What Is Reserve Proof, and Can It Restore Trust?

Crypto is abuzz with talk about proof of reserves. Exchanges are clamouring for their proof of reserve in an attempt to restore investor confidence after the collapse of FTX. What is Reserve Proof, and why is it more important now than ever? Our guide to proof of reserves will teach you everything you need.

What is a Proof of reserve (Possession)?

Proof of Reserve is a way to verify that all digital assets a cryptocurrency exchange holds are backed 1:1.

The exchange can do this by publishing a report detailing the amount of cryptocurrency it holds or by proving the ownership of wallets in the public blockchains via audits or the "Merkel Tree." Exchanges usually hold the majority of user funds in cold wallets. Hot wallets are used for immediate liquidity.

Proof of reserve is an important part of the crypto world. The phrase "not your key, not your crypto" means that unless you have your private keys, the exchange may lend out your deposit to earn yield, or "rehypothecate."

What is the importance of proof of reserves?

If an exchange is experiencing a "bank run" and they don't have the funds to back up the digital assets, liquidity issues can arise. Depositors may be forced to wait a long time before getting their money back.

Proof of Reserves is a way to assure users of exchanges that their money is secure. However, it doesn't stop issues in the event of an attack or hack.

Although Proof of Reserves (PoR) is not the perfect solution, it will likely force greater transparency in the industry, as many exchanges are now moving towards displaying PoR or having their wallets reviewed by independent parties.

What is a Proof of Reserves Audit?

In a Proof of Reserves audit, all deposits are rigorously checked to determine if they belong to the exchange or if funds equal the user's deposit. Exchanges can publish the results of their Proof of Reserve audits periodically (weekly or monthly) or make them available in real-time on their websites.

The "snapshots," or audits of exchange holdings, may suffice to prove solvency for a given time. However, the ability to access Proof of Reserves in real-time is superior because any user or member of the public can verify that funds are indeed held and supervised correctly by an exchange.

Why is Proof of Reserve important?

Establishing Trust:Proof of Reserve is vital for establishing trust between cryptocurrency exchanges and their users. By providing verifiable evidence of their reserves, exchanges demonstrate their solvency and reassure users that their funds are safe.

Addressing Transparency Concerns:Transparency is a significant concern in the cryptocurrency industry, and Proof of Reserve plays a crucial role in addressing this issue. It allows exchanges to publicly demonstrate their reserve holdings, ensuring transparency and accountability.

Mitigating Fraud and Scams:Proof of Reserve helps mitigate the risk of fraud and scams in cryptocurrency exchange. By regularly verifying and publicly disclosing their reserves, exchanges can detect and prevent fraudulent activities, protecting users from potential losses.

Preventing Insolvency: The insolvency of cryptocurrency exchanges has been a concern, leading to significant user losses. Proof of Reserve ensures that exchanges maintain the necessary reserves to honour user withdrawals and trades, reducing the risk of insolvency and protecting user funds.

Building Regulatory Compliance: Proof of Reserve becomes essential with the increasing focus on regulatory compliance in the cryptocurrency industry. It aligns with regulatory guidelines and demonstrates an exchange's commitment to following legal and financial regulations.

How is a Proof of Reserve Audit Conducted?

Anonymized snapshot of all balances:The custodian provides the auditor with an anonymized snapshot of all of its balances. This means that the auditor cannot access personal information about the custodian's customers. The anonymized snapshot is typically created by hashing the balances of each customer's account.

Merkle tree:The auditor creates a Merkle tree, which is a cryptographic data structure that allows the auditor to verify the accuracy of the snapshot without having to access the underlying data. The Merkle tree is created by hashing the hashes of the balances in the snapshot. The auditor then generates a Merkle root, a cryptographic fingerprint that uniquely identifies the combination of balances in the snapshot.

Merkle root and report:The auditor publishes the Merkle root and a report that attests to the accuracy of the snapshot. The report typically includes information about the custodian, the audit date, and the audit's scope.

Verification by customers:Customers of the custodian can then verify the accuracy of the audit by downloading the Merkle root and using it to generate a verifier. The verifier allows customers to check that their balances are included in the snapshot.

Benefits of implementing Proof of Reserve

Enhanced Transparency:Proof of Reserve allows cryptocurrency exchanges to provide verifiable evidence that they possess the necessary reserves to cover customer deposits. By implementing PoR, exchanges can publicly demonstrate their solvency and how they hold the required cryptocurrency or fiat currency reserves. This transparency reassures users that their funds are safe and increases trust in the exchange.

Mitigation of Counterparty Risk:Counterparty risk, the risk of loss from the default or insolvency of a trading partner, is a significant concern in the cryptocurrency space. Proof of Reserve helps mitigate this risk by providing real-time or periodic audits of the exchange's reserves. Users can verify that the exchange possesses the funds needed to honour withdrawals and trades, reducing the likelihood of losses due to counterparty defaults.

Prevention of Fractional Reserve Practises: Fractional reserve practises, where exchanges hold only a fraction of customer funds in reserve, can be risky and lead to liquidity issues. Implementing Proof of Reserve ensures that exchanges operate on a full reserve basis, holding 100% of customer deposits at all times. This approach eliminates the potential for fractional reserve practises and reduces the likelihood of a liquidity crisis that could impact users' ability to withdraw funds.

Increased Investor Confidence: By adopting Proof of Reserve, exchanges demonstrate a commitment to transparency and accountability. This increased transparency helps build trust among investors and traders, attracting new participants to the platform. Investors are likely to choose exchanges that can prove their solvency, providing a safer environment for trading and investing in cryptocurrencies.

Regulatory Compliance: Proof of Reserve aligns with the growing regulatory requirements in the cryptocurrency industry. Governments and financial authorities increasingly focus on consumer protection and anti-money laundering measures. By implementing PoR, exchanges can showcase compliance with regulatory guidelines, demonstrating their commitment to maintaining a secure and trustworthy trading environment.

Conclusion

Proof of Reserve is of utmost importance in the cryptocurrency exchange industry as it addresses transparency concerns, establishes trust, mitigates fraud and insolvency risks, and ensures regulatory compliance. By implementing Proof of Reserve, exchanges can enhance user confidence, attract more participants to the platform, and contribute to the overall development and maturity of the cryptocurrency ecosystem. It is a crucial step towards building a secure and trustworthy cryptocurrency trading and investment environment.

Implementing Proof of Reserve in cryptocurrency exchanges offers numerous benefits for users and the overall industry. By providing enhanced transparency, mitigating counterparty risk, preventing fractional reserve practises, increasing investor confidence, and ensuring regulatory compliance, exchanges can build trust and foster a more secure ecosystem for cryptocurrency trading. Adopting Proof of Reserve will likely become a standard practise as the industry matures, promoting transparency and accountability across the cryptocurrency exchange landscape.