What is Proof of Reserves in Crypto?

Proof of Reserve is now a hot topic after FTX’s collapse. 

The collapse of FTX is still under investigation. FTX’s case is a rabbit hole that brings up many issues about cryptocurrency. Its CEO, Sam Bankman-Fried is now heavily criticized for his mismanagement of the customer’s deposits. Also, it shows why many people still distrust the cryptosystem. 

In light of this problem, let’s get to know more about Proof of Reserves and how it will transform the various crypto exchanges around the world. 

Proof of Reserves Definition

Proof of Reserves is an objective auditing procedure that reflects the status of a cryptocurrency company’s assets. PoR audits employ cryptographic proofs and confirm the owners of wallet addresses. Independent third-party auditing agencies conduct PoR to preserve transparency. 

The main goal of a PoR audit is to prove that the crypto exchange indeed holds the number of crypto assets that they claim to have. 

What Happens in a Proof of Reserves (PoR) Audit?

The crypto auditor uses cryptography to check if the crypto exchange’s recorded assets on their balance sheets tally with customer holdings. 

Here is how it happens. 

First, the auditor takes a snapshot of all the balances. 

Then, the auditor converts the data in the snapshot into a Merkle tree. Merkle tree or hash tree is a data structure that encodes blockchain data. Using a Merkle Tree for data encoding makes the PoR audit more efficient and secure.

Next, after creating a Merkle tree, a Merkle root is obtained. The Merkle root is a cryptographic fingerprint that helps recognize account balance combinations during the time the snapshot was taken.

After that, digital signatures confirm the ownership of on-chain addresses and their corresponding balances. 

Finally, the crypto auditor does a comparison and authentication of the balances. It is important to check if the balances match the ones indicated in the Merkle tree. This will show that the clients’ crypto assets are truly on a full-reserve status.

Advantages of a Proof of Reserves Audit

 A PoR audit gives a more accurate picture of all user funds. The periodic conduct of PoR audits helps a crypto exchange gain the trust of its investors. Proof of Reservse emphasizes impartiality and transparency to users. Hence, it gives customers a reliable way of auditing their crypto reserves. On the other hand, this improves the credibility of a cryptocurrency exchange and it is essential for building a loyal customer base.

Drawbacks of a Proof of Reserves Audit

Even though it serves to verify ownership and wallet addresses, the PoR is unable to establish proof of private key ownership. 

This drawback is due to the factor that PoR needs to validate the management of the on-chain funds in a specific period during the audit. This can cause a problem if ever any hackers have a duplicate key. 

Moreover, Proof of Reserves cannot investigate whether the funds were borrowed for the sake of passing the audit. There is a big possibility that the owner lost their private keys or someone stole the assets right after the previous audit’s completion.

Similarly, the PoR auditor’s expertise and integrity can also be a problem under certain circumstances. 

Cryptocurrency Exchanges That Use Proof of Reserves Audits

Kraken

Kraken launched its Proof of Reserves initiative in February 2022. They are one of the top-tier cryptocurrency exchanges and have operated since 2011. 

Users have an ‘audit’ button on their accounts where they can check their wallet balances that Kraken involved in the latest audit. 

Gate.io 

Together with Armanino, one of the 25 biggest business consulting and accounting firms in the United States, Gate.io released its first audit results in August 2022. Investors can check the website or visit Armanino’s website to verify their balances.

Ledn

Ledn is a Canada-based bitcoin lending site. Additionally, they also partner with Armanino for their audits. They launched their PoR program in January 2021 which makes Ledn the first lending platform that practices transparency in their accounts. 

Other platforms that use Proof of Reserves are BitMEX, Nexo, and Coinfloor. Each company has its own way of implementing the PoR audit. They may use auditor-assisted, self-assessed combined with user validation, or a forensic firm-assisted partial validation.

Final Word

Proof of Reserve is absolutely essential in a financial system that is striving to be decentralized. It promotes transparency of financial records. In addition, it provides a guarantee of the security of investors’ digital assets. 

The Binance CEO Changpeng Zhao believes that Proof of Reserves audits give full transparency to the users and the custodians of their funds. 

It is a solution to the ongoing crisis in the crypto industry. But like many other technological innovations, the Proof of Reserves method will need continuous upgrades to meet the fast-changing times.