The Idea of Proof of Reserves
The purpose of a Proof of Reserves (PoR) is to verify that a custodian has the assets it says it does on behalf of its clients. It is an independent audit carried out by a third party. This approach enables the auditor to create a Merkle tree from an anonymized snapshot of all retained balances (a privacy-friendly data structure that encapsulates all client balances).
The auditor then gets a Merkle root, a cryptographic fingerprint that explicitly identifies the union of these balances at the moment the snapshot was made.
After that, the auditor gathers digital signatures created by the business that attest to its control over on-chain addresses with transparent balances. The auditor then confirms that these balances are more than or equal to the client balances reflected in the Merkle tree, demonstrating that the client assets are retained on a full-reserve basis.
By comparing specific bits of information with the Merkle root, any client can independently confirm that their amount was taken into account during the Proof of Reserves audit. The root will be impacted by any modifications to the other data, no matter how tiny, making any manipulation visible.
The Importance of proof of reserves
The PoR is increasingly crucial in giving an accurate picture of retained balances and aiding crypto exchanges, for example, in winning users’ trust because point-in-time attestations are susceptible to manipulation, and straightforward cash flow analysis cannot account for everything (such as unaccounted liabilities).
Proof of Reserves serves as a crucial defense against various security threats frequently seen in the cryptocurrency business, contributing to increased quality and transparency.
Audits of Proof of Reserves are advantageous to both users and custodians. The custodians gain the trust of their users, which aids in user retention, while consumers acquire a sophisticated tool to audit digital asset reserves.
PoR is also an intriguing prospect for regulators because this automated approach follows their broad strategy for the business, which is another benefit that bears addressing.
In summary, Proof of Reserves benefits the users, business community, and government.
Crypto reserves that use Proof of reserve
Several exchanges, including Chainlink, Kraken, Coinfloor, Gate.io, BitMex, HBTC, and Ledn, presently use Proof of Reserves. The Merkle technique is used by Kraken, Gate.io, and auditor-assisted user validation.
Chainlink Proof of Reserve enables the reliable and timely monitoring of reserve assets using #ProofNotPromises.
In contrast, Coinfloor, HBTC, and BitMex employ the Merkle technique, self-evaluation, and user validation.
In a recent tweet, Binance CEO Changpeng Zhao (CZ) stated that the cryptocurrency exchange would soon begin a proof of reserves program for complete transparency.
The following are the main reasons reserve proof is necessary:
1. Consumer, market, and regulator trust and transparency.
Digital assets’ market capitalization and the total number of tokens in circulation have increased dramatically since Satoshi Nakamoto’s much-discussed white paper for Bitcoin was published. Globally, it is acknowledged as a policy problem that a lack of transparency is a barrier to additional investment and innovation.
Digital assets are praised for being transparent and auditable. While these open-source blockchains offer a new level of openness, centralized parties’ databases make transfers and balances more difficult.
Confirming that a centralized party controls assets kept in a reserve is becoming more necessary. Examples of this include the following:
- A directive was released by the Office of the Comptroller of Currency (OCC) for national banks that conduct cryptocurrency payment and custody operations
- In a white paper, the European Central Bank (ECB) attempted to address the issue of regulating and managing stablecoins and evaluated reserves and stablecoins in the following scenarios:
- A different type of store of value.
- As a feature of a digital asset.
- As a new means of payment.
Regulators made previous attempts to address financial stability measures and apply regulatory norms.
Blockchain technology’s intrinsic and generic nature provides tamper-resistant, decentralized trust and authenticity of data. Most transactions and account balances for digital asset platforms, which function as centralized middlemen, are not connected to public blockchains, which is a disadvantage. Instead, these transactions are kept in these central service providers’ private databases (off-chain transactions). Co-mingled wallets are standard practice for digital asset platforms (i.e., Omnibus wallets). These mixed wallets cannot be accessed by the general public or audited. Due to the widespread use of co-mingled wallets and off-chain transactions by digital asset platforms, the idea of a publicly accessible auditable ledger and transactional data may thus encounter obstacles.
3. Fraud Prevention
Holding partial reserves or failing to disclose the loss of reserves could be prevented and clarified if the Proof of Reserve is standardized and made accessible to the public. Digital asset platforms and custodians are frequently targeted by hackers, just as centralized systems. An industry-wide consistent and standard audit procedure can help to lessen any such loss of reserves and may also be able to reveal it with a high degree of certainty.
4. Consumer Protection
In this context, the United States is used as an illustration. Each state has its own transmitter licensing process, which outlines specific consumer protection compliance criteria. State regulators typically require money service enterprises to implement specific customer protection procedures (MSB). These restrictions include but are not limited to, keeping a particular amount of capital reserves on hand and obtaining annual audited financial accounts.
An example is the New York two layers of security. It contains a law requiring licenses for money transmitters and a permit for conducting business with virtual currencies. This adjusts the rules for money transmitters to service providers for business activity using virtual currencies.