One of the major problems in the cryptocurrency sector has always been acquiring trust in a digital and decentralized market. Although there is transparency on the blockchain – as well as between two parties who make a payment, there are many centralised cryptocurrency exchanges that do not expose themselves to the public and are considered to be “behind closed doors”. This lack of public visibility leaves customers unsure about whether their deposits are at least fully backed or if they will be able to withdraw their funds at any point (due to potential mismanagement). This issue has only continued to become more imposing since the failure of several major cryptocurrency platforms, where customers would not have known that their funds were either mismanaged or completely unrecovered. To combat this issue, many cryptocurrency exchanges have implemented a protocol called Proof of Reserves. Proof of Reserves works as a verification mechanism that allows crypto exchanges to verify that they actually have enough digital currency available to satisfy the customer’s deposit when the customer wants to withdraw. Proof of Reserves ultimately will improve transparency across the exchanges, increasing customer trust and trust between customers and exchanges ultimately providing security from insolvency.
What Is Proof of Reserves?
To demonstrate that they have enough assets to meet or surpass customer balances, cryptocurrency exchanges and custodians use a method known as Proof of Reserves. Proof of Reserves gives users cryptographic proof of there being customer funds on-chain rather than just believing the exchange’s word. An outside auditor typically verifies these reserves by validating that an exchange’s blockchain wallet addresses exist on the blockchain and match the exchanges’ customer liability for deposits.
The purpose of having Proof of Reserve is to ensure that an exchange is not lending out, misusing, or spending customer deposits without consent.
Why Proof of Reserves Became Important
For years, centralized exchanges have functioned similar to traditional banking institutions with users depositing their funds into the exchange without any real indication of how their assets were being managed.
This lack of transparency has been demonstrated through some major failures in the crypto industry. In some instances, exchanges took client funds and used them as an investment or loan without keeping enough money in reserve to cover customer withdrawals.
These incidents have greatly diminished trust throughout the entire industry and created a demand from users for more accountability which led numerous exchanges to produce regular Proof of Reserves reports.
As such, Proof of Reserves has become a key standard by which to measure the overall financial health of centralized crypto exchanges today.
How Proof of Reserves Works
The technical aspects of the Proof of Reserves process employ complex cryptographic technology; however, the concept itself is simple. To begin, the cryptocurrency exchange will take a snapshot of all user accounts and thus create a complete accounting of all user liabilities or total liability to users. The exchange will then locate the addresses of the blockchain wallets that hold its reserve of cryptocurrencies. Because blockchain networks are public, the actual number of coins in these addresses is accessible to the public for verification.
Afterwards, the independent auditor will verify the exchange’s user liability against the number of coins in the blockchain wallets. If the amount of coins in the wallets is equal to the total user liabilities or greater than them, the exchange passes the audit.
Many Proof of Reserves systems also incorporate cryptographic techniques such as Merkle Trees to allow users to verify that their account balances were included in the proof of reserves audit without exposing the private account information of other users.
Understanding Merkle Trees
In the modern era of Proof of Reserves systems, Merkle Trees are widely leveraged and play a key role in enabling PoR systems to function.
Merkle Trees use cryptography to combine multiple (possibly thousands, if not millions) customer accounts/balances into one single element (Merkle Root) that can be frequently verified.
Each customer receives a unique identifier (Cryptographic Hash) so that they can know whether their balance has been included in the verification process. By only sharing encrypted hashes, customer privacy continues to be protected.
As such, this method provides a means for exchanges to prove transparency while at the same protects the privacy of customer’s financial data.
Benefits of Proof of Reserves
Exchanges and investors alike can benefit greatly from the use of Proof of Reserve, as there are multiple ways to see evidence of the exchange’s stability. Most importantly, the reserves are now available for independent verification, which means that users do not just have to take an exchange’s word when it comes to holding customer funds.
By using Proof of Reserve, exchanges demonstrate their willingness to be transparent with their customers, thus creating a stronger relationship. Those exchanges that commit to submitting reports on a regular basis have also shown that they are willing to accept accountability for their actions in managing customer money.
