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Proof-of-Reserves - Why does it matter?

February 9, 2022 - Kraken dropped a press release announcing the successful results of the proof-of-reserves audit showing the crypto exchange held $19 billion in Bitcoin and Ether. The audit's release is one of the many key steps in demonstrating Kraken's controls over its organizational processes and system and improved transparency as the company attempts to gain credibility with regulators and traders in preparing itself to go public.

What is proof-of-reserves and why Kraken and other exchanges are trying to prove they have that under control? Tokenized Bitcoin total market capitalization is currently hovering at $12.9B, where 81% of the wrapped Bitcoin is managed as WBTC, the oldest and original creator of the wrapped Bitcoin Token.

Let take a look an example of two "OG" cryptocurrencies: Bitcoin and Ethereum. A holder of Bitcoin may have an interest in leveraging the stored value of Bitcoin to utilize that on the Ethereum network to participate in decentralized finance (DeFi) which may not be as readily available on the Bitcoin network (e.g., yield farming). In the case of imBTC, users that provide liquidity through the locking of their Bitcoin to imBTC gain two sources of income:

  1. Fees paid by Tokenlon (e.g., the custodian/operator) users for purchasing imBTC

  2. Handling fees paid by users for redemption of BTC

Payment will start at 100% of the platform fee as stated above. Then it will be halved every year, that is:

  1. 100% platform income will be sent to you for your imBTC holding interest in the first year

  2. 50% platform income will be sent to you for your imBTC holding interest in the 2nd year

  3. 25% platform income will be sent to you for your imBTC holding interest in the 3rd year

  4. 12.5% platform income will be sent to you for your imBTC holding interest in the 4th year

and so on. In other words, the User benefits = (your imBTC amount / imBTC total amount) * The total interest from Tokenlon platform, the benefits will be sent to your ETH address through imBTC.

One way to achieve this objective is to sell or exchange the Bitcoin at a centralized exchange such as Kraken for Ether and then utilize the Ether to acquire the wrapped Bitcoin. However, there are several undesirable effects from this approach:

  1. Possible taxable impact from selling side

  2. Fees from the buying and selling the two assets

Alternatively, the Bitcoin can be deposited into a reserve, operated by an exchange or service. The reserve custodian, then issues the depositor, on Ethereum network, the same number of wrapped bitcoin in ERC-20 tokens in a 1:1 ratio as the deposit amount collected on the Bitcoin network. ERC-20 is the basic compatibility standard of the Ethereum blockchain — allowing it to be fully integrated into the latter’s ecosystem of decentralized exchanges, crypto lending services, prediction markets and other ERC-20-enabled decentralized finance (DeFi) applications.

The deposit of Bitcoin is locked into the custodian's controlled vault, untradable by anyone. When the depositor is no longer require the use of the wrapped Bitcoin, the depositor redeems the number of wrapped Bitcoins, allowing the custodian to remove the same number from circulation on Ethereum network, and return the equivalent number of Bitcoins to the depositor.

The above generalized processes are handled on Ethereum through multiple smart contracts from verifying the deposit, overseeing the minting process (e.g. the creation of the ERC-20 tokens), to the burn of the issued wrapped token, and the release of the deposit back to depositor. In all designs, network confirmation plays a key role in the deposit as well as the use of multi-signature transactions to authorize the issuance of wrapped token and the release of deposits.

On Ethereum, there are several service offerings of Bitcoin to wrapped Bitcoin including:

Of the services listed, the wrapped Bitcoin network appears to offer to the most transparent proof of reserve. Specifically, the users of the site can observe in real-time:

  1. Confirm that specific deposit was made before mint issuance.

  2. The specific transaction and the amount that was minted corresponding to the deposit

  3. The transaction to redeem the deposit

  4. The burn confirmation of the wrapped token

  5. The issuance of the deposit corresponding to the burned wrapped token.

It is also important for transparency that the relevant smart contract(s) can also be examined in details. If the smart contracts were previously audited, such audit reports should publicly available. Where funds are held by the custodian, the wallet addresses should be made available for examination and reconciliation. Furthermore, the proof of reserve should be independently tested at least on a quarterly basis to ensure that adequate controls are implemented and effective. The testing should employ statistical sampling techniques to ensure sufficient coverage across deposit, mint, burn, and redemption processes. A public report should be made available outlining the methodology taken to evaluate reserve and any observation or finding from the auditors. Cares should be taken to explain any discrepancies in deposit vs. redeem amounts to due network and/or service fees, or significant imbalance between custody total vs. issued wrapped tokens particularly if the issuance is significantly greater than the custody total.

Where possible, forensic tracing of the money flow from the deposit into the custody addresses and vice versa should also be made.

The custodian should also be required to demonstrate controls over the wallets by moving some specific amount of funds across addresses. In the above example, imBTC custodian can move a certain amount of BTC as required by the auditors across its three addresses: imBTC Custody #1, #2 and #2.

Check in with us at a later time where we provide a deep dive analysis of these mint and burn transactions.

Transparency is a key element to ensure the wrapped token ecosystem can be trusted to be utilized and that the exchange of values are maintained in a determined balance in a repetitive manner. Traders or users of wrapped tokens should be cognizant that the degree of transparency can vary from platforms to platforms as well as there are unique exceptions. For example, imBTC requires any deposit greater than a certain amount to be manually reviewed in a 24 hrs period, thus may impact your ability to receive the equivalent wrapped tokens.

We do hope that all companies in this space continue to take the kind of transparent and secure approach that we know is possible. That's the unique thing about this industry, right? It's not even possible in the older financial system to do something like this.

Jeremy Welch - Kraken's Chief Product Officer


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