PoR) is a transparent auditing practice used by crypto exchanges to demonstrate they hold sufficient reserves to cover customer balances. Preferably conducted by an independent third-party auditor.
What is Proof of Reserves?
Proof of Reserves (PoR) is a transparent auditing practice for crypto exchanges that offers an independent report on their reserve assets. Preferably, this audit should be performed by an outside third-party auditor.
PoR audits provide customers with peace of mind that their funds are secure on a crypto exchange, helping to prevent liquidity crises from customers withdrawing their funds in mass amounts, while at the same time giving users insight into where their money is held.
Proof of Reserves may have its limitations. At best, it provides assurance that an exchange has sufficient assets at hand to cover its liabilities at a particular time.
Second, it only displays the on-chain assets owned by the custodian and is incapable of tracking where these assets come from. Furthermore, it only offers an initial snapshot in time; therefore it may not provide an accurate depiction of balances over time; meaning a cryptocurrency exchange could still be vulnerable to other risks like an adverse economic climate or internal management issues.
What is Fractional Reserves?
Fractional Reserves are an integral component of banking that enable banks to utilize part of their customers’ deposits as loans that help stimulate the economy and make more cash available for people in need.
However, one drawback of this system is its potential to cause bank runs. A bank run occurs when there’s an unexpected surge of depositors seeking to withdraw all their funds at once from an institution.
Fractional reserves are designed to avoid bank runs by requiring that depositors only withdraw funds when needed – usually this won’t be an issue as most customers won’t try withdraw their entire balance at once.
Central banks that set interest rates and reserve requirements play a vital role in keeping this system on course, providing banks with confidence that they will serve as lender of last resort in times of economic distress.
Proof of Reserves and Fractional Reserves
Fractional Reserves are an integral component of the financial system that allow banks to hold onto some customer deposits as fractional reserves and use this capital for lending, helping stimulate the economy through freeing up capital to be put to good use by lending businesses and individuals alike.
One way of understanding the difference between Proof of Reserves and Fractional Reserves is that Proof of Reserves provide smart contract applications with definitive on-chain proof of true collateralization of assets settled using smart contract enabled block chains, helping Deify users build trust-minimized products which protect user funds from under collateralized wrapped assets backed by central wrapper custodians. Fractional Reserves on the other hand only provide approximate proof.
Deify users and applications must take care to prevent this model from creating economic instability; as such, real-time verification of collateralized wrapped assets and smart contracts on-chain is vitally important to ensure their stability and integrity.
How do Fractional Reserves Work?
Fractional Reserves is a banking system which enables commercial banks to make money by loaning out portions of customers’ deposits to make loans at interest. While this method has long been controversial, some believe that its presence stimulates the economy.
Banks can earn interest on loans they issue and keep funds aside to pay clients who withdraw their money from their accounts.
Fractional reserve systems also help safeguard customers against mass withdrawals known as “bank runs,” which occur when consumers and investors panic about economic conditions and rush to their banks to withdraw capital.
Conclusion
Fractional reserve systems are supported by central banks, who serve as lenders of last resort in case of bank runs and ensure stability during periods of financial uncertainty – increasing trust among consumers and businesses alike.
