What is Proof Of Reserves and Why it’s Important?

Proof of Reserves (PoR) is a way exchanges use to ensure safety and availability of funds withdrawal by publicly revealing digital assets in their possession.

It’s also a method of cryptographically auditing a cryptocurrency exchange for safe back-up funds, should there be hacks or technical attacks.

Proof of reserves is a concept that offers assurance to customers about the capacity for solvency and liquidity of the exchange company holding their assets.

It’s simply an attestation that crypto custodians, or exchanges have 1:1 backing for all the funds deposited by users.

Centralized exchanges offer proof of reserve audits for customers to help verify the state of their assets on the platform.

How proof of reserves is conducted

The three major components of conducting proof of reserves on an exchange consist of audits, assets and liabilities with merkle tree structure.

Let’s explain each of the components in details, you will understand the role each of them plays in the concept.

1. Assets and liabilities

A cryptocurrency custodian is expected to produce a record of its assets and liabilities to be audited separately in a PoR.

In this case, assets are the total amount of tokens held by an exchange wallet, while the liabilities represent the user’s deposits.

When these two are separated, it becomes transparent for users to accurately track the financial position of an exchange.

Aside the users, it also help accountants and auditors to spot misappropriation of funds in an exchange company.

2. Merkle tree structure

A Merkle tree is a cryptographic data structure that is employed in an audit to ensure that users’ account balances are verified without exposing any private information.

It also enables cryptocurrency exchange users to verify that their account balance is held in reserve.

The merkle tree hashes users’ account balance into leaf, branch, and root, where the root serves as a central source of data.

Auditors can ask for a sample of leaf hashes, and the platform in question provides them with a partial path to the root hash.

3. Auditing

The simplest way to PoR audit an exchange is having them sign a message using private key to the wallet address it claims to control.

However, the most popular method eliminate the possibility of reserve data being falsified, is using an independent third-party auditing firm.

These auditing firms are responsible for taking a snapshot of users’ account balances, and producing a report attesting to an exchange asset balance.

Benefits of Proof of Reserves

Here are the reasons why PoR is very important to both users and crypto exchange firms in the market.

1. Trust and transparency

There’s always a need for these exchanges to maintain user trust and transparency with their customers.

By providing proof of reserve, exchanges can demonstrate that users’ funds are safe and can be withdrawn at any time.

2. Prevents misuse of funds

Proof of reserves makes it more difficult for exchanges to engage in the misappropriation of funds.

Since statement of asset balance is open to the public, users will be made aware of any subtle attempt to pilfer funds.

Additionally, it allow these plaforms to accurately track their financial position, and become mindful of their liabilities.

3. Fraud avoidance

This concept helps cryptocurrency users to easily identify fraudulent exchanges, and stay away from them.

It also help existing exchanges to restrain from activities that may present them as frauds to their customers.

How to track an exchange proof of reserve

Crypto market analytic companies like CoinMarketCap and Coingecko publish exchange Proof of Reserves on their websites.

The steps below are how you can check an exchange’s PoR using CoinMarketCap site.

  1. Visit CoinMarketCap platform

    On the platform select an exchange and click on the ‘Reserves’ icon displayed beside the listed exchange.

  2. View the exchange reserves

    Once you click the ‘Reserves’ icon (which signifies that an exchange supports PoR), you will view the exchange PoR details.

On this site, you can verify if your funds are accounted for by the exchange’s PoR audit by also clicking on ‘Audit’ on your profile.

Final conclusion

Despite the above stated benefits, proof of reserves audit has some disadvantages that cannot just be overlooked.

The critical issue with PoR audit is tat the information vitality depends upon the auditor’s competence.

A fraudulent audit result may be produced by a third-party auditor in collaboration with the exchange under consideration.

In addition, an exchange may manipulate the facts, as the correctness of verified balances is only valid during the time of audit.

Moreover, a proof of reserve audit does not state if the money was borrowed to pass the auditing process.

If you want my candid advice, I will suggest you don’t always leave your crypto investment in an exchange where you bought them.

The best investment strategy is to make use of a non-custodial crypto wallets to store your assets.

About The 'Staunch

Henry is an accountant that turned cryptopreneur to pursue his crypto and defi interest. He founded this site to show you how to invest safely in these kind of assets using his over-the-years experience. When he's not reading, he will then be writing guides and reviews on cryptocurrency investments.