What is Proof of Reserves and How Does It Secure Your Funds?

Using the Merkle tree hashing mechanism that underpins blockchain technology keeps the data secure and protected from any tampering or hacks. Proof of reserves is completed by a third-party auditor that creates a snapshot of all of the company’s balances to show transparent “proof” that the crypto company has enough assets to cover its liabilities at any given time. This gives customers confidence that the crypto company is not at risk of a liquidity crisis, and that customers can withdraw their funds at any time. To verify individual account balances without the danger of exposing personal https://www.xcritical.com/ or sensitive information, a proof of reserves audit uses a data structure called a Merkle tree. Without getting too technical, this data structure is a way of validating information, whilst obscuring its sensitive contents. The main idea of the audit is to verify that platforms actually have the funds they claim to have, therefore reassuring users that their funds are in safe hands.

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In the case of prior exchange collapses like FTX, Quadriga, or Gox, these exchanges were insolvent for months and years. They never had sufficient reserves to honor all possible client withdrawals. The moment an exchange what is proof of reserves was even under-reserved, the PoR would have been impossible to pass. So PoR makes it virtually impossible to behave badly for any meaningful period of time. For modern PoR like the ones done by Derebit of BitMEX, the entire liability set is released, so there’s no real uncertainty around the completeness of liabilities.

• This is because if the exchange were to understate its liabilities by excluding certain accounts, the account owners could individually see that their information was excluded, and report this to the broader public.
• In times of high volatility, the crypto market liquidity will be lower because the fluctuating market prices discourage trades, causing buy and sell orders to take longer to fulfil as there is less activity in the market.
• Anytime you trust a 3rd party with your assets, you introduce a point of failure.
• If an institution’s proof of assets is equal to or greater than its proof of liabilities, it has a reserve ratio of at least 100% and is considered full-reserve.
• Smaller institutions may find it challenging to bear the financial burden of frequent audits, making it more difficult to provide continuous and up-to-date proof of reserves.
• By encouraging custodial exchanges to adopt PoR, I am hoping that user assurances at custodial exchanges can be bettered.

What account balances are included in the PoR audit? When are the balance snapshots taken?

For instance, given that many exchanges exist under muddy regulatory regimes and legal contexts, it’s not guaranteed that depositors would be senior to creditors in the case of bankruptcy. This means that it’s possible that large debts could consist of a hidden liability that would weaken depositor claims on reserves in a worst case scenario. This is why I recommend including an auditor in a PoR process, so these more complex liabilities (and an assessment of the seniority of depositors) can be understood. More generally, exchanges should adopt a legal policy in which depositors are absolutely privileged and senior to all creditors. These hierarchical data structures validate block transactions and customer holdings without revealing their balances. Central to these is the Merkle root, a hash that uniquely identifies any transaction block.

Who is conducting the PoR for Crypto.com? Why have you selected them?

Proof of Reserves works especially well for Bitcoin since the Bitcoin blockchain is public and transparent. Chainlink Proof of Reserve helps DeFi users get transparency into their risk exposure, increasing confidence in the backing of onchain tokens collateralized by offchain reserves. Issuers minting onchain tokens representing offchain or cross-chain assets can integrate Chainlink Proof of Reserve to help provide additional guarantees that they cannot mint more tokens than assets stored in reserves.

Proof of reserve can be published as a report at regular intervals or a dashboard that provides continuous live data. In either case, the purpose is to help build trust and transparency between the exchange and its customers. It relies on voluntary engagement and does not guarantee full transparency of a custodian’s financial situation. However, given the industry’s poor record of transparency concerning customer funds, it is, by many, considered a start to establishing a minimum standard of self-regulation. Moreover, exchanges and lenders are encouraged and free to seek additional regulation to increase their reputation in the market, and in doing so, gain their customers’ trust. Proof of Reserves (PoR) is a method of using cryptographic verification to demonstrate possession of digital assets.

Some exchanges and crypto lending platforms, including Kraken, Nexo, BitMEX, and Gate.io, moved to launch their proof of reserves before the implosion of FTX. Yes, PoR doesn’t fix this kind of issue (no one has ever claimed it is a panacea). The way to fix this is to ask exchanges to hold assets in a segregated trust held for the benefit of clients, which is insulated from other liabilities. However, cryptocurrency users have a revealed preference for custodial ownership, at least for a portion of their coins. By encouraging custodial exchanges to adopt PoR, I am hoping that user assurances at custodial exchanges can be bettered. The reviews mitigate that risk by enabling an audit of crypto exchange holdings.

For instance, PoR can be tampered with by borrowing assets on a short-term basis while the balance sheet snapshot is provided. Thus, PoR should always include wallet addresses to enable the tracking of fund movements. Released last week, it said that at the time of assessment, Binance controlled in-scope assets in excess of 100% of their total platform liabilities. Exchanges can also use Chainlink’s system to provide security around the guarantees that they cannot issue more tokens than assets stored in reserves. Using cryptographic proofs, the PoR protocol verifies the validity of user balances and transactions.

