What Is Proof Of Reserves In Crypto

The collapse of FTX in 2022 sent shockwaves through the global cryptocurrency industry. Revelations that the exchange had misused billions of dollars in customer funds—diverting them to affiliated trading firm Alameda Research—sparked widespread concern about the financial health and transparency of centralized crypto platforms. The incident laid bare the lack of oversight in crypto exchange operations and highlighted the urgent need for greater trust, accountability, and user fund protection.

In traditional finance, regulators require platforms to maintain sufficient reserves to cover customer withdrawals. However, many centralized exchanges operate with opaque accounting practices and minimal transparency, making it difficult for users to verify whether their deposits are fully backed. In response, Proof of Reserves (PoR) has emerged as a promising mechanism to restore trust and verify solvency across the crypto ecosystem.

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.

• Verifying User Balances Using a Merkle Tree

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.

• Verifying Exchange-Owned Assets

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.

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

PoR has gained traction as a proactive transparency solution for crypto platforms. Some of its key advantages include:

• User Trust and Confidence: PoR reassures users that their assets are fully backed and accessible, even in times of heightened uncertainty.

• Transparency and Accountability: It sets a clear standard for crypto platforms to follow, helping distinguish responsible exchanges from risky operators.

• Fraud Mitigation: By disclosing holdings and using cryptographic proofs, PoR makes it harder for exchanges to misrepresent or misuse customer funds.

• Regulatory Alignment: As crypto regulations evolve, PoR can serve as a compliance-friendly mechanism to demonstrate solvency and safeguard user interests.

The Case Against Proof Of Reserves

While Proof of Reserves offers greater transparency, it is not without limitations:

• Snapshot in Time: PoR only verifies reserves and liabilities at a single moment. It does not account for what happens before or after the audit, allowing for potential manipulation.

• Omission of Liabilities: Most PoR audits do not include off-chain liabilities, such as loans, debts, or pending obligations to external creditors. This means an exchange could appear solvent on-chain but still be at financial risk.

• Lack of Standardization: There is currently no universally accepted PoR standard. Methodologies vary across platforms, and the quality of audits depends on the credibility of the third-party auditor.

Despite these challenges, many believe that Proof of Reserves represents a meaningful first step toward a more transparent and accountable crypto industry.

Why Proof of Reserves Matters Now More Than Ever

In the aftermath of FTX and other high-profile failures, user trust in centralized crypto exchanges has been deeply shaken. As the industry seeks to rebuild credibility, Proof of Reserves can serve as a foundational tool to restore transparency and protect retail and institutional investors alike.

Leading exchanges have started publishing PoR audits regularly, signaling their commitment to transparency and user protection. Over time, this could evolve into a baseline expectation for all centralized platforms, much like financial audits in traditional finance.

For users, platforms that offer Proof of Reserves reporting are generally safer, more responsible environments for managing digital assets.

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 a significant risk of loss due to its high price volatility, and is not suitable for all investors. Please refer to our Terms.