Another benefit of proof of reserves is that they allow for more timely detection of any financial issues that may arise within the exchange. This is possible because audit procedures will be more difficult for any exchange that attempts to hide their reserve shortfalls or to misuse customer funds for long periods of time.
Finally, another advantage of Proof of Reserves is that it helps to raise the overall standards of the industry by incentivizing exchanges to be more accountable and responsible in managing and reporting customer assets.
Limitations of Proof of Reserves
The Proof of Reserves approach provides transparency. However, there are limitations to this model as well.
One limitation is that while Proof of Reserves provides verification of an organization’s assets at a given point in time, it may not necessarily reflect more than just customer deposits for liabilities. For example, an organization may have outstanding loans, investor obligations, and/or debt that would not be reflected in a reserve statement.
Another limitation is the timing of a Proof of Reserves audit. Most audits of this nature are performed at a particular time, and do not take continuous reporting into account. Therefore, an organization may borrow assets on a short-term basis prior to an audit and have returned those borrowed assets prior to the audit being issued, resulting in the organization having a stronger balance sheet than reality would indicate.
Lastly, the Proof of Reserves audit does not provide any assessment of an organization’s internal governance, cybersecurity, and operational risk management practices. Therefore, while Proof of Reserves may provide verification of an organization’s ownership of its assets, that does not necessarily mean that the organization is operating business responsibly.
Proof of Reserves vs. Traditional Financial Audits
Companies that perform traditional financial audits will review the entire set of a company’s financial statements, which can consist of many different components including assets, liabilities, income or loss, expenses and general overall business health.
In contrast, Proof of Reserve focuses primarily on the veracity of verifying all of a company’s Cryptocurrency (BTC, ETH and altcoin) holdings in order to give added transparency to how blockchain-based assets are recorded. However, while this additiional level of public transparency is valuable for those companies with Blockchain-based assets, it does not provide enough information to take place of a thorough Financial Statement Audit. Ideally, reputable exchanges would issue their own independent financial statement audits along with regular Proof of Reserve reports that detail the company’s entire financial situation and state.
How Investors Can Use Proof of Reserves
As an investor, you should consider Proof of Reserves among other factors when looking for a cryptocurrency exchange.
Before making a deposit on an exchange, be sure to check for regular publicly available reserve reports that have been verified by an independent auditing firm — as well as whether the wallet addresses of the exchange are publicly visible and whether any customers’ balances are verified through cryptographic methods such as Merkle Trees.
In addition to these factors, weigh how secure the exchange has been in the past, if they adhere to regulations, if they have sufficient insurance policies and their reputation within the larger community of cryptocurrency users. Combining all these elements provides an overall picture of the reliability of any exchange you’re considering.
The Future of Proof of Reserves
The Proof of Reserves is anticipated to emerge as a growing trend in the Industry as cryptocurrencies continue to gain traction with new users. Other developments may include an ability to monitor reserves in real-time, an automated blockchain verification process, and providing expanded reporting for both the assets held and the liabilities owed by exchanges. The use of advancements in technology such as zero-knowledge proofs and additional privacy preserving cryptographic technologies will also assist exchanges with providing an even higher level of transparency while still maintaining the confidentiality of their customers.
Regulators in many jurisdictions have also encouraged cryptocurrency exchanges to provide enhanced disclosure requirements and as a result, the use of Proof of Reserves will play an essential role in meeting future crypto compliance regulations.
Conclusion
In the cryptocurrency industry, proof of reserves is a key milestone in restoring transparency and building trust. By permitting exchanges to prove that they are held in full by on-chain reserves, it enables users of these platforms to have more confidence in them.
Though proof of reserves can help reduce risk of fraud, it cannot provide 100% assurance of financial viability. An examination of independent audits, security measures, regulatory compliance and good corporate governance must also provide information about a single centralized exchange; thus, it forms a vital element in evaluating whether any cryptocurrency investor feels sufficiently comfortable making investments within an increasingly fluid and ever-changing (digital asset) marketplace.
