What is Proof of Reserve and Why is it Essential?
Introduction
One of the ways through which centralized exchanges can show transparency and gain users’ trust is by issuing their exchange “Proof of Reserve.”
Binance CZ’s CEO tweeted, “All crypto exchanges should do Merkle-tree proof-of-reserves.”
If you have been active on crypto Twitter and Reddit, you would have seen people shouting proof of reserve; what do they mean by that? What are the benefits and limitations?
This article is going to explain all the questions above. Are you ready? Let’s dive in.
What is Proof of Reserve (PoR)
Proof of Reserves (PoR) is a strategy adopted by using cryptographic verification to verify ownership of digital assets. Centralized exchanges use it to ascertain their solvency and assure customers that the exchange will be eligible to pay out customer deposits in times of market volatility.
PoR refers to digital assets verified through on-chain methods like tracking wallets. It does not include off-chain assets like cash reserves or other fiat assets.
Armanino is the leading auditor for most crypto service providers.
What makes Proof of Reserve Important?
1. It boosts Users’ Trust: A Proof of Reserve(PoR) attestation signals vigilance regarding a centralized exchange’s solvency. It enables user trust in a custodian and testifies to a certain degree of transparency the custodian guarantees.
While it is clear that proof of reserves can deliver a different transparency than non-custodial, blockchain-based platforms, their advocates argue that more transparency is better than nothing.
2. PoR is a means of self-regulation: Even though some exchanges are not regulated in the United States, PoR may result in more favourable treatment by US regulators and more confidence from their user base.
When combined with public and legally binding disclosure of liabilities, users can view proof-of-reserve attestations to verify on-chain that the custodian has enough assets to back a third-party audit of deposits.
3. It helps to kick against bad behaviour:
Proof of Reserve (PoR) makes it more challenging to hide illegal and unethical business practices like rehypothecating user deposits.
How are the audits performed?
During an audit, the third-party auditor obtains proof of reserves by taking an anonymized snapshot of user balances. They are typically calculated by hashing a user’s account balance with their unique ID.
The auditor then aggregates them into a cryptographic Merkle tree that produces a Merkle root — a cryptographic hash that uniquely represents a combination of all user balances.
The Merkle tree makes it possible to verify the accuracy of all balances by only cross-examining a few anonymous balances with the verified ones. For example, any user can verify if their proper account balance was included in the tree. They would need to:
Hash their account balance and unique ID; and
Search for it in the Merkle tree.
A series of these verifications can then be used to prove the accuracy of the whole tree without examining each one.
The final step is to obtain digital signatures from the custodian proving that they control the on-chain addresses holding the assets. If the balance on the associated digital signatures matches those obtained from the Merkle tree, the auditor can verify that the platform maintains a reserve of all client assets.
The benefits of Proof of Reserve
PoR can be paraphrased as follows:
1. Trust: Exchanges can regain the trust of their users and the general crypto community by conducting a truly transparent Proof of Reserve (PoR). If the audit is done in good faith, it will help restore trust and adoption.
2. Auditability: PoR is a first step toward verifying full solvency and authorizing the tracing digital assets owned by a company.
3. Fraud: PoR creates a baseline for decent practices regarding financial transparency and disincentivizes users from engaging with companies that don’t provide such attestations.
Users can easily detect any exchange that is not financially transparent, and they can move away from such exchanges.
4. Customer Protection: PoR ascertains a willingness to protect customer assets and put the customer’s interest first. This will clearly distinguish the bad actors from the good actors.
5. Counterparty Risk: PoR can help mitigate fear-driven bank runs that result from uncertainty over the solvency of a custodian’s asset holdings.
Limitations of Proof of Reserve (PoR)
1. Proof of Reserve (PoR) cannot prevent hacks. From 2020 till now, hacks have been a significant way through which exchanges have lost money.
2. Proof of Reserve (PoR) is not secured as your coins are in your private wallet.
Don’t forget that “Not your keys, not your coin.” Trust no one, not even the largest centralized exchange. The future is toward total decentralization.
3. Some exchanges may not report their liabilities while showing proof of Reserve(PoR).
4. Tracking of Liabilities is one of the challenges of Proof of Reserve because a reliable, clean financial audit is required to succeed.
5. PoR is not trustless. It relies on voluntary engagement and does not guarantee full transparency of a custodian’s financial situation
Conclusion
The effects of FTX’s demise have prompted calls for more stringent regulatory control over the cryptocurrency market. While significant market participants continue to provide some transparency to win back the public’s trust, experts believe that proof of reserves alone cannot be predicated upon.
Exchanges should ensure that their audit is being done in good faith, and regulators should always be at the door to sanction any exchange that manipulates their PoR.
