Proof of Reserves: Could It Have Avoided the FTX Meltdown?

What Is Proof of Reserves (PoR)?

Proof of reserves (PoR) is a transparent auditing practice for cryptocurrency companies that provides an unbiased report of the companies’ assets in reserve. Third-party auditors access cryptographic signatures representing the total balance of customer assets, and ensure that the custodian of these assets has an equal (or greater) amount of reserve assets in place to cover all potential customer withdrawals.

This helps prevent a liquidity crisis if there is a “run on the bank” and customers withdraw funds en masse, and it provides transparency to users about where their funds are. Proof of reserves uses blockchain technology, offering a secure way to audit a crypto company without exposing any private user data.

Key Takeaways

  • Proof of reserves (PoR) reports the results of a third-party audit of a crypto company.
  • Proof of reserves shows whether customer funds are safe, meaning that sufficient funds are backing all deposits.
  • Crypto companies may publish periodic proof-of-reserves audit results or have a real-time track of reserves available on their website.
  • Proof of reserves uses blockchain technology to publicly verify a crypto company’s on-chain assets.

Why Is Proof of Reserves (PoR) in Demand After FTX Collapse?

Proof of reserves is becoming more and more popular, especially with the November 2022 downfall of the FTX crypto exchange and recent comments from crypto exchange Binance about the importance of transparency. It also will become important as regulators look to set industry standards to protect consumers, as proof of reserves is a secure and transparent way to ensure that customer funds are safe.

Understanding Proof of Reserves (PoR)

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.

Proof of reserves employs a secure data structure known as a Merkle tree (or hash tree), which aggregates the total of all customer balances without exposing any private information. The total aggregate data is accessible via the Merkle root. The Merkle root is the tamper-proof cryptographic fingerprint that auditors can access to verify the balance information. Using the Merkle tree hashing mechanism that underpins blockchain technology keeps the data secure and protected from any tampering or hacks.

All of these checks and balances ensure that a crypto company has the reserve assets that it needs to serve all customers, and that liquidity is maintained no matter the market conditions. 

Concerns About Proof of Reserves (PoR)

Although proof of reserves offers assurance that a crypto company has the assets in place to cover its liabilities, it is only a single snapshot in time, not a live accounting of balances over time. It also only shows the on-chain assets of the custodian; it does not track where those assets come from (i.e., whether the assets were borrowed for the purposes of the audit).

While proof of reserves can be touted as a way to show a crypto company’s solvency, there are still ways to thwart this, including having off-chain liabilities or colluding with the auditing team. But that being said, proof of reserves is likely to become the minimum disclosure standard for any crypto company going forward.

Goal of Proof of Reserves

The goal of providing proof of reserves is to offer financial transparency about a crypto company’s balance sheet, especially in regard to customers’ funds. A third-party audit gives consumers confidence that the crypto company they are using has sufficient liquidity to handle day-to-day operations, and more importantly, customer withdrawals.

What assets can be considered reserves?

Assets that are considered reserves are cryptocurrencies (or other types of assets) that offer strong liquidity. In other words, the company could sell off the assets to cover withdrawals or other liabilities, if needed. These may include cash or other fixed income assets. As for cryptocurrencies, this would include the more popular coins, such as Bitcoin and Ethereum, and stablecoins, like Tether, USDC, or BUSD.

What is a proof-of-reserves (PoR) audit?

A proof-of-reserves (PoR) audit of a crypto company generates a certification called an attestation. The attestation shows the current balance of reserves at a company. Audits may be performed on a regular schedule (such as monthly or quarterly), but some crypto companies offer a real-time proof-of-reserves balance on their website, which is updated several times a day.

Do all crypto exchanges need to publish reserve balances?

Crypto exchanges are the most highly trafficked crypto companies in the world, with the highest trading volume and value of customer deposits. While there is no current regulation requiring proof of reserves, this may be coming soon, especially in light of many crypto companies failing due to liquidity issues in 2022. Proof of reserves is recommended for any crypto company that acts as a custodian for customers, as it gives verifiable proof that customer funds are safe. Noncustodial crypto companies do not need to show proof of reserves, as they are not holding any customer funds.

The Bottom Line

Proof of reserves (PoR) is a step in the right direction for any crypto company, ensuring that customer funds are safe and proving (cryptographically) that the company has sufficient liquidity. As more regulation is introduced for the crypto industry, any crypto exchange or company that acts as a custodian on behalf of their customers would benefit from a proof-of-reserves audit. While the process does have some downsides (such as not tracking company liabilities), it can provide customer assurance and bolster their confidence.

Article Sources
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  1. Binance. “Our Commitment to Transparency.”

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