What is Proof of Solvency?

Key Takeaways

• Proof of Solvency provides a full financial snapshot of custodians by verifying both reserves and liabilities using cryptographic methods.
• It helps rebuild trust in centralized entities, such as exchanges and stablecoin issuers, by enabling real-time, privacy-preserving, and verifiable transparency.
• Use cases include centralized exchanges, stablecoins, banks, and insurers.
• Challenges include ensuring accurate asset valuations, providing timely updates, preventing fraudulent reporting, and striking a balance between transparency and user confidentiality.

Transparency is a core value of the crypto ecosystem, yet users are often asked to trust crypto custodians without being able to verify what lies beneath the surface. Many of the industries major players are custodial, including centralized exchanges and stablecoin issuers, yet they often operate behind opaque curtains. The collapse of FTX in 2022 amid misuse of customer deposits highlighted how devastating the absence of verification can be. 

Although some institutions use Proof of Reserves, this method alone doesn’t produce a full picture, since it only shows assets but not liabilities. This leaves room for manipulation, or could create a false sense of security for users, while omitting key details.

In an era where stablecoin adoption is growing rapidly, the crypto industry urgently needs a complete and verifiable picture of financial health. This is where Proof of Solvency plays a critical role. In this article, we’ll explore what Proof of Solvency is, how it works, why the crypto world needs it, its use cases, and challenges.

What is Proof of Solvency? Definition

Proof of Solvency is a cryptographic method that allows custodians to prove they hold more assets than liabilities, without revealing sensitive user information. It combines two key components: Proof of Reserves and Proof of Liabilities. This ensures a platform can meet its financial obligations and is not operating on fractional or fabricated holdings.

Unlike traditional accounting audits, which happen periodically and are often inaccessible to the public, Proof of Solvency enables transparent, real-time, trustless verification. There’s no clear way to publish Proof of Solvency records. Users and regulators can usually verify an institution’s financial health with mathematical certainty by viewing cryptographic evidence on-chain.

Why Do We Need Proof of Solvency?

Cryptocurrency was created to eliminate the need to trust centralized entities. Ironically, a few centralized financial entities have become essential to the ecosystem. Whether using stablecoins or trading on exchanges, users regularly rely on custodians. Without transparent checks, this opens the door to risk. Famous failures that led to massive losses for users include Mt. Gox, the QuadrigaCX bankruptcy and, more recently, the implosion of FTX. In each case, the public was unaware of the insolvency until it was too late.

Proof of Reserves offered a partial solution, but without a matching Proof of Liabilities, it fails to show the full picture. Institutions could have large reserves yet owe far more. To rebuild trust, users need transparency that is continuous, verifiable, and privacy-preserving. Proof of Solvency addresses all three needs.

Proof of Solvency vs Proof of Reserves

While Proof of Solvency and Proof of Reserves are sometimes used interchangeably, they’re definitely not the same. Proof of Reserves shows that an institution holds a certain amount of cryptocurrency in its wallets. Exchanges may publish wallet addresses or obtain an attestation from an auditor. While helpful, it does not tell you what the institution owes.

Proof of Solvency, on the other hand, includes a Proof of Liabilities, cryptographically committing to user balances. It then uses zero-knowledge proofs or Merkle trees to show the total liabilities without exposing individual users. By comparing this to reserves, regulators can verify solvency.

In short, Proof of Reserves answers what the platform holds. On the other hand, Proof of Solvency answers the more important question of whether the platform can meet its obligations.

How Does Proof of Solvency Work?

Institutions can prove solvency using a mix of financial, legal, and cryptographic techniques. Each method helps build a clearer and more exhaustive view of an entity’s financial health.

Financial Statements

Traditional financial documentation remains important. The two primary statements include:

• Balance Sheet: Shows assets versus liabilities, providing a snapshot of solvency.
• Income Statement: Demonstrates profitability, which indirectly supports an entity’s ability to remain solvent.

These documents are often reviewed periodically but may not reflect real-time changes.

Third-Party Audits

Independent audits add credibility to any claims. These audits can:

• Verify asset valuations
• Cross-check liabilities
• Ensure financial practices meet established standards

However, audits are only as reliable as the auditors themselves and may not be updated frequently.

