What Is Proof of Reserves (PoR)?
In finance, reserves commonly refer to assets held by a company that could serve various purposes, including fully matching customer deposits. Proof of Reserves (PoR) is a term to describe an independent audit to verify that the audited party holds enough reserves to back all of its customer balances.
For crypto asset PoR, this means an auditor verifies that the on-chain assets held by the company are no less than 100% matching customer assets as shown in their balance at the time of the audit. This can help reassure customers that the company is sufficiently liquid and solvent, and that the funds are accessible to the customers should they choose to withdraw. In light of recent developments in the crypto industry, PoR is crucial to:
Provide transparency to customers on the availability and backing of funds.
Provide trust by allowing each customer to independently and cryptographically verify that their account balances are included in the PoR.
How Proof of Reserves Works
Generally, the most common way to verify that customer balances are fully backed in a crypto exchange is by constructing a data structure called a Merkle Tree (using a snapshot of individual customer balances).
This data structure allows customers to independently verify that their assets are included in the snapshot balance. PoR consists of several steps:
Verifying that the audited company owns the assets they claim to control on behalf of their customers.
Verifying the assets held by the audited company against the exact amount of total customer assets per their aggregated account balances for each of the audited assets.
Constructing a verification tool that allows each customer to individually verify that their account balances were indeed included in the PoR.
For trustworthy and experienced digital asset service providers, undergoing a proof-of-reserves audit is a critical step in the regulatory process. The PoR audit ensures customers and the public that the custodian is sufficiently liquid and solvent, and they can withdraw funds anytime, providing transparency on the availability of their funds.
The Make-Up of a Merkle Tree (Leaves and Roots)
Simply put, a Merkle tree is a data structure constructed by repeatedly hashing a set of data (i.e., two or more pieces of data). With every layer of hashing, the number of data pieces (Merkle leaves) is exponentially reduced (e.g., halved if two pieces of data are hashed each time) until, eventually, a single hash — also referred to as the Merkle root — remains, sitting at the top of the Merkle tree.
Hashing is a computation to transform a value into another value that is hard to reverse engineer. For example, if given a value, it is easy to compute what its hash is; yet given the hash of a value, one could not reversely work out what the original value is. Therefore, hashing (or repeated hashing) is frequently used as a 'one-way' function to protect privacy and avoid exposing the values of the underlying data.
In the context of crypto exchanges, applying a Merkle tree allows the auditor to aggregate the data of all customers' account balances into a single Merkle root without publicly exposing the account balance of any individual customer, thereby preserving privacy. Thanks to their security and privacy-friendly features, Merkle trees have been adopted in many Distributed Ledger Technology (DLT) projects, including Bitcoin.
Benefits of Proof of Reserves
Proof of Solvency
The PoR audit ensures customers and the public that the custodian is sufficiently liquid and solvent, and they can withdraw funds anytime, providing transparency on the availability of their funds. By proving solvency, exchanges can reassure their customers that their funds are safe and secure, even in the face of market volatility or other external factors.
Proof of Liabilities
In addition, proofs of reserves appeal to regulators as a self-regulating approach that fits with their broad industry strategy. Furthermore, addressing the lack of confidence brought on by exchanges' inability to cover consumer deposits with sufficient assets also increases product adoption. By proving liabilities, exchanges demonstrate to regulators and customers alike that they are operating in a responsible and transparent manner, helping to increase confidence in the industry as a whole.
Limitations of Proof of Reserves
As these audits are commonly done by a centralized third party, they can be lengthy, time-consuming, and require manual processes. Even regular audits or attestations by third parties may not suffice. The companies may have tricked the auditors: Perhaps they only moved funds into the right wallets just in time for the third party to tick the box that claims the funds are in the right place, then invested money in risky funds.
Conclusion
Proof of Reserves is totally changing the game for how we trade on crypto exchanges. It's not just about proving anything; it's about building trust and fostering a more transparent, secure ecosystem for all.
FAQ
What is the concept of proof of reserves?
Proof of Reserves (PoR) shows a crypto exchange has enough assets to cover customer balances. It's all about transparency.
What are the benefits of proof of reserves?
What is the difference between proof of reserves and proof of liabilities?
Disclaimer
The information contained herein has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial, legal, or investment advice. Wirex and any of its respective employees and affiliates do not provide financial, legal, or investment advice.
The value of cryptoassets may fluctuate significantly over a short period of time. The volatile and unprecedented fluctuations in price may result in significant losses over a short period of time. Any Cryptoassets may decrease in value or lose all its value due to various factors including discovery of wrongful conduct, market manipulation, change to the nature or properties of the Cryptoasset, governmental or regulatory activity, legislative changes, suspension or cessation of support for a Cryptoassets or other exchanges or service providers, public opinion, or other factors outside of our control. Technical advancements, as well as broader economic and political factors, may cause the value of Cryptoassets to change significantly over a short period of time.