PoR helps to increase transparency and accountability in the industry, as well as reduce the risk of fraud and insolvency. By performing a PoR audit, the entity can demonstrate that it is operating in a transparent and trustworthy manner. Some exchanges go even further and provide an opportunity for their clients to confirm that their account has been included in the PoR verification. For example, on Binance, you can select the “Audit” menu and check if your account participated in the construction of the Merkle tree. Proof of Reserves (PoR) is a concept pioneered by Binance’s founder, Changpeng Zhao, which aims to bring centralized exchanges closer to decentralized ones. Binance has recently begun publishing information about the total balances of bitcoins, ethers, and stablecoins on their wallets under the name “Proof of Reserves.”

In traditional and digital financial systems, a lack of transparency and certainty about reserve levels can lead to panic. Proof of reserves contributes to the overall stability of the market by reducing the risk of a liquidity crisis. Therefore, users can have peace of mind knowing that their privacy remains intact while the exchange demonstrates its financial soundness. This process continues until we reach the very top of the tree, where we have a single hash, known as the root of the Merkle Tree. Since 2017, Hacken has expanded beyond smart contract audits, completing numerous PoR audits for leading industry projects, like Gate.io, Crypto.com, Bybit, among others. Ensure stablecoins, CBDCs, and wrapped cross-chain assets are properly backed.

In an ideal world, investors should be able to trust that issuers have enough underlying assets in reserve for redemption. In practice, this is often risky for investors, as seen in events such as the downfall of FTX. Therefore, investors and issuers strive to come closer to a trustless world without a single point of failure.

Proof of reserves relies on auditors to independently verify the accuracy of the disclosed information. Different jurisdictions have varying requirements and regulations concerning financial transparency and reporting. Fractional reserve banking is a practice in which banks keep only a fraction of their customers’ deposits in reserve, lending out the rest. This system can be risky, as it relies heavily on the assumption that not all depositors will simultaneously withdraw their funds. At the very bottom of the tree, we have the leaves (leaf nodes), which represent individual pieces of data, such as individual account balances or transaction details. These leaves are then combined in pairs and hashed together to create what we call a parent node.

We began pioneering PoR audits in 2019, well before they became an industry necessity. Hacken’s Merkle Tree & Verifier Tool ensures that on-chain assets fully match user liabilities. Bridge the gap between off-chain real-world assets and their digital representations with verifiable audits that enhance trust and regulatory compliance.

Knowing what is proof of reserves is very important, but understanding how it works is also crucial so you can safely identify scams. Discover what is proof of reserves and the role it plays in the protection of your funds. With Hacken’s PoR service, you can generate on-demand proofs at any time, giving your users confidence and peace of mind about your platform’s solvency. Generate proofs of solvency at any time with Hacken’s flexible PoR solution, empowering your platform to stay ahead with timely updates that users and stakeholders trust. Ensure the integrity of staked assets, prevent double-counting, and verify validator set security for a transparent staking process. To prove that an exchange is the true owner of the addresses it publishes, it may provide an attestation, such as a transaction from its address that follows a predefined formula.

Understanding the verification process is crucial for cybersecurity professionals. Hacken provides a PoR verification platform where users can verify various exchanges themselves. Implementing such systems yourself requires an in-depth analysis and even development integrations. Whereas before, PoA users or agencies had to believe whatever reports an exchange said, Proof of Reserves gives users the ability to check whether their funds are gone or in place. Liquidity is essentially how easy it is for things to be bought and sold without causing a drastic change in an asset’s price, and it can refer to both markets and assets. In the crypto world, to ensure that holders can get speedy trades, the market must be liquid, meaning high activity and minimal spread between the bid and ask prices.

All of the big four as well as RSM, in my esteem, have the technical competency to undertake a PoR but have thus far appear to have been unwilling to on a perceived risk basis. We evaluate the audit scope, timeline, and costs based on your project’s documentation to set clear expectations from the start. Trusted by Gate.io, Crypto.com, and Bit2Me, Hacken’s PoR audits help you build credibility, strengthen trust, and stay ahead of competitors. These are some of the methods, that together could provide a Proof of Reserves audit.

Proof of Reserves audits allow crypto institutions, such as centralized exchanges, to improve transparency in the unregulated market. On the other hand, blockchain oracles can conduct these audits in a completely decentralized manner.Oracles are systems that can provide smart contracts with real-world data from off-chain sources. For example, if you want a smart contract to execute an action when a specific real-world event occurred, you would need an oracle. The objective of any audit is to provide an impartial assessment of an institution’s financial health.