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    Proof of Reserves (PoR)

    Pathik Bhattacharya
    Pathik Bhattacharya
    Published on November 22, 2022 10:07 AM

    Updated on January 10, 2023 1:03 PM

    A Proof of Reserves audit indicates that an exchange is collaborating with a third-party crypto auditor to guarantee that it has assets on its balance sheet and that customer holdings are balanced.
    Proof of Reserves (PoR)
    Source: freepik

    Have you ever noticed how the Bank withdrawal system works? They have desired amount reserved on their back to support and allow the customers to withdraw their funds. To do so, Proof of Reserves has been introduced.

    What is Proof of Reserves (PoR)

    Proof-of-Reserves (PoR) is an open auditing procedure for cryptocurrency organizations that gives an independent report on the assets held in reserve. Third-party auditors have access to cryptographic signatures indicating the entire balance of client assets and guarantee that the custodian of these assets has a similar (or larger) quantity of reserve assets on hand to cover any prospective customer withdrawals.

    This helps to avert a liquidity crisis if there is a "run on the bank" and clients withdraw cash in large numbers, and it also informs consumers about the whereabouts of their funds. Proof-of-Reserves employs blockchain technology to provide a safe method of auditing a cryptocurrency corporation without disclosing any sensitive user data.

    During the FTX crash, Binance's Changpeng Zhao coined the phrase "Proof of Reserves," implying that crypto exchanges should provide proof of reserves regularly.

    More simply, Proof of reserves (PoR) is a background check performed on crypto exchanges by a third-party auditor. This sophisticated cryptographic accounting technique employs a Merkle Tree structure, which divides complicated data into smaller, more digestible bits for faster and more efficient processing.

    The ultimate objective is for the exchange to be financially sound and to carry an amount equal to or higher than the sum of the clients' balances. 

    How Proof of Reserves Work?

    A Proof of Reserves audit indicates that an exchange is collaborating with a third-party crypto auditor to guarantee that it has assets on its balance sheet and that customer holdings are balanced. This is to ensure that client funds are not misappropriated and that the cryptos kept are backed by genuine assets. These third-party reports are reconciled cryptographically, assuring privacy and security. The Merkle tree approach is used to carry out the full operation. In summary, here's what occurs.

     

    • The third-party collects data on all balances stored in the form of a Merkle tree.

    • The Merkle root is then computed, which uniquely identifies and adds the balances of all the accounts examined.

    • These balances are then validated on public blockchains where assets are housed using the exchange's digital signatures.

    • The balances and information of the assets on the public blockchains are confirmed. These figures should balance to provide uniformity.

    • Customers will also be able to check to see if the assets they own have been validated.

    • Any changes in data will have an impact on the Merkel root, suggesting suspected asset manipulation.

     

    Source: Kraken

    Why do Crypto Exchanges Need Proof of Reserves?

    Ensures Complete Transparency & Safeguards Client Assets

    By putting everything on the table, a cryptocurrency exchange is discouraged from engaging in clandestine financial operations, such as lending out more money than the collateral it possesses and risking insolvency. As a result, the client's assets are also safeguarded.

    Assists Exchanges in Gaining the Trust of Their Users

    Proof-of-reserve audits give an unbiased and honest image of a crypto exchange's funds/financial support, allowing customers to make better-educated judgments. The presence of a PoR ensures users that their money is backed by actual assets, and a larger user base means more potential profit, making it a win-win situation.

    FTX Crisis Triggered the Need for PoR

    The financial statement of one of the world's largest exchanges, FTX, was released on November 2, 2022. It also revealed that the majority of its funds/reserves were made up of its native token, FTT. The problem is that FTX and Alameda Research print FTT straight... As a result, the exchange's value was likely inflated, leading people to believe FTX was performing better than it was.

    Binance CEO Changpeng Zhao announced that his company would liquidate its FTT holdings because of unspecified "new disclosures." Withdrawals from FTX were halted on November 8, 2022. Binance made a bid to purchase FTX the same day but retracted it the next day.

    On November 11, FTX stated that the firm has filed for Chapter 11 bankruptcy in the United States, with CEO Sam Bankman-Fried departing.

    Significance of PoR

    It is critical to have checks and balances in place in a decentralized arena like Crypto, where systems are ideally built to not have a single point of failure.

    Bankruptcies have also occurred in the case of traditional financial firms. However, in most situations, governments bailed out these organizations. In the event of insolvency, crypto institutions do not have the benefit of government institutions bailing them out. Thus, the notion of Proof of Reserve combines the best of both worlds: asset management transparency and client asset privacy.

    In the case of centralized cryptocurrency exchanges, user assets are held in a centralized database, and the Proof of Reserves approach assures that these assets are effectively stored using the Merkel tree methodology and that reputable third parties may audit and validate the data. It aids in the prevention of financial mismanagement.

    Concerns Related to Proof of Reserves

    Although Proof-of-Reserves ensures that a crypto corporation has enough assets to satisfy its liabilities, it is merely a single snapshot in time, not a live accounting of the balances over time. It also just displays the custodian's on-chain assets without tracking where those assets originated (i.e., whether the assets were borrowed for the audit).

    Conclusion

    With additional crypto exchanges on board, proof of reserves should become a standard practice in the industry very soon. Meanwhile, if you have assets that are held directly on crypto exchanges, consider shifting them to hardware wallets (cold wallets) for further protection.

    Note: Although it is a Proving method, Proof of Reserve should not be confused with any proof consensus mechanisms as used by blockchain. It’s just a method to audit the crypto asset and to provide sufficient liquidity. 

    Overall, proof of reserves is only one element for determining the reliability of a crypto platform. An ounce of prevention is worth a pound of cure, as the adage goes. We advise you to be proactive by researching strategies to secure your bitcoin.