Note: You can find the italian version here
Proof of reserves and zero knowledge proof are the foundations the cryptocurrency and blockchain world is betting on to regain credibility.
These are not good times for the world of blockchain and particularly cryptocurrencies and NFTs. The problem is not with the technology but with the trust that has been almost totally lost by the mainstream after some excellent failures such as the FTX exchange that was the third largest in terms of volume in the world or the countless scams related to NFTs with images that were not really held by the rightful owners.
As it always happens when a still immature technology fails in its beginnings (blockchain and cryptocurrencies have been around for many years but can still be considered in an early stage of development towards the general public) there are always those who declare its end, the same happened with the internet after the first dot-com crash between 2000 and 2001.
So looking back 20 years, we can imagine that we are facing something similar and that we are most likely just witnessing an inevitable settling down and that blockchain and everything on it will still have a long future ahead.
Speculation, fraudsters and individuals attracted by the easy money are always pouncing on new prey, 20 years ago they were the first Web2 companies, these days they have become the companies on the blockchain-based Web3.
Over time, government regulations and greater public knowledge of the industry intervene, which help a new industry grow organically and not inflated by speculators.
The problem is that cryptocurrencies and blockchain technology are associated with decentralization and the idea of being outside the control of governments and financial institutions. Regulation could potentially undermine these principles but it is obvious that protection for consumers from fraudulent practices is absolutely necessary to regain lost trust.
Thus preventing government regulation (which will likely be inevitable and in some countries already exists), the blockchain world is trying to self-regulate for a pure survival motivation. The remaining exchanges have adopted or are adopting what is called “proof of reserves.” It is a mechanism that allows a cryptocurrency exchange or other financial institution to prove that it holds the assets it claims to hold.
This can restore customer confidence, as it demonstrates that the institution is financially solid and is not involved in fraudulent behavior such as “exit scams,” in which the company takes customers’ funds and then shuts down, disappearing with the money.
Proof of reserves and zero-knoledge proof
There are several ways in which a cryptocurrency exchange or other institution can provide proof of reserves such as using an independent auditor to certify that the institution holds the assets it claims to hold or publishing a list of the institution’s assets, along with proof that the assets are in the institution’s possession, and finally one can use a cryptographic technique called zero-knowledge proof to prove that the institution owns the assets without revealing any information about the assets themselves. This is the most suitable technique for blockchain and the safest from manipulation but also the most difficult to explain to the general public. So how can trust be regained if the evidence you want to show for trust is not easily accessible as understanding?
The answer to this question will be what will determine the success or otherwise of this self-regulatory strategy.
For now, we will try it by explaining some applications and practical examples.
Zero-knowledge proof is a cryptographic technique that allows one party (the prover) to prove to another party (the verifier) that a certain statement is true, without revealing any information about the statement itself. This technique can be useful in a variety of situations, in the specific case for a cryptocurrency exchange that wants to prove to its customers that it holds a certain amount of assets without revealing the specific assets or addresses involved.
Zero-knowledge evidence has some key properties:
Completeness: If the claim being proven is true, the verifier will be convinced of its truth.
Soundness: If the statement being proved is false, the prover will not be able to convince the verifier of its truth.
Zero-knowledge: The prover does not reveal to the verifier any information about the statement being proved.
To give a concrete example, suppose Alice runs a cryptocurrency exchange and wants to demonstrate to her customers that she holds a certain amount of Bitcoin in reserve, without revealing the specific Bitcoin addresses or transactions involved. She could do this by creating a cryptographic commitment that her Bitcoins in reserve are consistent with the Bitcoin blockchain. This allows her to prove to her clients that the Bitcoins in reserve are real and not fraudulent, without revealing any information about Bitcoin addresses or specific balances.
Alice publishes this evidence allowing her customers to verify and confirm that she holds the Bitcoins she claims to hold. Customers can perform this verification at multiple levels, manually for the more experienced using cryptographic libraries, through the use of online services that automate the process making it affordable for anyone, up to verification directly within their own cryptocurrency wallet on their exchange (for those that support this service).
If you are still unclear how the concept of zero-knowledge proof works, watch this video in which professor Amit Sahai explains the concept to 5 different people: a child, a teenager, a college student, a graduate student, and an expert. You might think it’s boring but instead it’s very interesting and within everyone’s reach, not for nothing, it has over 5 million views.
All these concepts, still quite alien to most, are the foundations of a “healthy” blockchain that manages to self-regulate by excluding fraudulent operations and can grow stably by bringing its enormous benefits to the general public. Regulations will be inevitable, but their flexibility or rigidity will also depend on what the blockchain world has been able to do first in the meantime.