What Is Proof of Reserves (PoR)?

Proof of Reserves Explained

What Proof of Reserves Means

In simple words, to answer the question: “What is proof of reserves? Proof of Reserves is a validation method, which allows cryptocurrency exchanges and custodial services to publicly show that they have sufficient assets to settle all user deposits. It is an audit process that provides information and confidence to the viewers that their money is safely banked and is capable of being withdrawn whenever they wish.

Basically, Proof of Reserves Crypto is a product of a sequence of activities that are often conducted by an external third party to present certainty into what is held in addresses managed by a custodian or a swap. It can also have a facility where customers are given the ability to check by hand the fact that their assets are included in the Proof of Reserves totals as reported by the custodian or exchange.

Why PoR Became Critical for Crypto Exchanges

Proof of Reserves became especially important after major exchange failures, most notably the collapse of FTX in 2022. In that case, customer funds were misused, and the exchange did not hold enough reserves to meet its obligations.

Without clear proof of reserves, users risk dealing with exchanges that operate on fractional reserves or are insolvent. By implementing PoR, exchanges can increase trust, reduce counterparty risk, and improve overall market transparency.

How PoR Increases User Transparency and Trust

Proof of Reserves is an important step in an industry that is often seen as uncertain. It allows exchanges to clearly demonstrate that they are financially sound and responsibly managing user funds, which helps build trust with both existing and potential users.

As regulators around the world work on clearer rules for the crypto market, exchanges that adopt Proof of Reserves show a willingness to operate transparently and responsibly. This proactive approach may also make it easier to comply with future regulations and avoid potential issues later on.

How a Proof of Reserves Audit Works

Merkle Tree Verification Method

Auditors often use a Merkle tree to maintain a large number of accounts without necessarily making balances public. The balance of every account is converted into hashed item which is known as leaf. Leaves are combined and hashed with their predecessors to form a branch and then more hashing is done until only one hash is left known as the Merkle root. This root would give the summary of all balances and could be used to check whether a certain account had been included in the snapshot or not without making the details of other accounts known.

Auditor’s Role and What They Verify

Auditing proof-of-reserves is the usual procedure performed by an independent auditor as the means of ensuring that the assets held by a crypto custodian are equivalent to the sum of the holdings of its customers.

Firstly, the auditor or auditing company outsourced takes an anonymous record of the balance in the accounts of the institution. The auditor organizes these balances into a Merkle tree, where information about custodials is stored and has multiple branches that are lockable with the help of hash codes.

After this, the auditor is able to compile the personal contributions by the users utilizing the unique signatures of each account holder.

The next thing is to ensure that the assets of the customers are kept on a full-reserve basis i.e. the reported balances of the individual contributors should be no less than the values in the Merkle tree. This is done through the comparison of the digital signatures and the entries in the Merkle tree.

Users can check their respective transactions after the proof of reserves audit.

Proof of Reserves in Crypto Exchanges

How Exchanges Implement PoR

Proof of Reserves is important in the cryptocurrency sector because the adage that maintains that not your keys, not your crypto means that unless you have access to your own private keys, an exchange may be putting your deposits to work or rehypothecateing your funds to them.

When an exchange experiences a situation similar to a bank run, and the exchange does not have enough funds, or 1:1 support, of the digital currencies deposited, it may be liquidity challenged, and the depositors may be forced to wait long queues before being refunded their money, or not at all.

Whereas Crypto Exchange Proof of Reserves may provide people with a degree of trust that their assets are protected, it does not remove the risk of issues caused by a hack, or malicious attack.

Proof of Reserves is by no means a panacea, yet as many different exchanges start to report their Proof of reserves or get their wallets audited by third-party agencies, it is likely to stimulate more transparency in the industry.

Common Challenges and Limitations

The main challenges and limitations of Proof of Reserves include the following:

1. Proof of Reserves reflects asset holdings at a specific point in time. Even if performed correctly, it does not account for what may have happened before or after the audit.

2. PoR focuses mainly on on-chain data and compares customer assets recorded on the blockchain. It does not fully reflect the overall financial position of an exchange, including off-chain liabilities or other obligations.

3. There are currently no universally accepted auditing standards for Proof of Reserves. As a result, procedures may differ between auditors, making results harder to compare across the industry.

Binance Proof of Reserves

How Binance’s PoR System Operates

Binance conducts audits and publishes internal audit reports for proof of reserves Binance. The third-party auditing firms apply the encryption technology to help them confirm the audit reports that users safely keep the funds in the Binance reserves. Besides, users of Binance can confirm on their own that their personal account balances are included in such audited reports.

There are three ways through which ownership can be identified by auditors on the Binance platform. This is also verified by the auditor in the information extraction process of the trading platform.

1. Cryptographic signatures of information.

2. Transfer funds as directed.

3. Search addresses on a blockchain explorer: The auditors may access a blockchain explorer to find the address of Ethereum (ETH) and Binance Smart Chain (BSC) on Etherscan and BscScan respectively to confirm that the address is registered as a part of the trading platform.

FAQ About Proof of Reserves

What is Proof of Reserves in crypto?

Proof of reserves in crypto is a method of verifying the funds of a given crypto exchange to protect investors from exchange collapses and improve investor trust.

Are PoR audits fully reliable?

No, because there are no audit standards for Proof of reserves currently in existence. This makes the quality of such procedures in question and prevents results from being comparable across the industry.

How can users verify PoR results?

It depends on the crypto exchanges that users use, as every platform has its own procedure to verify Proof of reserves results.

Does Binance provide Proof of Reserves?

Yes