After a series of loud and unforeseen crashes of crypto exchanges in the world of cryptocurrencies, the society of investors and crypto-enthusiasts is thinking about the vital need to apply special tools and means aimed at conducting an inspection (audit) of a crypto company in order to confirm whether its reserves contain sufficient security to cover its obligations to customers. Thus, the Proof of Reserves mechanism appeared.
This article will tell you what the Proof of Reserves mechanism is, how it works, and what its benefits are.
- Proof of Reserves is a new form of auditing crypto organizations to confirm their solvency.
- Among the benefits of PoR technology are its versatility, practicality and transparency.
What is the Proof of Reserves?
Proof of Reserves or PoR is a verifiable audit procedure that helps increase the transparency of centralized cryptocurrency reserves and checks exchanges for fraud. PoR uses cryptographic evidence, verification of ownership of public wallet addresses, and repetitive third-party Proof of Reserves audits to validate centralized platform fund reserves.
Reserve proof proves that one centralized facility has a 1:1 reserve to users’ funds. That is, users are guaranteed the ability to withdraw their funds. It is never too late for cryptocurrency centralized exchanges (CEX) and other custodial service providers (firms that own the private keys of user wallets and therefore own user funds) to disclose a verifiable audit to prove their solvency and no mishandling of user funds, whether through public wallet ownership, cryptographic evidence or third-party audit services. The official measure of financial strength, the reserve ratio (the ratio between a firm’s existing funds and user funds), should be at least 100 percent to ensure that crypto assets are safe.
Proof-of-Reserves is an integral component of the overall Proof of Solvency auditing system for crypto firms. This concept includes Proof of Reserves and Proof of Liabilities mechanism based on reliable tools to help prove that the total amount of crypto asset held by a crypto exchange (or any other crypto company) exceeds the total amount of its liabilities. If financial agents (custodians) hold client reserves in cryptocurrencies, they must also prove ownership of the keys to their accounts holding the digital assets. These procedures are mandatory and help to determine with 100% probability the level of trust of the crypto company in terms of holding reserves.
- The Proof of Reserves mechanism is an integral part of the Proof of Solvency system, which also includes a tool for checking the fulfillment of obligations – Proof of Liabilities.
How Does Proof of Reserves Work?
The essence of the PoR mechanism originates in verifying assets by exchanging software infrastructure files. To assess information verification and file integrity, Proof-of-Reserves verification transforms each account’s balance data structure into a Merkle tree, enabling a single hash for many data fragments. A structure with branches diverging from its base to intermediate nodes can be used to depict a hash tree. At the tips of the branches are leaves that represent data chunks. The tree’s base contains the root hash (Merkle root). Data about user balances are hashed into a “leaf.” The “leaf” is then hashed to create a “branch”, which is subsequently hashed to create the “root” group. The third party auditor independently verify that the exchange owns the blockchain’s public keys and associated addresses.
A cryptocurrency exchange creates a cryptographic hash of its available funds. It is generated by a computer program that randomly selects a number from 0 to 100,000,000. This number is then added to the number of stored assets. A hash of the amount of funds is published on the exchange’s website, along with a link to a third-party Proof of Reserves audit report. This not only proves that the exchange has assets, but also protects users from having their funds misappropriated by the site’s employees.
After creating a snapshot as part of the independent audit, the auditor confirms the accuracy of the published data and the consistency of the hash with the stored funds, reducing the likelihood of fraud, after which it receives the Merkle root: a cryptographic fingerprint that uniquely identifies the combination of balances at the time the snapshot was created. The auditor then collects digital signatures created by the crypto-merchant that prove ownership of the addresses in the chain with the publicly audited balances. Finally, the auditor compares and finds that these balances exceed or match the customer funds (balances) represented in the Merkle tree so that client assets are held on a full reserve basis.
Benefits of Proof of Reserves
Recently introduced, but with great potential in the field of auditing crypto firms, Proof of Reserves mechanism has all chances to be the benchmark in matters of solvency verification of crypto subjects in order to ensure the security and sufficient liquidity of trading activities using any classes of digital assets. Let’s look at a few distinctive advantages that Proof of Reserves technology offers.
The practicality of using PoR lies in the use of distributed ledger technology as the basis, which a priori enables audits of any class, any crypto entities in the market within any specific conditions with 100% probability. This practice eliminates third-party interference to manipulate the actions of auditors or regulators, providing full control over the verification and validation processes of all information and data necessary to prove the solvency of a crypto company quickly, accurately and conveniently.
The practice of using Proof of Reserves is not limited to auditing cryptocurrency exchanges, although after several large cases of their collapse in the market, it is primarily intended to provide the necessary conditions to confirm their reliability. On the other hand, the PoR mechanism can be applied to conduct financial audits of any crypto industry participants, be it cryptocurrency product companies, crypto wallets or stable coins. The versatility of this method has no limits and can become an important aspect of using blockchain technology to enable independent audits of any structure.
Transparency in transactions with customer assets is one of the most important points when it comes to ensuring their safety. The Proof of Reserves mechanism uses a combination of blockchain-based technologies and financial auditing mechanisms that can provide a comprehensive approach to comprehensively analyze, verify and report on a crypto company’s trading activity, examine its reserves and draw conclusions based on the information obtained. This practice will help avoid the distortion of information obtained in the course of verification, as well as the possibility of its falsification and misinterpretation, which will ultimately increase the overall efficiency and speed of such verifications.
The current state of affairs in the crypto sphere has prompted its community to develop and implement effective tools to verify and control trading activities, one of which is the Proof of Reserves mechanism for crypto audits. Its practical application will help increase transparency of transactions not only in the crypto niche, but also in any other financial sector