Blockchain technology continues making new strides in different sectors worldwide with multiple value-based improvements. However, 2022 has brought many formidable challenges for the crypto industry, impacting exchanges and traders. How is Proof of Reserves important for the future of blockchain and crypto? The bankruptcy of the FTX exchange in November 2022 invited attention to the need for improving audits. In addition, many other platforms, such as BlockFi, Hodlnaut, Celsius, and Voyager Digital, also collapsed.
Popular centralized custodians’custodians’ downfall affected users’users’ trust in these services. Most importantly, users who did not have any opportunity to derive revenue directly from the custodial services were the first ones to avoid centralized custodians. Therefore, centralized exchanges need to find effective solutions to win back users’users’ trust and avoid a mass exodus of users.
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What is Proof of Reserve?
Proof of Reserve or PoR is an essential concept in the world of blockchain and crypto right now. In traditional finance, reserves point to the assets in possession of a company. These asses could address different objectives, such as completely matching customer deposits. The answer to “What is a Proof of Reserve?” would highlight an independent audit process for verifying that the concerned party has adequate reserves for backing the balances of all its customers. In the case of crypto assets, the Proof of Reserve suggests that an auditor would check whether the on-chain assets of a company are not less than 100% of the matching customer assets during the audit.
Proof of Reserve offers assurance to customers about the capacity for solvency and liquidity of the concerned company holding their assets. Users can access the funds in their balance when they withdraw their assets. Centralized exchanges offer Proof of reserve audits for customers to help verify the state of the assets on the platform. Customers could ensure that the institution has the assets showcased in their balance and an equal or higher amount of reserves for backing their deposits.
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What Do You Find in a Proof of Reserve?
Proof of Reserve showcases a centralized institution’s ability or exchange to allow withdrawals at any time. Now, it is important to learn about Proof of Reserve, explained in detail with a description of what it includes. The Proof of Reserve for a centralized custodian includes two distinct parts such as liabilities and assets. Liabilities refer to the existing record of token deposits of customers and assets point at the pool of tokens in a collection of exchange addresses. Centralized custodians and exchanges should refrain from using user funds for other applications, implying the necessity of matching liabilities and assets.
Interestingly, the attention on Proof of Reserve blockchain networks would draw attention to methods for determining Proof of Reserve. The blockchain industry follows a trust-minimized and on-chain method for recording Proof of Reserve. In addition, the on-chain proofs are accessible by anyone and can be verified effortlessly. The exchange or centralized custodian has to provide a report of the assets in the institution’s custody. At the same time, the centralized custodian must also map the assets in custody to individual accounts, followed by storing a share of the information on the chain.
As a result, the individual users and interested 3rd parties could help verify that the company has the concerned assets in its custody. The assets in the company’s custody must also match users’ specific account balances. Most importantly, Proof of Reserves does not reveal the identity of users. Modern Proof of Reserve mechanisms helps simplify the custody verification process with one click. For example, crypto exchanges such as Kraken have already introduced the facility for obtaining Proof of Reserve reports with one click.
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Importance of Proof of Reserve
The introductory guide on Proof of Reserves crypto platforms can offer now also emphasizes the importance of Proof of Reserve. The CEO of Binance exchange pointed out an issue on FTX, one of the largest crypto trading platforms in the world. Events leading up to the issue pointed out the misuse of funds in the custody of the exchange for a long time. Users could find records of their assets in the account balance, while the assets did not exist in the custody of FTX. The withdrawal requests were on hold as the exchange could not fulfill the requests. Certain estimates suggest that the deficit between user balances and assets in the custody of FTX amounted to almost $10 billion.
The FTX collapse led to a ripple effect that affected other exchanges, with some of them found to have been using customer assets for other purposes. With the downfall of one of the biggest crypto trading platforms, the demand for better transparency increased by substantial margins. Before the introduction of Proof of Reserve blockchain platforms, crypto investors trusted centralized custodians with the safety of their crypto assets. Investors should have bothered about transparency or verification of balances in the reserves of centralized custodians. However, users’ inherent trust in centralized custodians has started dwindling, thereby calling for Proof of Reserve.
