Crypto Exchanges and Proof of Reserves: How It Protects Investors and Maintains Market Stability
Reading Time: 4 minutesConcerned about the safety of your investments? Discover how Proof of Reserves can provide valuable insights about your crypto exchange.
Are you looking to ensure your digital assets—held by your favorite crypto exchange—are safe and secure? The need for reliable and accountable methods of confirming the solvency of crypto exchanges is becoming increasingly important, especially as the crypto industry evolves.
Proof of reserves (PoR) appears to be the answer to this need.
What Is Proof of Reserves in Crypto?
In November 2022, FTX, a crypto exchange community giant, declared bankruptcy. This occurred shortly after customer funds were misused—FTX allegedly blended investor deposits with its trading business. Since FTX collapsed, investors have demanded different types of audits and attestations from their crypto custodians to confirm that the funds held match investors’ deposits.
Proof of reserves is an audit process confirming that an exchange’s reserves can back its customers’ balances. PoR, usually conducted by an independent third-party audit contractor, assesses the crypto exchange’s solvency.
A PoR audit can also prove that exchanges possess the assets they claim to have. And this proof would promote transparency and increase customers’ confidence in the financial institution.
PoR audits seek to prevent the misappropriation of funds, where crypto exchanges use their customers’ funds for other purposes.
How Does Proof of Reserves Work?
Crypto exchanges or companies often engage third-party auditors to conduct a PoR audit. The auditors then publish their findings, bringing investors up to speed on the financial state of their exchange.
There are different steps involved in a PoR audit.
1. Asset Verification
First, the crypto exchange submits its assets for a physical audit. Then, the auditor calculates the total balance of the assets. This balance calculation also includes liabilities, like outstanding customer withdrawal requests.
2. Cryptographic Methods
The audit contractors use cryptographic methods to prove that the institution actually owns these assets. These mathematical algorithms secure digital data and prevent unauthorized access or counterfeiting.
Common examples of cryptographic methods crypto exchanges use to verify ownership of declared assets are digital signatures, hashing, and zero-knowledge proofs, to name a few.
3. Public Ledgers
Public ledgers are one of the many ways crypto exchanges provide proof of reserves. The exchange’s transaction history and balance will be displayed on a public ledger, like a blockchain explorer. This provides even more transparency and is instrumental in building trust between the crypto exchange and its investors.
Merkle Tree Proof of Reserves
Most crypto exchanges use a Merkle tree proof of reserves to provide cryptologic proof of their assets. With the Merkle tree, blockchain transactional data is encrypted and will allow you to audit the total holdings of the exchange properly. You can even verify your transactions that contributed to the total balance.
A Merkle tree PoR functions just like other types of PoR. The first step is asset balance verification, where the exchange’s assets are calculated, including the cryptocurrency and fiat currency balance.
Hash generation—a cryptographic method—is the next step. Here, the asset data is processed through a hash function. Each hash is a unique code assigned to each data item to form leaf nodes, which are the bottom layer of the tree. Next, these hashes are paired together to form parent nodes situated one layer above the leaf nodes and are continually paired as parent nodes until a root node is formed.
A root node is the entire data set of the Merkle tree. To demonstrate PoR, the audit contractors present the root node and a set of hashes. The root node shows that the crypto exchange actually possesses the assets it claims to hold, while the set of hashes provides evidence for the specific assets owned by the exchange.
Merkle tree-based PoR can be published at regular intervals, whether weekly, monthly, or quarterly, at the exchange’s discretion. However, some exchanges provide real-time attestations online on their websites.
Advantages of Proof of Reserves for Investors and the Crypto Industry
Binance CEO Changpeng Zhao set the ball rolling for PoR by calling crypto exchanges to start publishing their Merkle tree PoR. Then, on November 25, 2022, Binance announced its first batch of PoR audits, becoming the first crypto exchange to do so.
Other crypto exchanges widely regarded as safe followed soon after, including Kraken, Coinbase, Gate.io, and Gemini.
PoR has various advantages for the exchanges and their customers. Here are some of these merits:
1. Transparency
PoR allows crypto exchanges to publish their assets in a verifiable and transparent manner. As a result, customers can confirm that their crypto exchange actually holds their digital assets. This way, trading platforms foster a trusting relationship with their customers.
2. Reduces Risk of Insolvency
PoR shows the customers that their exchange has enough to meet their withdrawal requests. In this way, PoR helps reduce the risk of insolvency, which can happen when most exchange customers try to withdraw all their funds due to uncertainties.
3. Risk Management
PoR helps crypto exchanges identify potential risk factors by providing a rundown of all assets and holdings. This information allows exchanges to manage risks and respond better to other preconceived threats.
Limitations of Proof of Reserves
The major limitation of proof of reserves is that customers do not know their exchange’s true solvency risk. Crypto exchanges typically provide a snapshot of their assets. However, this snapshot does not detail the company’s liabilities or corporate holdings. So while the whole process might appear transparent, customers are still in the dark regarding the real risk of the exchange’s insolvency.
In addition, while publishing PoR is laudable, note that past performances are not a guarantee for future success. PoR audits usually offer investors a false sense of security that could be misleading, especially in periods of high market volatility.
Keep Close Tabs on Your Crypto Exchange Despite Proof of Reserves
The purpose of proof of reserves is to hinder crypto exchanges from running fractional reserves—the exchanges’ profit by using their customers’ deposits as loans. Several trusted, popular exchanges publish their PoR audits to assure investors of the safety and stability of their assets.
While this process promotes transparency, it doesn’t tell the whole story. Therefore, you should closely monitor the activities of your chosen crypto guardian to avoid falling victim to the false sense of security that PoR can bring.
Reference: https://www.makeuseof.com/crypto-exchanges-and-proof-of-reserves/
Ref: makeuseof
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