How Blockstream is Fighting Crypto Exchange Fraud

February 12, 2019 / by Steven Lubka

It is no secret that cryptocurrency exchanges have a bad reputation for mismanaging, losing access to, and misrepresenting customer funds and liquidity. The most recent debacle was the “death” of Quadriga Exchange’s founder.

According to the exchange, Founder Gerald Cotten died with sole access to the cold wallet that stored customer’s funds. However, many customers and third-parties dispute this narrative and see it as an attempt by the exchange to scam customers out of their money. To learn more about this story, check out Crypto.IQ’s article on the Quadriga Exchange debacle.

Unfortunately, the Quadriga situation is one of many controversies plaguing crypto exchanges, and up until now, there hasn’t been a clear solution in sight. But Blockstream recently proposed a potential solution that would verify exchange funds. The solution is called “Proof of Reserves,” and it presents a way for exchanges to confirm exactly how much cryptocurrency each exchange holds. It makes it much harder for exchanges to engage in questionable or illicit activities with customer funds.

Proof of Reserves works without much software. It uses a simple client in which any exchange can create a transaction that spends all of the exchanges cryptocurrency but includes one invalid “input.”

An input is like a wallet address that the exchange is sending funds from. By including an invalid input, the transaction can not actually go through, but it is constructed in such a way that it confirms that the rest of the funds are actually valid and where they are held. This data can then be shared through the Proof of Reserves client to the interested party or auditor.

This method also eliminates the need for an exchange to move all of its funds to demonstrate its reserves, which is a security risk. Proof of Reserves does not require a live transaction.

The project will continue to develop and is aiming to address one shortcoming which that it requires the exchange to reveal a lot of financial data about its holdings. Proof-of-Reserves is currently integrated with the Bitcoin Core Wallet and Trezor with Ledger support coming soon.

Proof-of-Reserves will allow customers to verify that an exchange is reporting funds honestly, and holding all of its customer’s funds. This will lead to greater transparency in the exchange ecosystem and will require users to trust exchanges less. It will also close one avenue for exchanges to freely mismanage funds.