Blockchain development company, Blockstream, has published a standardized method by which Bitcoin exchanges can provide an accurate audit of their Bitcoin reserves. The technology startup revealed that it had submitted its Proof of Reserves protocol as a Bitcoin Improvement Protocol (BIP).
Blockstream announced the news in a blog post published on Monday (February 4, 2019) by Core Tech Engineer, Steven Roose. According to the announcement, the project was brought about by the need to create a single method that allows anyone, be they traders or regulators to audit a Bitcoin exchange platform.
How Blockstream’s Proof of Reserves Work
Rather than requiring live transactions, this new protocol relies on unspent Bitcoin transactions (UTXOs). To use the tool, an exchange creates a new single transaction that contains all of its UTXOs and an invalid input parameter.
The purpose of the invalid parameter is to prevent the execution of the transfer when propagating the transaction throughout the network. Blockstream says this method if done correctly, presents proof of all spendable Bitcoin UTXOs belonging to a particular exchange platform based on the structure of the transaction.
Furthermore, Blockstream says, the process allows for external validation. A customer or regulatory agency can simply request for the transaction data from the process. All that is required would be a Proof of Reserves client and a basic knowledge of Common Language Infrastructure (CLI).
According to the announcement, Blockstream noted that the present state of the protocol gives potentially gives away too much information about an exchange’s finances. Thus, the data would only be safe in the hands of auditors and regulators. However, the company is planning integration with its own Liquid technology to reduce these risks drastically.
Ensuring Best Practices for Bitcoin Exchanges
The Proof of Reserves idea is another step towards ensuring best practices for cryptocurrency exchanges. A standardized auditing process for exchanges could enhance the perception of the market among investors. On the face of it, the Proof of Reserves protocol could potentially shine the spotlight on platforms that are overstating their balances.
Fantastic, really hope this gets picked up. Bitcoin hasn’t seen exchanges do significant Proof of Reserves since right after the MtGox collapse in 2014. https://t.co/bE0Rcu0skZ
— Tuur Demeester (@TuurDemeester) February 5, 2019
Back in September 2018, Zaif, an Osaka-based cryptocurrency suffered a hack, with the cybercriminals able to steal $60 million worth of cryptocurrency. At the time, the Zaif team say it didn’t discover the hack for five days.
With continuous Proof of Reserves in place, a situation like Zaif wouldn’t be possible. Once the hack occurred, a check on Bitcoin UTXOs would show a deficit from previous values. With more advanced programming, the process could even be automated, providing real-time proof of Bitcoin reserves.
The QuadrigaCX Saga
Presently, there is an ongoing saga concerning QuadrigaCX and access to over $190 million. Reports indicate the platform no longer has access to its cold wallet following the alleged death of its CEO.
However an investigation carried out by cryptocurrency analyst with the Twitter handle @ProofofResearch, it appears QuadrigaCX was running an elaborate Ponzi scheme. Furthermore, the platform didn’t have anywhere near the stated $190 million.
If these allegations prove to be factual, then it appears that the once largest cryptocurrency exchange in Canada was running a fractional Bitcoin reserve scheme. Fractional cryptocurrency reserves remains a controversial topic in the industry and is one of the reasons that brought up the need for Proof of Reserves.
Creating a standardized process also ensures the participation of more stakeholders in the auditing process. Presently, the platforms that enable Proof of Reserves use different protocols. Thus, anyone wishing to audit them needs to become acquainted with each process which usually requires expert programming knowledge.
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