Proof Of Solvency: Definition & Understanding Of The Concept

Solvency verification is a crucial indicator of a custodian’s financial stability. It merges Proof of Reserves and Proof of Liabilities to guarantee that the total assets held are greater than the liabilities. Moreover, if the custodian stores reserves in cryptocurrencies, they must demonstrate control of the keys to the accounts where the funds are located. User-side, this verification ensures that your funds remain easily accessible whenever necessary. 

This blog post aims to clarify the solvency concept, including its definition and practical tips for measuring it.

What is Solvency?

Solvency is a critical measure of a company’s ability to fulfill its financial responsibilities over the long term. It indicates the company’s ability to maintain its operations and is an essential indicator of its financial health. To determine a company’s solvency, we can evaluate its shareholders’ equity on the balance sheet, which shows the value of its assets after deducting liabilities. Solvency ratios can also provide further insight into specific areas of a company’s solvency.

A company with negative shareholders’ equity implies that it is insolvent. Negative shareholders’ equity means the company has no book value, which could result in losses for small business owners unless limited liability terms protect them in case of company closure. In brief, if the company must shut down immediately, it will have to sell off all its assets to pay its liabilities, leaving shareholders’ equity as the sole remaining value. This information is essential for investors, creditors, and individuals who wish to make informed financial decisions.

How to Provide a Proof Of Solvency?

Solvency is established using two main methods : the traditional and the cryptographic methods. 

The former requires engaging a third-party auditing firm to track an organization’s financial records and confidential information before producing a solvency report. This method is time-consuming, expensive, and non-private since confidential data is shared with a third party. In contrast, the latter employs an innovative technology called Zero-Knowledge. An organization utilizes zk-proof to prove the validity of its solvency statement to a third party without disclosing any other information.

Understanding Zero-Knowledge Proof

Zero-Knowledge proofs (zk-proofs) is a vital part of Zero-Knowledge technology, developed in the 1980s for enhanced privacy, security, and processing speeds in information validation. This technique utilizes mathematical models and cryptographic protocols to enable a third-party authenticator to verify the truth of a statement without obtaining or having the ability to access the statement’s contents. These statements are referred to as zk-proofs.

A valid zk-proof must adhere to three principles. Firstly, it must be complete, meaning an honest verifier can verify it through the zk-SNARK protocol. Secondly, it must be sound, meaning a dishonest prover cannot persuade an honest verifier that it is valid. Lastly, it must be zero-knowledge, meaning a prover only needs to provide the necessary information to validate the zk-proof protocol, and the statement’s content can remain private.

Measuring Solvency

Solvency pertains to a company’s ability to meet its long-term financial obligations. The technique of proof of reserves is employed to ascertain whether the company’s reserves are sufficient to pay for its total liabilities, which is determined via the proof of liabilities method.

Two Parts Of Proof Of Solvency

The process involves organizing all user and assets into Merkle trees. This mechanism enables users to validate their inclusion in financial obligations without disclosing confidential data. The reliability of the proof is directly proportional to the number of users who check their balances against the tree.

A Merkle tree is a highly effective and secure method to verify the integrity of data in vast amounts of information. By utilizing Merkle trees, users can easily confirm their account balance and compute all debts while keeping their personal data private.

The evidence of liabilities is bifurcated into two fundamental segments:

  • Assets reserved by users, including ETH, BTC, ICN owned on the platform, and all DAA holdings.
  • Allocated assets maintained by DAAs.

Solvency vs. Liquidity

Solvency pertains to a company’s capacity to fulfill its financial liabilities encompassing the total of its debts. On the other hand, liquidity encompasses a company’s capability to meet its short-term financial commitments. It is highly significant to evaluate a company’s liquidity levels whenever its book value falls negatively. Deducting short-term liabilities from short-term assets is the easiest and quickest way to determine a company’s level of liquidity.

Short-term assets and liabilities refer to those with a one-year time frame, such as cash and equivalents as a common short-term asset and short-term accounts payable as a standard short-term liability. While insolvency can be survived for a limited time, a lack of liquidity can lead to a company’s downfall. Some proper ratios are the quick ratio, current ratio, and working capital turnover.

Final Thoughts

Proof of Solvency verifies that a custody provider holds more assets than liabilities through reliable validation mechanisms involving Proof of Reserves and Proof of Liabilities. 

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