Customers now need “proof of reserves” from bitcoin exchanges due to recent industry incidents. Former top-five crypto exchange FTX went bankrupt after squandering client cash.
What Is Proof Of Reserves?
Proof of reserves (PoR) audits, commonly performed by smart contract audit organizations, verify that a custodian (such as an exchange) retains the assets it promises to maintain for its customers. The independent auditor creates a Merkle tree of all custodian balances so the public may check them.
Reserves show a custodian has enough money to guarantee consumer deposits. Blockchain makes crypto business audits safe without revealing user data.
Why Are Proof Of Reserves Important?
The cryptocurrency business warrants suspicion. Yet until recently, many crypto enthusiasts believed industry actors had the assets they claimed. Celsius, Voyager, FTX, and BlockFi’s 2022 explosions raised concerns about assets and on-chain transactions.
These high-profile insolvencies often came from reckless lending or trading losses. However, it seems consumer cash may have been diverted for other reasons, raising questions about whether FTX and other exchanges owned the assets users believed they were trading.
Recent instances include FTX, which may not have the assets represented. Other firms may have misrepresented their assets. Many exchanges and companies rushed to record consumer crypto holdings after FTX’s failure. Reserve proof is a valuable tool for auditing assets.
Merkle PoR Tree
Merkle trees consolidate vast quantities of data into one pool. A hash tree combines hashes of several data blocks into a single hash.
A crypto exchange maintains assets in multiple wallets, and a Merkle tree sums them up at the root. User account balances may be checked in Merkle.
Other Issues With Proof Of Reserves
Limitations: Proof of reserve reports only reflect the exchange’s assets, not its liabilities. An exchange may have $1 billion in crypto assets but $3 billion in liabilities, which the PoR report will not show. Few exchanges like BitMex provide liability evidence.
Not real-time: A PoR report is a snapshot of an exchange’s assets. Things may change between snapshots and now.
Limited scope: A PoR report only displays the exchange’s on-chain assets, not their origin (e.g., if they were borrowed to pass the audit).