Crypto Confidence: What is Proof of Reserves?

The domain of cryptocurrency has not escaped the repercussions of recent macroeconomic events that have affected traditional finance markets. Global factors, including war, inflation, and the ongoing pandemic, have resulted in turbulence and fluctuation in the industry.

Furthermore, the collapse of several cryptocurrency exchanges has led to a lack of certainty and trust in the community. Moving forward, a significant question arises: what measures must cryptocurrency exchanges undertake to restore trust? A prominent solution proposed is transparency regarding reserves. In this regard, this article delves into proof of reserves and liquidity in cryptocurrency.

Definition of Proof of Reserves

Proof of Reserves (PoR) is a trusted auditing process used by cryptocurrency companies to provide an honest account of their assets in reserve. This ensures that the number of assets held in reserve for clients corresponds to the clients' assets held by the cryptocurrency exchange or financial institution. PoR is widely recognized as the best method for crypto investors to ensure their assets are protected. It is a critical tool for crypto platforms to demonstrate their ability to support trades and withdrawals.

When executing PoR, a third-party auditor examines the holdings and liabilities of a trading platform to verify the exchange's claims. The results are made available to the public, ensuring that exchange-owned reserves always match the digital assets that are held in custody for users by the exchange.

Proof of Reserves helps prevent a liquidity crisis by providing users transparency about their funds’ location. It employs blockchain technology to audit a crypto company without exposing any private user data, ensuring a secure process of auditing crypto companies.

How Does The Process Work?

While several options are available for securing cryptocurrency, many people opt for custodial storage to ensure convenience and security. Using a centralized platform gives users flexibility and the ability to trade assets quickly. The platform acts as a custodian, securing private keys that provide access to crypto assets.

However, recent high-profile collapses of major crypto platforms have questioned custodians’ integrity. PoR audits are employed to verify a company’s holdings and ensure they match investors’ assets.

Process of Auditing

The third-party auditor creates a picture of the cryptocurrency company's liabilities, which includes the entire amount of user deposits.

The auditor also confirms the ownership of the company's cryptocurrency holdings. The firm offers a digital signature using the private keys associated with all of its addresses.

Lastly, the auditor confirms that the assets’ total value exceeds the liabilities.

Furthermore, several exchanges use independent customer verification to increase transparency and convince clients that their account is included in the obligations covered by the stored assets. Here is how it works:

●    A Merkle tree is created, a large amount of user data consolidated into a single hash, with each client account acting as a leaf.

●    An auditor validates that the Merkle tree includes all commitments.

●    They provide each consumer with information about their leaf and a mechanism to validate the path from their leaf to the Merkle root.

The Concept of Merkle Tree Explained

Merkle trees, popularized by the scientist Ralph Merkle, are an influential cryptographic data structure used in computer science. They function by repetitively hashing data, resulting in a tree-like structure with a single hash value (Merkle root) at the top. Bitcoin and other cryptocurrencies utilize this concept by summarizing block transactions in a Merkle tree, providing a way to verify their inclusion in a block.

The benefits of Merkle trees include:

1.  Ensuring the integrity of a large dataset by generating a single hash value for it.

2.  Simplifying the verification of a single node or leaf in the structure requires only the path to the root, not the entire tree.

Merkle trees are particularly advantageous for auditors in the context of proof of reserves (PoR), as they enable aggregating all customer account balances into a single Merkle root without compromising individual privacy.

Possible Challenges for PoR

Proof of reserves is a valuable tool for assessing a cryptocurrency company's ability to cover its liabilities. However, it is important to note that it only provides a snapshot of the company's assets at a particular time and does not reflect ongoing balance changes. Additionally, proof of reserves only reveals on-chain assets and does not indicate the origin of these assets, including whether they were borrowed for the audit. It is important to consider these limitations when taking into account proof of reserves to evaluate a cryptocurrency company.

What are Exchange Reserves?

Reserve assets are specific types of assets, like cryptocurrencies, designed to provide adequate liquidity for the company. They are readily convertible to cash to cover potential withdrawals or other obligations. Alongside cash and fixed-income assets, commonly used cryptocurrencies such as Bitcoin and Ethereum and stablecoins such as Tether, USDC, or BUSD are considered examples of these reserve assets.

Final Takeaways

Proof of Reserves (PoR) is crucial for any cryptocurrency company to secure customer funds and demonstrate adequate liquidity through cryptographic verification. Given the increasing regulatory scrutiny in the crypto industry, any exchange or company functioning as a custodian for their clients ought to procure a proof-of-reserves audit. Though the process may have some drawbacks, such as its incapacity to account for company liabilities, it still serves as a powerful tool in engendering customer trust and reinforcing their faith in the company's operations.