Cryptographic Proofs (in Digital Finance)

Blockchain-based institutions can leverage cryptographic techniques to prove solvency:

• Public Disclosure of Asset Keys or Reserves: Platforms publish cold wallet addresses, allowing anyone to view balances.
• Merkle Trees: Used to verify that individual user balances are included in a total liabilities calculation without revealing sensitive information. In other words, users can verify their inclusion without seeing others’ data.

Legal Documentation

In some cases, institutions may need to file court-ordered documents such as:

• Declarations or Affidavits: Legal proof of solvency can be enforced by regulatory or judicial bodies, especially during investigations or bankruptcy proceedings.

Reserve Requirements

Stablecoins and custodians may be held to predefined reserve levels by regulators or internal governance. These levels may:

• Specify the minimum assets required
• Help enforce discipline
• Provide thresholds for acceptable operational risk

Maintaining such reserves can be proven through both third-party verification and on-chain monitoring.

Use Cases for Proof of Solvency

Proof of Solvency can have broad applications across both traditional and crypto finance:

Stablecoins

Stablecoins are widely used in trading, payments, and decentralized finance. However, they usually rely on an enormous reserve of fiat currency to back their digital coin, giving it the much desired ‘stability’ users need. However, if users cannot verify both the backing assets and liabilities of the issuer, they face significant risk. For example, if the issues has greater debt than cash in reserve, this can lead to the stablecoin de-pegging, causing massive losses for users as well as loss of trust in the system.

Proof of Solvency allows stablecoin issuers to prove:

• They hold enough reserves to back the circulating supply
• Their liabilities do not exceed their assets

Cryptocurrency Exchanges

Centralized cryptocurrency exchanges are custodians of user funds, which makes transparency around solvency essential. Proof of Solvency enables them to show they hold enough reserves to cover all customer balances, without relying on blind trust.

• Enables public verification using cryptographic tools like Merkle Trees.
• Reduces counterparty risk by offering transparency post-FTX collapse.
• Maintains privacy while providing reserve balances

Banking and Financial Institutions

Banks and fintech platforms are increasingly adopting different types of digital assets. For these entities, Proof of Solvency supports regulatory compliance and helps meet capital adequacy requirements without waiting for quarterly audits.

• Supports compliance with capital adequacy frameworks.
• Improves audit efficiency through real-time verifiable data.
• Reassures depositors and regulators about the institution’s financial health.

Insurance Companies

Whether traditional or decentralized, insurers must prove they can meet claims. Proof of Solvency provides a way to demonstrate financial readiness, especially during large-scale claim events or market downturns.

• Shows capacity to cover liabilities through verifiable reserves.
• Improves transparency.
• Applies to both Web2 and Web3 insurers
• Helps meet solvency requirements set by insurance regulators.

Challenges of PoS

Although Proof of Solvency is a powerful tool, it comes with challenges:

Accurate Asset Valuation Complexities

Valuing crypto assets accurately is difficult due to volatility and illiquid markets. Stablecoins and altcoins may not have consistent or transparent pricing, and off-chain assets like tokenized securities require third-party verification. If valuations are wrong or manipulated, the proof can mislead users about an entity’s true financial health.

Timeliness and Frequency of Proofs

Proofs that are infrequent or delayed lose effectiveness. Crypto liabilities and reserves change constantly, so a single snapshot may not reflect current solvency. While real-time systems are ideal, they require complex technical setups and cross-team coordination.

Risk of Fraudulent Reporting

Even with cryptographic methods, entities can manipulate solvency proofs. For example, a platform can borrow assets to inflate its reserves or hide liabilities. Without independent audits and well-designed protocols, users can’t be sure the data reflects reality.

Confidentiality vs Transparency Trade-offs

Full transparency can compromise user privacy or expose business strategies, while too little undermines trust. Furthermore, sharing wallet addresses or debt structures may lead to front-running or reputational risks.

Closing Thoughts

In the wake of crypto’s high-profile failures, Proof of Solvency stands out as a necessary evolution in transparency. Unlike Proof of Reserves, it offers a full picture, covering both assets and liabilities. From stablecoins to custodians, any crypto service holding user funds can benefit from solvency-proof methods to build trust and protect users.