A Beginner's Guide to Understanding Proof of Reserves in Crypto
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The collapse of FTX—the fourth largest centralized crypto exchange in the world—in November 2022 and the subsequent ripple effect shook the ground of the entire crypto industry. Its meltdown and the events that followed raise questions about whether such a crisis could have been avoided if the exchange possessed proof of reserves.
The crashes of centralized exchanges happen more often than you may think, and whenever they fail, users are doomed to lose their funds. To prevent their money and assets from vanishing, users are demanding centralized crypto exchanges to be audited. It has turned out that there is no more convenient audit than proof of reserve.
To learn what proof of reserves audit is and why it’s important, delve into our latest blog post.
What Is Proof of Reserves?
Proof of reserve (PoR) refers to the process of verifying that users’ assets kept in a crypto exchange or other financial institution are the same as the amount of assets the company has in its reserve on behalf of its users.
In other words, PoR acts like a receipt that proves that a crypto exchange actually possesses the digital assets it alleges to be holding for its customers. Plus, it transparently shows the users where their assets are held.
This particular audit of crypto institutions involves a third party that evaluates the assets those institutions hold against their debt. These assets are called liabilities and could be fiat (USD, GBP, EUR) or cryptocurrencies (BTC, ETH).
With PoR, a centralized custodian demonstrates its solvency and liquidity, assuring the crypto holder or investor that all their withdrawal requests will be fulfilled once they are made. This helps hinder a liquidity crisis in the event of a run on the bank, when a mass of clients suddenly decide to withdraw their assets, as was the case with the FTX exchange.
Needless to say, proof of reserve relies on blockchain technology; as such, it audits a crypto exchange without exposing or compromising the customer’s private and sensitive information.
Proof of Reserves in Traditional Finance vs. in Crypto
The notion of auditing is nothing new. Before crypto was invented, traditional financial institutions underwent audits to have their financial health assessed.
While the way of performing audits in tradFi is pretty much the same as that of crypto—involving a third-party auditor—the obtained results are different. Although the ultimate goal is to be more transparent, traditional centralized finance institutions will share the information only with board members and stakeholders.
Clients, on the other hand, may access just a portion of information on the institution’s financial health. TradFi prefers to keep the audit reports confidential and inaccessible to the general public.
In the crypto world, however, the blockchain technology on which the audit is performed keeps everything transparent. The auditor records company holdings, together with the users’ assets, and stores them on-chain. Since everything is public and transparent, customers can check the audit report via blockchain explorers.
How Does Proof of Reserves (PoR) Work?
The proof of reserve crypto auditing process involves three steps:
- Firstly, the external auditor takes an anonymized snapshot of the crypto company’s balances and organizes them into a Merkle tree. The Merkle tree includes custodial data and several branches authenticated using hash codes.
- In the next step, the auditor gathers individual clients’ contributions using the unique signatures of every account holder.
- The third step of the process involves authenticating whether the users’ assets are stored on a full reserve basis, that is, whether the contributor’s reported balances equal those taken from the Merkle tree. This is performed by comparing signatures with tree records.
Once the proof-of-reserve audit is done, users have a chance to check their transactions. To do so, they need to visit the crypto exchange that holds their assets and find their Merkle leaf and Record ID.
Benefits of Proof of Reserves
Proof of reserve has great potential in the audit of crypto companies, despite being introduced quite recently. Here are some of its benefits:
#1. Practicality
The effectiveness of PoR audits lies in the implementation of distributed ledger technology as the foundation, which allows for audits of any class with 100% probability.
Such practice forbids any malicious intruders to interfere with audit results or manipulate the auditor’s action. Plus, it offers complete control over the verification of information needed to prove the solvency of the crypto company.
#2. Universality
The concept of PoR is not restricted to crypto company auditing. PoR mechanisms can be used for auditing any participant in the crypto industry—crypto wallets, stablecoins, or crypto product companies.
The versatility of PoR can quickly become an important aspect of blockchain technology that will allow for independent audits of any structure.
#3. Transparency
Transparency in asset transactions is among the most significant points when it comes to their safety and security. PoR blends blockchain technology with financial auditing mechanisms to analyze, verify, and report on the trading activity of a crypto company.
The same mechanism is used for the evaluation of reserves and coming to conclusions according to the data obtained throughout the verification processes.
Limitations and Risks of Proof of Reserves
In spite of the advantages that PoR has in the crypto industry, it still comes with specific challenges and limitations. Here are some of them:
#1. Privacy Concerns
One of the main challenges PoR faces is the concern that users’ privacy might be compromised. Even though specific information is required to make audit results public—like liabilities and overall asset holdings—crypto exchanges may reveal more data than needed.
This may further lead to the exposure of customers’ private information, which is a considerable concern in the crypto realm.
#2. Frequency and Consistency
Another significant issue is the irregularity in the consistency of proof of reserve audits across exchanges. While some are audited on a regular basis, others lack a set schedule.
This may result in users obtaining an inaccurate snapshot of a company's financial status, leading to confusion regarding asset holdings and user liabilities.
Besides, even if the audits are performed regularly, they might be carried out by an underqualified auditor and thus provide incomplete results.
#3. Limited Scope
PoS tends to be limited in scope and might not offer a full illustration of the crypto company’s actual financial state. Auditors evaluate the company’s assets and liabilities at a specified time. This implies that clients can’t know for sure whether the exchange is financially strong during crypto market downturns or over longer periods of time.
To tackle this, crypto exchanges should submit extra information like liquidity ratios, which will allow users to make better investment decisions.
Key Takeaways
Following the fallout of the FTX collapse, centralized crypto companies turned to proof of reserves (PoR) to regain the trust of crypto holders and investors. The main goal of PoR audits is to verify that users’ assets stored in a crypto exchange correspond to the amount of assets that the company has in reserve on behalf of its clients.
Being stored on the blockchain, the results of the PoR audits are public and transparent, so any user may check them out. They only need to log into their crypto exchange and provide the required information.