What is Proof of Reserves And Why Does it Matters?

Proof of reserves (PoR) has been a hot topic in the cryptocurrency community in the wake of the recent FTX collapse, with investors demanding that exchanges provide proof of their crypto holdings. But what exactly is proof of reserves, and why does it matter?

Proof of reserves is a method of verifying that a trading platform or crypto firm holds the amount of digital assets that it claims to have in custody on behalf of its customers. The process involves a third-party organization conducting an attestation and publishing the results, which helps investors understand the financial state of a centralized exchange and whether it has sufficient funds to match customer deposits.

Different types of attestations have been developed, with some providing more confidence in a firm than others. One of the most popular types of proof of reserves is the Merkle Tree-based proof of reserves.

Merkle Tree-based Proof of Reserves -

Merkle Tree-based PoR protocols use a Merkle Tree proof to integrate large amounts of data into a single hash and verify the integrity of the data set. By using cryptographic proofs, the PoR protocol verifies the validity of user balances and transactions.

Crypto exchanges may publish Merkle Tree-based PoR attestations at regular intervals, including weekly, monthly, or quarterly snapshots. Alternatively, firms might provide real-time attestations that are available on their website at all times, allowing anyone to ensure that funds are indeed held by the exchange.

While snapshots may be sufficient to prove a crypto firm’s solvency at a set point in time, real-time attestations are considered to be superior when verifying an exchange’s reserves. This is because they allow anyone to verify the exchange’s holdings at any time, giving a more accurate picture of its financial state.

Why Do Proof of Reserves Matter?

Proof of reserves is a step in the right direction when it comes to ensuring customer funds are safe. By cryptographically proving that a company has sufficient liquidity, it helps to mitigate the risk of funds being lost or stolen. In addition, proof of reserves helps to build trust between exchanges and their customers, as it gives users a greater understanding of the exchange’s financial state.

However, while proof of reserves is an important step forward, it is not without its limitations. By simply providing a snapshot of the assets held on the platform’s associated addresses, exchanges give an overview of their holdings. However, they — with few exceptions — do not disclose the company’s liabilities to customers, meaning that users are required to trust the auditor’s attestation about the assets in question.

This can lead to a situation where an exchange uses its proof of reserves to appear transparent without disclosing its true solvency risk. In addition, some exchanges may be less forthcoming about their proof of reserves, making it more difficult for users to assess the financial stability of the platform.

Conclusion

Proof of reserves is an important concept in the cryptocurrency community, providing a way to verify that a trading platform or crypto firm holds the amount of digital assets that it claims to have in custody on behalf of its customers. While proof of reserves is a step in the right direction when it comes to ensuring customer funds are safe, it is not without its limitations.

Users should be aware of the limitations of proof of reserves, and be cautious when relying on attestations provided by exchanges. It is important to consider a range of factors when evaluating the financial stability of a platform, including the type of proof of reserves provided, the auditor’s reputation, and the platform’s history.