What Are Proof Of Reserves In Crypto?

We explain what proof of reserves are as well as how they work. We also discuss the potential shortcomings of this auditing technique.

Recent events in the crypto industry have prompted customers to demand "proof of reserves" from the exchanges they use to store or purchase cryptocurrency. FTX, formerly a top-five crypto exchange, recently became insolvent due to misusing customer funds.

The platform filed for bankruptcy while reporting$9 billion in liabilities. Thus, many exchanges have begun posting proof of reserves (PoR) to assure users that their funds are safe and that they won’t find themselves in a similar situation as FTX.

What Is Proof Of Reserves?

A proof of reserves (PoR) is an independent audit of a crypto exchange, usually by smart contract audit companies, showing that a custodian (e.g., an exchange) actually holds the assets it claims to hold on behalf of its users. The independent auditor takes a snapshot of all balances held by the custodian and aggregates them into what's called aMerkle tree so that the public can verify the assets.

Proof of reserves provides evidence that a custodian has sufficient funds to back all customer deposits. It uses blockchain technology to securely audit a crypto company without exposing private user data.

Why Are Proof Of Reserves Important?

There’s plenty of reason for skepticism in the cryptocurrency industry. But until recently, many in the crypto space were more willing to trust that industry players have the assets they claim to have. Several spectacular implosions in 2022, including Celsius, Voyager, FTX, and BlockFi, led to increased scrutiny of assets as well as on-chain transactions.

In some cases, these high-profile insolvencies resulted from risky lending or trading losses. However, in the case of FTX, it appears customer funds may have been used for other purposes, creating doubt as to whether FTX (and other exchanges) actually held the assets customers thought they were trading.

FTX was among the most recent examples of companies that may not have the assets claimed. But there could be other companies whose stated assets don’t match reality. FTX’s collapse put the crypto world on guard, with many exchanges and platforms rushing to document their crypto assets held on behalf of customers. Proof of reserves provides a powerful tool to audit holdings at a given point in time.

What Is A Merkle PoR Tree?

A Merkle tree is a type of data structure that allows the consolidation of large amounts of data into a single pool. It consists of hashes of different blocks of data combined into a single hash, so it’s also known as ahash tree.

A crypto exchange holds different assets in different wallets, and a Merkle tree sums up the assets held by the exchange into the root of the Merkle tree. Users can verify that their account balance is included in the Merkle tree.

Exchanges With Proof Of Reserves And/Or Tree

• Kraken: You can verify your account’s assets with Kraken’s third-party auditor.
• BitMEX: Has provided proof of reserves and liabilities.
• OKX: You can verify your assets in the OKX Merkle tree from your account.

Issues With Proof Of Reserves

• Liabilities: Proof of reserve reports don’t tell the full picture because they only show the assets the exchange holds but not their liabilities. For example, an exchange could have$1 billion worth of crypto assets, but if they have$3 billion of liabilities, the PoR report won’t indicate it. Only a few exchanges like BitMex show their proof of liabilities.
• Not real-time: A PoR report isn't a live view of the assets an exchange holds but a snapshot at a single point in time. Things can change between the time of the snapshot and the present.
• Limited scope: A PoR report only shows the on-chain assets of the exchange; it doesn't track the origin of the assets (e.g., if the assets were borrowed to pass the audit).

To Sum It Up

Given the recent occurrences in the crypto industry, it’s safe to say that you shouldn’t use an exchange that hasn’t provided a proof of reserves report or indicated plans to do so. A proper exchange should show proof of holding users’ assets in custody and not misusing them as in the case of bad examples like FTX.

Frequently Asked Questions