The cryptocurrency industry was shaken by the collapse of FTX, a cryptocurrency exchange and hedge fund, and the liquidation of Three Arrows Capital, a cryptocurrency hedge fund, raising concerns about the reliability and integrity of crypto custodians.
To address these concerns, a proof-of-reserves (PoR) audit can be conducted to confirm that a custodian’s on-chain holdings match the client assets listed on their balance sheet, providing reassurance to customers that the business is financially sound and able to continue serving their needs.
What is Proof of Reserves and Why is it Important?
Proof of reserves is a cryptographic technique used by cryptocurrency exchanges and other financial institutions to prove that they hold the number of assets they claim to hold. This is important because it helps to build trust and confidence in the financial system, particularly in the case of cryptocurrency exchanges, which are not regulated by any central authority.
As I mentioned above, what is proof of reserves and why is it important, by providing proof of reserves, these institutions are able to demonstrate that they have sufficient assets to cover their liabilities and that they are not engaging in fraudulent activities such as fractional reserve banking.
Proof of reserves and why is it important, can help to protect consumers and investors from financial loss, as well as promote stability in the financial system. Proof of reserves is generally considered a best practice in the cryptocurrency industry, and many exchanges have implemented it as a way of demonstrating their financial integrity.
How Does a Proof-of-Reserves Audit Work? Detailed Guide
To get a better understanding of how a proof of reserves works, it’s helpful to first understand the auditing process. Essentially, an audit is used to evaluate the financial health of an exchange, which is determined by whether the exchange’s assets are greater than its liabilities and obligations. If this is the case, the exchange is considered solvent. If not, it is considered insolvent. However, there may be situations where this simple binary assessment is not enough, such as when an exchange needs to demonstrate that it maintains fractional reserves.
When an exchange operates with fractional reserves, only a portion of its deposits is kept readily available for withdrawal in the form of cash or other highly liquid assets. The rest of the funds are lent out to borrowers. This means that the exchange only holds a fraction of its deposits in reserve, rather than keeping the full amount on hand.
The auditing process can be broken down into the following three steps:
Proof of Liabilities
In order to determine the solvency of an exchange, it is necessary to evaluate the exchange’s liabilities or the outstanding balances that are owed to its clients. These balances can be calculated by summing up the balances in all customer accounts. To complete the solvency assessment, this total is compared to the exchange’s total reserves. The proof of liabilities component of the audit also involves calculating the hash of the fraction factor and the root of a Merkle tree.
In order to verify the exchange’s liabilities, a Merkle tree is constructed using user account information. This involves taking the cryptographic hash of each customer’s identity and using the amount owed to that customer to generate a leaf on the tree. The next level of the tree is created by pairing together the leaves and hashing them, and the process of merging and hashing nodes is repeated to create the root of the tree. This allows for a secure and efficient way to verify the exchange’s liabilities without having to individually check each customer’s balance.
Proof of Reserves
The assets that an exchange holds in the form of cryptocurrencies on the blockchain are referred to as reserves. To calculate the total assets of the exchange, the balances of all crypto addresses that the exchange controls the private keys for are summed up. This gives a complete picture of the exchange’s reserves, which can then be compared to its liabilities to determine its solvency.
To prove that it is the rightful owner of a specific crypto address, an exchange can provide the public key associated with that address and sign it with the private key. This verifies that the exchange has control over the address. For added security, the exchange can also sign a nonce, such as the hash of the most recent block added to the blockchain, along with the signature. The outputs of the proof of reserves process include the sum of the address balances and the hash of those balances. These outputs can be used to validate the ownership of the addresses and the accuracy of the balances.
To perform an audit, it is not necessary to parse the entire blockchain to determine which balances need to be included. Instead, the audit program can use a preprocessor, which is a deterministic collection of publicly available data. This allows the audit to be completed more efficiently and accurately.
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A deterministic function is one that always produces the same output when given the same input values. This is an important characteristic for any blockchain to have, as it ensures that transactions always produce the same result, regardless of who initiates them or where they are executed. This is necessary in order to achieve consensus within the blockchain network, as it is difficult to reach an agreement if the outcomes of transactions are not predictable.
Proof of Solvency
The proof of solvency for a cryptocurrency exchange consists of two components: the outputs of the audit and an attestation that can be used to confirm that the auditing software was run in a secure and trustworthy environment. Together, these two elements provide a comprehensive assessment of the exchange’s financial health and help ensure that its clients’ funds are being handled responsibly.
