How Proof Of Reserve Works?

The phrase “Proof of Reserve” originated as a result of the failure of cryptocurrency exchange FTX. According to statements made by Changpeng Zhao, CEO of Binance, on November 9, “all crypto exchanges should do Merkle-tree proof-of-reserves. Banks run on fractional reserves, Crypto exchanges should not. Binance will start to do proof-of-reserves soon. Full transparency.”

What Is Proof-Of-Reserve?

Proof of Reserve, also known as PoR, is a verifiable auditing process that contributes to increased transparency for centrally managed cryptocurrency reserves. PoR verifies the fund reserves of a centralized platform using cryptographic proofs, checks the legitimacy of public wallet entries, and routine third-party audits. Customers can use this information to determine whether the platform is in a strong financial position and whether customer deposits can be matched. Despite the fact that PoR makes use of blockchain technology, it still relies on the accuracy of the accounting processes and the appraisal of off-chain assets.

How Proof Of Reserve Works?

Proof of reserves (PoR) is an independent audit carried out by a third party to confirm that a custodian actually holds the assets it represents to its clients as being in possession of. This auditor compiles all held balances into a Merkle tree using an anonymized snapshot of all balances.

Notably, a Merkle is a cryptographic commitment scheme in which the cryptographic hash of each “leaf,” or node, is identified. They are primarily used to check data that has been handled, sent, or stored between computers. Despite being created in 1979, the idea is still widely used in blockchain peer-to-peer networks.

The auditor then obtains a Merkle root, which is a cryptographic fingerprint used to identify the particular combination of these balances at the time the snapshot was taken.

The auditor next gathers digital signatures created by the cryptocurrency exchange that attest to who is in control of on-chain addresses with publicly accessible balances. Finally, the auditor makes a comparison and checks to see if these balances are greater than or equal to the client balances shown in the Merkle tree.

The PoR method made sense and was praised by many in the crypto community because it appeared to be a step toward a more transparent crypto ecosystem. Using transaction records and specific assets held, centralized exchanges can record each account’s liabilities. To maintain their anonymity in the public eye, they would have to publish with a tag that only their account owners know.

In general, the effects of FTX’s demise have prompted calls for more stringent regulatory control over the cryptocurrency market. While major market participants continue to provide some transparency in an effort to win back the public’s trust, experts believe that proof of reserves alone cannot be predicated upon.