What Is Proof Of Reserves In Crypto

Cryptocurrencies
What Is Proof Of Reserves In Crypto

The collapse of FTX and the revelations that the crypto exchange allowed another of Sam Bankman Fried’s companies, Alameda Research, to borrow billions in customers’ funds sent shockwaves around the industry. Regulators typically require trading platforms to hold enough assets to match the amount of customers' deposits so that if customers withdraw their funds, companies can process these withdrawals. FTX underestimated the amount it needed to keep on hand which led to a liquidity crisis and ultimately the downfall of the company.

This episode stirred a discussion regarding the adoption of Proof of Reserves by crypto exchanges. If you want to know what are Proof of Reserves and the case for and against it, read on.

What Is Proof Of Reserves (PoR) In Crypto

Proof of Reserves is increasingly being implemented by crypto exchanges to assure users that these exchanges have sufficient liquidity and assets to meet any withdrawals, especially during events where there is a “run on the bank”. As its name suggests, Proof of Reserves is an approach that crypto exchanges can use to prove the amount of assets (reserves) that they have.

Trading platforms such as crypto exchanges are meant, in theory, to hold assets equivalent on a 1:1 basis to users’ deposits. However as the asset data of many centralized crypto exchanges are kept private, it is hard to verify the safety of users’ funds. That is where audits such as Proof of Reserves can come in to serve as checks and balances to ensure that these crypto exchanges have the assets to match the deposits of their users.

How Does Proof Of Reserves Work?

There are two parts to the Proof of Reserves approach: 1) proving the amount of users’ deposits on the crypto exchange and 2) proving the amount of assets that the exchange holds.

  • Users’ assets on the crypto exchange

The auditor tasked with verifying the balances of the crypto exchange will aggregate the total deposit balance of the users into a Merkle tree, a secure data structure that does not expose any private information. The total aggregate data or the total user balance in this case can be viewed via the Merkle root.

The benefit of using a Merkle tree data structure to map out users’ deposits is that the approach is tamper-proof. Any changes made to the data, however small, will affect the Merkle root which makes tampering obvious.

  • Assets the crypto exchange holds

The third-party auditor will require the crypto exchange to list down all the assets and reserves that it claims to have and their corresponding addresses. The auditor will randomly select a few addresses and the crypto exchange has to move funds to demonstrate ownership of them.

https://twitter.com/cz_binance/status/1597192848025464833

After the verification, the auditor will then add up the assets that the crypto exchange has. If the amount of assets matches or exceeds the balance of users’ deposits that are represented in the Merkle tree, this proves that the assets on the crypto exchange are held on a full-reserve basis.

The Case For Proof Of Reserves

To determine the usefulness of the Proof of Reserves, we need to first understand the end goal in mind. The goal is to prove to the public, and in particular to its users, that the amount of assets that the crypto exchange holds matches up to users’ deposits. In other words, to ensure that the crypto exchange has enough assets that it can sell off to cover users’ withdrawals. By auditing the assets and deposits that crypto exchanges hold, Proof of Reserves fulfills the criteria in this regard.

The Case Against Proof Of Reserves

Although Proof of Reserves allows crypto exchanges to transparently prove their assets, it has some limitations.

  • Proof of Reserves only shows the assets of crypto exchanges at a specific time and it tells very little about what happened before or after the moment the snapshot was taken.

  • Proof of Reserves does not track the liabilities (ie. off-chain liabilities) that crypto exchanges have beyond users’ deposits. This can be a potential issue in the event of a liquidity crunch or bankruptcy where other creditors might be senior to users in terms of claims on the assets of the crypto exchange.

Proof of Reserves is one way in which crypto exchanges can prove that they have the required assets in balance and sufficient liquidity. Despite some of its limitations, Proof of Reserves is a step in the right direction that crypto companies can take to assure customers and bolster their confidence in them.

Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.