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Benefits of Proof of Reserve
The importance of Proof of Reserve explained the immediate need for transparency in the operations of centralized crypto exchanges and custodians. Interestingly, it would help if you also learned about the benefits of Proof of Reserve for users and custodians. Proof of Reserve can introduce the following benefits for users.
Proper Verification of Asset Custody
One of the foremost objectives of the Proof of Reserve concept focuses on helping customers verify assets in the centralized institutions’ custody. Investors could rely on the Proof of Reserve applications to track changes in their accounts. It can help monitor individual accounts effectively to offer a better impression of how the funds of users are managed. The Proof of Reserve algorithm can help improve clarity regarding the centralized institution’s different actions.
The facility of Due Diligence
Before setting up an account on a crypto trading platform or exchange, you should carry out due diligence. A clear overview of preliminary research regarding the institution, such as its reputation and financial dealings, can help with due diligence. You can rely on PoR as an effective tool for obtaining relevant data regarding the custody of customer assets on specific platforms. As a result, investors are less likely to lose their assets to unprecedented events due to misuse of user funds. In addition, Proof of Reserve also helps modify or withdraw investments from a custodian when investors find discrepancies in custody practices.
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Transparency of Transaction Records
The benefits of Proof of Reserves crypto exchanges offer to users would focus on the accessibility of hands-on transaction records. Proof of Reserve applications offers a transparent account of an institution’s finances. With proper mechanisms for determining Proof of Reserve, users could monitor their activities and implement informed decisions.
The advantages of Proof of Reserve also apply to custodial institutions. Here are the prominent benefits for custodial institutions with Proof of Reserve evaluation.
Regaining and Strengthening User Trust
The fall of FTX has affected users’ trust in centralized custodian platforms. Failure of big platforms like FTX has induced fear in investors’ minds regarding custodial exchanges and institutions. On the other hand, Proof of Reserve blockchain solutions could help improve centralized custodians’ transparency, thereby improving users’ trust.
Verifiable Source of Truth
The Proof of Reserve is an important tool for users to access a verifiable source of truth. Even if centralized custodians follow an accurate internal record-keeping system, errors can occur, or malicious agents can exploit vulnerabilities. On the other hand, documentation of all transactions on-chain, along with the facility for verification, can help improve custodial platforms’ scrutiny.
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Working of Proof of Reserve
The next important highlight in the introduction to “What is a Proof of Reserve?” would draw attention to its working. Custodial assets have control of users’ private keys and can use them at their will. You can obtain details of transactions with the hot and cold wallets used by centralized custodians. However, it offers an aggregated impression of the total amount of assets in the custody of the platform. The Proof of Reserves auditing process could focus on many other aspects for verifying discrepancies in account balances. Let us find out how you can conduct the audit process.
First, the auditor starts with a snapshot of the balances of the institution. Subsequently, the auditor arranges the balances by using the Merkle tree system. The custodial data of the institution are arranged in a single data tree with branches of partitions. The next step involves the identification of the data pieces with hash codes. Auditors would then derive the Merkle root, which denotes the single connection point among data pieces in the tree.
In this case, you can recognize the individual account responsible for depositing the assets with the help of unique digital signatures. Verifying individual contributors involves matching the digital signatures with Merkle tree records. The next step of signature verification involves checking whether the balances of the individual are equal to the balances visible in the Merkle tree. The Merkle tree can detect changes in individual balances through drastic modifications in the data structure. As a result, the institution could not modify user balances without detection.
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The detailed overview of the different value-based benefits of the Proof of Reserve algorithm showcases its necessity. You need to identify how Proof of Reserve is essential for returning users to centralized custodial platforms in cryptocurrencies. Most users choose centralized custodians for the secure and faster execution of crypto transactions. However, some centralized custodians have been accused of misusing users’ funds.
In the event of loss of user funds, the centralized custodian platforms could not honor withdrawal requests by users. The importance of trust is growing radically for the adoption of crypto platforms. Proof of Reserve provides an effective instrument for transparent audits of centralized custodians. Learn more about blockchain security and other audit mechanisms in detail and become a certified blockchain professional now.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!