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Banks are closely regulated by government agencies, requiring them to disclose their assets in annual reports to ensure customer funds are protected. However, crypto exchanges and custodians, which operate outside of traditional regulation, face a different challenge in providing a similar level of assurance.
The recent collapse of FTX and the bankruptcy of crypto lender Celsius highlight the importance of verifying that the crypto custodians manage the funds responsibly.
As of today, Proof of Reserves is the best way to do so.
PoR meaning
Proof of Reserves (PoR) is a concept pioneered by Binance's founder, Changpeng Zhao, which aims to bring centralized exchanges closer to decentralized ones. Binance has recently begun publishing information about the total balances of bitcoins, ethers, and stablecoins on their wallets under the name "Proof of Reserves."
PoR in crypto is an independent audit conducted by a third party to verify that a custodian, such as a centralized crypto exchange, actually owns the assets it claims to have.
Currently, most centralized exchanges and other CeFi crypto platforms, such as lenders and custodians, store their asset data in private, proprietary databases. Thus, they may claim that their users' funds are safe, but these claims are difficult to verify.
With PoR, clients don’t have to take their word for it anymore. Now they can see the actual proof, returning to the basic principle of cryptography - "do not trust, verify."
Why is Proof of Reserves important?
It provides 100% transparency and protects the client's assets
A proof-of-reserves (PoR) audit verifies the financial stability of custodians. It also gives customers confidence that the company is solvent and liquid enough to continue doing business with them.
Especially after recent events, every crypto investor values transparency and almost demands valid proof of the platform they are dealing with.
It helps exchanges gain user trust
PoR provides an unbiased and completely honest picture of the funds/financial support of a crypto exchange, thereby helping users make more informed decisions. Having a PoR balance reassures users that their money is backed by real assets, while a larger user base leads to more potential profits, making it a win-win situation.
New industry standard
Another important result of Proof of Reserves is that it creates a safe and healthy ecosystem. At its core, Proof of Reserves is a self-regulatory practice that promotes openness by requiring exchanges to regularly disclose their reserve assets to the public.
This allows market participants to make informed decisions about where to trade and ensures that everyone is playing by the same rules. Ultimately, PoR is essential to provide a safe and secure environment for the exchange of value in cryptocurrencies.
How does it work?
PoR works by utilizing a data structure called a Merkle tree.
Generally, Merkle trees allow for quick and secure verification of large datasets and ensure data consistency by separating the proof of the data from the data itself. In the context of proof of reserves, a Merkle tree can be used to prove the existence of a user's deposit within the exchange's overall holdings without revealing the entire list of deposits.
Here's the inside scoop on how it operates:
- When checking Proof-of-Reserves (PoR), information about the balances of each account is transformed into the Merkle tree.
- The user's balance data is hashed into a "leaf". The user group data ("leaves"), is then hashed to form a "branch", and the group of "branches" is, in turn, hashed to form a "root". Next, the auditor verifies that the exchange owns the corresponding addresses (i.e. public keys) in the blockchain.
- As a rule, an “instructed transfer of funds” takes place, in which the exchange transfers a certain balance of cryptocurrency from one wallet to another at a set time, providing the corresponding transaction hashes and thereby confirming that the funds are at its disposal.
In terms of algorithms, there are other validation concepts such as zk-SNARK or zk-STARK. But the Merkle tree is the most common and efficient method.
Some exchanges go even further and provide an opportunity for their clients to confirm that their account has been included in the PoR verification. For example, on Binance, you can select the “Audit” menu and check if your account participated in the construction of the Merkle tree.
While PoR is a step towards greater transparency and security in the crypto industry, it is not a perfect system.
Some potential drawbacks include:
- Possible violation of customer privacy due to access to information about their account balances;
- Often, exchanges provide information only about assets but not about liabilities. Therefore, it does not give an understanding of what will happen in the event of a collapse;
- Auditors can be wrong. For example, the same FTX has also been audited;
- The PoR does not consider assets involved, for example, in lending.
The recent decision by Mazars, a leading auditing company, to cut ties with the crypto industry is a cause for concern, but it is unclear at this time whether it is a good or bad sign.
Bottom Line
The Proof of Reserves method is only in its infancy. To improve it, the industry should work towards establishing trust in certain auditing companies, defining which assets to take into account, cooperating with regulatory agencies such as the SEC, and implementing mathematical-based auditing algorithms.
In the meantime, investors' best course of action is to check the PoR balance of any platform they are dealing with and store their crypto in non-custodial wallets.
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