The final result of an audit is a binary value, either true or false. It is considered true if the exchange’s reserves are greater than its liabilities, and false otherwise. The attestation serves as a signature for the hashes of the executed program and the platform measurements, providing an additional layer of security. Consumers can verify that their account balance was included in the calculation by using the root of the Merkle tree. This allows them to have confidence in the accuracy of the audit and the exchange’s solvency.
What is a Proof of Reserve Audit in Crypto? Step by Step
A proof-of-reserves (PoR) audit is a process that verifies that a cryptocurrency custodian, such as an exchange or a hedge fund, holds the number of cryptocurrency assets that it claims to hold. This is done to provide reassurance to customers that the custodian is financially sound and able to continue conducting business with them.
Here is a step-by-step breakdown of the process:
- A custodian agrees to undergo a PoR audit and selects an independent third-party auditor to conduct the audit.
- The auditor creates a list of the custodian’s client assets and compares it to the custodian’s on-chain holdings.
- The auditor uses various tools and techniques to verify that the custodian’s on-chain holdings match the client assets listed on their balance sheet.
- The auditor compiles a report detailing their findings and any discrepancies that were found during the audit.
- The custodian reviews the report and takes any necessary corrective actions.
- The auditor publishes the report, providing transparency to the custodian’s clients and the broader cryptocurrency community.
After a proof of reserves (PoR) audit has been completed, users can verify their own transactions to ensure that they were accurately accounted for. For example, if someone has held their crypto assets on the Binance exchange, they can find their Merkle leaf and Record ID by logging in to the Binance website, clicking on the “Wallet” tab, and then selecting “Audit.” This allows them to check that their balance was properly accounted for in the audit and that their funds are secure.
Overall, a PoR audit is a way to ensure that a cryptocurrency custodian is holding the assets it claims to hold and is able to meet its financial obligations to its clients.
The Benefits of Proof-of-Reserves Audits for Cryptocurrency Exchanges
A proof-of-reserves (PoR) audit has several benefits, as it verifies that an exchange’s on-chain holdings of cryptocurrency match the balances of its users. For example, a PoR audit can be used to confirm whether tokens like Wrapped Bitcoin (wBTC) are backed by an appropriate amount of actual Bitcoin. Decentralized finance (DeFi) applications can use this information to audit the Wrapped Bitcoin reserves by obtaining data from a network of Chainlink oracles, which check the custodian’s BTC balance on the Bitcoin blockchain every 10 minutes. This helps to ensure the integrity and transparency of the DeFi ecosystem.
In addition to providing reassurance to users, proof-of-reserves audits are also appealing to regulators as a self-regulatory approach that aligns with their overall industry strategy. By addressing the lack of confidence that can result from exchanges being unable to cover consumer deposits with sufficient assets, proof-of-reserves audits can also help to increase the adoption of cryptocurrency products. This is because they provide a level of transparency and accountability that helps to build trust in the industry.
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Additionally, users can independently verify the transparency of a proof-of-reserves audit using the Merkle tree hashing method. This allows them to have confidence in the accuracy of the audit and the security of their funds. Similarly, investors can use proof-of-reserves audits as a due diligence tool to gather important information about an institution’s client asset management practices, reducing the risk of losing funds. At the same time, users may be more likely to trust custodians who are willing to undergo proof-of-reserves audits, which can help the custodians retain their clients. Overall, proof-of-reserve audits can help to promote trust and confidence in the cryptocurrency industry.
I hope now that you’re well aware of what is Proof of Reserves and why it is important. In conclusion, Proof of reserves (PoR) is a process used by cryptocurrency exchanges to verify that they have sufficient assets to cover their liabilities or the balances owed to their clients. This helps to ensure that the exchange is financially solvent and that clients’ funds are being handled responsibly. PoR audits can be conducted by third-party auditors or through self-regulation, and they involve verifying the exchange’s assets and liabilities using cryptographic methods such as Merkle tree hashing. PoR audits provide an important level of transparency and accountability in the cryptocurrency industry, helping to build trust and confidence among users and regulators. They also serve as a useful due diligence tool for investors and a means of retaining clients for custodians.
What happens if you don’t show up for reserve duty?
If you don’t show up for reserve duty, you may face disciplinary action, such as being marked as absent without leave (AWOL) or being court-martialed. Failing to fulfill your reserve duty obligations can have serious consequences for your military career.
What are the 3 types of reserves?
There are three types of proof of reserves: cryptographic proof, independent audit, and self-reported proof.
Which proof is best in crypto?
The cryptographic proof is generally considered the most reliable and transparent form of proof of reserves in the cryptocurrency industry. This is because it uses cryptographic techniques such as Merkle tree hashing to verify the accuracy of the reserve balances, providing a tamper-proof record that can be independently verified.