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.

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).

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.

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.